Pension Equity Plans

October 20, 2003

Any idea of where I can find an example of a pension equity plan?

Thank you

mbozek · October 20, 2003

See Cooper v. IBM, 2003 WL 21767853 S.D. Ill Jul 31, 2003 for court decision on how Pep plan formula results in age discrimination.

GBurns · October 20, 2003

A search on Google will give you lots of sources of information on PEP Plans.

E as in ERISA · October 20, 2003

I'm oversimplifying it here....but this might help a little. A pension equity plan is a hybrid plan like a cash balance plan. But where the cash balance plan describes what the hypothetical contribution and earnings rate are, the pension equity plan describes the balance or potential lump sum that a person should have.

Mike Preston · October 21, 2003

I think the basic definition of a Pension Equity Plan is that a participant's benefit (account balance) is determined with reference to a formula that is multiplied by their compensatioin earned since inception (or, at least, since some date in the past). A typical formula might be 7.5% of pay. Hence, if an individual makes $40,000 in 2003, has worked for 10 years, and has never received a raise, they would have $400,000 in compensation and their PEP "benefit" would be a lump sum of $30,000. If that person started employment with $22,000 of compensation in the first year, and $40,000 in the last year, increasing $2,000 per year, then their total compensation over that 10 year period would be $300,000 and they would then have an account balance of $22,500.

As you can see, this is something like a cash balance plan without any interest adjustment (I know that is definitely oversimplifying).

PEP plans are not typically provided by non-governmentals as it is almost impossible to meet the Internal Revenue Code 411 accrual rules in a "pure" PEP.

At least, that is my understanding.

October 21, 2003

Actually, a large number of Fortune 500 companies sponsor PEPs. See the IBM case mentioned above. There are good arguments they satisfy the various qualification rules but there is no firm guidance on this at this time.

GBurns · October 21, 2003

Actually IBM does not sponsor a PEP Plan. In 1995 IBM converted their Plan to a PEP then later in 1999 converted to a Cash Balance Plan. See the IBM case transcript etc.

Very few Fortune 500 companies use a PEP version.

Mike Preston · October 21, 2003

Your definition of good and my definition of good are different. With a non-increasing percentage formula, only a tortured interpretation of the longstanding rules applicable under 411 can possibly enable a PEP to survive. If a CB plan has a problem with measuring accruals against annuities, and it does, a PEP has that issue in spades. As already mentioned it is most closely described as a CB plan without future interest adjustments, something that even most CB plan diehards admit is necessary in order to not violate 411 and 417.

It may very well be that the political reality forces the defined contribution rules into play when measuring compliance with respect to hybrid plans, rather than the defined benefit plan rules. Such a result might be politically necessary, and would therefore "prove" those who advocated them to have been "right." But, IMO, it is symptomatic of why our entire pension system is viewed with such distrust by those who do not understand all of the intertwining issues.

[/rant]

Once upon a time, if a plan sponsor had a concern about a particular plan provision, conventional wisdom was to submit an LOD application to the IRS and see whether the concept could be approved. Then, somebody at the IRS developed the concept of "infinite hold" whenever there were issues that they either didn't want to deal with or couldn't deal with. This put practitioners in a tough spot. Either stop innovation or risk a position that might ultimately be held to violate one rule or another. In our competitive society there was no choice. As things diverged from the old "once upon a time" paradigm, the IRS saw their comments made at conferences as to the advisability of various designs given less and less credibility when applied to newly developed concepts. This emboldened certain practitioners. The result is a system where inertia has allowed such concepts as CB plans (and, you say) PEP's to flourish notwithstanding the apparent lack of guidance. Great risk was therefore assumed by those who jumped on these bandwagons. I wonder how many were fully informed of the positions taken without clear guidance? All of those positions taken on the basis of "good" arguments, no doubt. The fault in this scenario, if there is one to be had, was the IRS' decision to "mothball" those things that they felt couldn't be dealt with. I'm sure there were some that thought they were doing the right thing by not rushing to judgment. A cynic would have you believe that they thought they could accomplish by inaction that which they couldn't by forthrightly dealing with the issues. The undermining of the system was predictable.

What we need now is an arm of the government that can and will work with the private sector to provide for clarity. A pipe dream? Probably.

[/rant]

Blinky the 3-eyed Fish · October 21, 2003

Mike, your rant still does not hold a candle to Scorpionpenn's. I recommend you season yourself with some vitriol, bile and perhaps a bit of senility to become champion.

david rigby · October 21, 2003

BTW, a PEP could be designed (I think) with reference to final average comp, rather than total comp as described in Mike's post of 10/20/03.

October 21, 2003

"With a non-increasing percentage formula, only a tortured interpretation of the longstanding rules applicable under 411 can possibly enable a PEP to survive."

Please specify which provisions of section 411 you believe would be violated and I will put forth my "good" argument.

October 21, 2003

GBurns -

I said a large number of Fortune 500 companies sponsor PEPs. You said very few do. Perhaps a "large number" was a bad choice of words. I would say a "statitistically significant" number of Fortune 500 companies sponsor PEPs. I am very familiar with the large employer universe and I believe this is a true statement.

Finally, every PEP plan I've seen is a final average pay plan. In a sense, pay increases take the place of interest credits in a cash balance plan.

Mike Preston · October 21, 2003

What if pay doesn't increase? Doesn't the design of the plan have to satisfy the accrual rules 1.411(b)-1? Care to demonstrate how it complies with any of the three rules? Use two employees, both entering at age 21. One with no compensation increases. The other with a 5% salary increase per year. What if compensation decreases? Is it a final pay plan? Or a high x-year pay plan?

david rigby · October 21, 2003

Do you make that determination with reference to individual results, or to the underlying plan fomula?

GBurns · October 21, 2003

I have to presume that the people at Hewitt and the lawyers, actuaries and other pension professionals who testified and provided evidence in the IBM, Xerox and other cases have as much large plan experience and familiarity as any of us, regardless of what Harry O, might think.

This is a link to a Hewitt report. Notice that a differentiation is made between PEP. Cash Balance AND OTHER hybrids. In other words they are not the same things. The same differentiation is made in the IBM case and dates are given for each change. A change would also mean that there is a difference between the types of plans beyond the change of name. the fact that a plan "is a final average pay plan" does not necessarily make it a PEP plan.

http://was4.hewitt.com/hewitt/resource/leg...crimination.htm

By the way, the Hewitt report states 25 - 30% of Fortune 500 have converted to these hybrids. PEP plans being one of these hybrids would therefore have a portion of this 25-30%. Considering that there is public information that the majority were Cash Balance, who went PEP changed to Cash Balance, it seems that PEP plans would have a small portion of 25-30% not taking into account those that changed back to traditional. How many are still PEP and whether it is statistically significant, I do not know.

Mike Preston · October 21, 2003

"....and that ERISA age discrimination prohibitions apply only to participants who attain normal retirement age".

http://was4.hewitt.com/hewitt/resource/leg...quity_plans.pdf

See page 4

Yes, I call that one of the tortured conclusions.

WDIK · October 21, 2003

STATISTICALLY SIGNIFICANT

Definition: Describes a mathematical measure of difference between groups. The difference is said to be statistically significant if it is greater than what might be expected to happen by chance alone.

I don't think that "statistically significant" is the proper choice of words either.

October 22, 2003

Mike Preston -

That is actually one problem a pension equity plan does NOT have. The accrual rules your refer to are the anti-backloading rules designed to prevent late career INCREASES in pension accruals. Pension equity plans and cash balance plans typically have DECREASING accruals -- that is why they are in hot water.

Most PEPs easily satisfy the 133% rule. For arguments sake, lets assume we have to test the age 65 annuity. The amount of annuity purchased each year decreases (much like a cash balance plan) because the employee is one year closer to age 65. The rate of benefit accrual therefore satisfies the 133% rule -- the rate of benefit accrual in a subsequent year is never more than 133% of any prior year. No problemo. You get into backloading problems when you have a formula that is graded for age and service but all but the most steeply graded formulas should pass.

The "soft underbelly" of pension equity plans is the same issue that tripped up IBM -- some would say that the rate of accrual decreases on account of increasing age and service (see above) and that, if not monitored by the employer, the actual accrued benefit can decrease (see discussion in IBM case where court ruled against IBM on this issue even though no one could identify any employee that this actually happened to). There are good arguments against these positions -- which, by the way, were accepted by two federal district courts in Onan and AT&T.

Bottom line is that the accrual rules of 411(b)-1 are the least of PEP's problems.

Mike Preston · October 22, 2003

411 has rules in addition to the "basic" anti-backloading rules. Remind me again what happens in the case of an individual that doesn't have a large increase in compensation? Let's take the example of a 64 year old that has participated in the plan since age 25. Let's assume that compensation through age 64 is 1885031 ($25,000 initial compensation, 3% salary scale) and the PEP benefit is 7.5%, or $141,377.33. Let's assume GAR94 and the annual rate for 2003, of 4.92%. This is an annuity purchase rate of 142.49185 at age 65. The $141,377.33 at age 64 is $148,333.09 at age 65 (maybe more if we increase for mortality - for simplification purposes, I won't), which is a retirement benefit of $1041. Now, what happens between ages 64 and 65? We have to assume that compensation stays level, I think, so $79,175.67 * 0.075 is added to the lump sum, which yields $147,315.51. A smaller amount that what was started with. How does this satisfy 1.411(b)-1©(3)?

I am reminded of a discussion I once had with Ira Cohen on this issue. We were talking about grandfathering of benefits payable under a defined benefit plan. Maybe he has changed his mind since the mid-80's. Then again, maybe not.

But in the valuation software I use, the plan's benefit accrued at normal retirement, payable in the normal form, is not allowed to decrease as a participant increases his "age or years of service."

As I think I said during my rant, those who wish to apply DC type rules to the hybrid plans are guilty of tortured reasoning. They are ignoring 414(j) to begin with, or they are ignoring one or more rules of 411.

Note that I'm not disagreeing with Onan. Age discrimination might very well be measured on the basis of DC concepts and therefore such a design might not be age discriminatory. However, with that said, I must admit that the fine line difference between "rate of benefit accrual" and "accrued benefit" is difficult to fathom without a bit of stretching (from Cooper v IBM):

"Defendants argue that § 204(b)(1)(H)’s phrase “rate of benefit accrual”

should not be expressed in the form of an age 65 benefit and that the term benefit accrual means something different than the term accrued benefit."

Again, this ignores the plain application of 411, which is all I was addressing.

Thanks for indulging me in this discussion as I admit that I don't sheppard any cash balance or PEP plans personally, because every Plan Sponsor I have talked to about the issues isn't willing to bear that particular risk. In the end, the political reality might be that it is impossible for the court system, or Congress, to ignore the steamroller.

October 22, 2003

Lets read the regulation in question slowly -- ". . . a defined benefit plan shall not be treated as satisfying the [accrual] requirements . . . if the participant's accrued benefit is REDUCED on account of any increase in his age or years of service." Your example gives a common illustration where this might happen -- a long service employee with flat pay. This is avoided by simply protecting the higher accrued benefit at any earlier age. In your example, if the age 64 accrued benefit was higher than the age 65 benefit, the employee is paid the higher age 64 benefit when he retires. Its that simple. Thus, there is no REDUCTION in the employee's accrued benefit.

Well-drafted PEP plans have this protection spelled out in the document and well-administered PEP plans have this safeguard built into the system. This issue was discussed in the IBM case and the court ruled against IBM even though the plaintiffs could show no employee who suffered such a reduction.

Again, the make or break issue for PEP plans is section 411(b)(1)(H) -- the rate of accrual issue.

P.S. You scoffed at the notion that the ERISA age discrimination requirements only apply after normal retirement age. Please read the Code -- the heading to section 411(b)(1)(H) says "Continued Accrual BEYOND NORMAL RETIREMENT AGE" (emphasis added).

mbozek · October 22, 2003

There are two separate prohibitions against age discrimination in ERISA: IRC 411(b)(1)(G) which was part of ERISA, prevents a reduction of the accrued benefit on account of any increase in age. Since the accrued benefit is the benefit payable at normal retirement age which was 65 (IRC 411(a)(7)), the benefit formula cannot reduce the annuity payable at NRA on account of an increase in age. IRC 411(b)(1)(H) applies to benefit accrual after NRA. (b)(1)(H) was added in 1986 when Congress protected employees over age 70 from age discrimination and eliminated the option to exclude employees hired within 5 years of NRA e.g. 60, from participation in a DB plan. According to the IBM court both provisions apply to benefit accrual in a DB plan.

Mike Preston · October 22, 2003

If every time a requirement is identified, the underlying formula(s) is(are) changed to accomodate the issue, I agree with you that the requirement is satisfied. No mention was made of the safeguards until your last message.

No description I've ever read of a PEP or a CB plan has included the safeguard you mention. Glad to know that they are there. In some plans, at least.

GBurns · October 22, 2003

One of the reasons that some discussions seem to go in circles etc etc is a difference in the definitions used etc.

HarryO,

You posted,

"Well-drafted PEP plans have this protection spelled out in the document and well-administered PEP plans have this safeguard built into the system. This issue was discussed in the IBM case and the court ruled against IBM even though the plaintiffs could show no employee who suffered such a reduction."

The problem with your post and logic is that I cannot find where the court ruled against IBM regarding a PEP Plan NOR where it was even discussed. The ruling and discussions were against the IBM Cash Balance Plan which was adopted in 1999 to replace the PEP Plan.

October 23, 2003

GBurns -

!!!

About two-thirds of the opinion focused on IBM's pension equity plan! See the discussion of the "Pension Credit Formula" or "PCF". That was IBM's pension equity plan until July 1999 when they adopted a cash balance plan.

GBurns · October 23, 2003

Harry O

So that brings us back to the point raised in your post of August 21 in which you claimed that a large number of Fortune 500 companies sponsor PEP Plans and in which you also claimed that IBM does. I pointed out that this was not so and you argued.

As per your posts, the article, the discussion and the case, IBM USED TO sponsor, in other words they do not any longer sponsor a PEP Plan, it was converted years ago. As I pointed out this seems also true of most of those who HAD a PEP Plan. As a result very few Fortune 500 companies have a PEP Plan in 2003 and few ever had.

October 23, 2003

GBurns -

Where in my post of August 21 (sic) (actually October 21) did I say that IBM *currently* sponsors a PEP?

I'm not sure where you get your information that many large PEP sponsors have "converted" out of pension equity plans. What are you basing this on -- Professional experience? Surmise? Your careful reading of the IBM case?

I would hardly view conversion of a PEP to a cash balance plan as a flight to safety! Moreover, just about no one converts from a hybrid plan back to a traditional plan these days!

GBurns · October 24, 2003

That should have been October 21 where you posted "Actually, a large number of Fortune 500 companies sponsor PEPs. See the IBM case mentioned above." Your post is in the present tense meaning currently. Sponsor not sponsored and yoy cied an example namely, IBM.

As for the number of sponsors who have converted, that can be extrapolated from many of the reports such as the Hewitt report and exampled by IBM who "converted" in 1999.

No one has said that anything about converting back to traditional and no one has said anything about any flight to safety etc.

October 24, 2003

GBurns -

Lets agree to disagree!

david rigby · October 24, 2003

Finally an end to one of the longest, and silliest, pi**ing contests yet seen on these Message Boards!

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