Andrea S. Rattner and Myron D. Rumeld are partners and Russell L. Hirschhorn is an associate in Proskauer Rose LLP’s Employee Benefits and Executive Compensation Law Group. Rattner focuses on the design and legal aspects of all types of benefit and compensation plans and arrangements; Rumeld and Hirschhorn focus on ERISA litigation relating to all types of benefit plans.

During the past two decades, many companies have begun offering their employees retirement benefits through a cash balance or other hybrid-type plan formula rather than a traditional defined benefit plan formula, such as a final average pay plan or career average pay plan. Although these plans have become increasingly popular, they have been subject to legal challenge and uncertainty in recent years for many reasons, including:

(i) the Internal Revenue Service’s (“IRS”) moratorium on issuing determination letters on cash balance plans since September 1999;

(ii) the failure of the U.S. Department of Treasury and IRS to issue concrete guidance of the requirements to maintain these plans;¹ and

(iii) a district court decision in 2003, Cooper v. IBM Personal Pension Plan,² which concluded that cash balance plans are age discriminatory.

In addition, the plaintiffs’ bar has been vigilant in its attack on cash balance plans asserting a variety of other claims, such as accrued benefit and disclosure-related claims.³

As a result of two recent significant developments that affect cash balance and other hybrid pension plans, however, plan sponsors and fiduciaries are breathing a sigh of relief. First, on Aug. 17, 2006, the President signed the Pension Protection Act of 2006⁴ (the “Act”), which affirms the legitimacy of these plans on a prospective basis if certain new requirements are met. Second, in a long-awaited decision, the U.S. Court of Appeals for the Seventh Circuit issued its decision in Cooper v. IBM Personal Pension Plan, ---- F.3d. ----, 38 EBC 1801 (8/25/06) (7th Cir. Aug. 7, 2006), ruling that cash balance plans do not violate the prohibitions against age discrimination under the Employee Retirement Income Security Act of 1974, as amended (“ERISA”).

Although these recent developments certainly “tip the balance” in favor of cash balance plan sponsors, they do not resolve all legal issues pertaining to these plans. The Act’s new requirements, in fact, leave a number of questions unanswered, some of which are expected to be addressed by Treasury regulations. In addition, although the Act addresses the rate of benefit accrual claims (discussed below) on a going-forward basis, cash balance and other hybrid plans in existence prior to the Act’s effective date remain subject to these claims outside the Seventh Circuit.

This article discusses the cash balance provisions of the Act and the Cooper decision as well as the possible implications for plan sponsors and fiduciaries.

Hybrid Plans Generally.

Cash balance and other hybrid pension plans are defined benefit pension plans that contain features of both defined benefit plans and defined contribution plans. Many employers have adopted these plans (or converted traditional defined benefit plans into hybrid plans) in order to provide employees with a specified retirement benefit at normal retirement age in an easy-to-understand manner.

Under a cash balance plan, a hypothetical account is established in each participant’s name. Each participant is credited with an employer’s hypothetical contributions (compensation credits) and hypothetical earnings (interest credits). Compensation credits are usually expressed as a percentage of pay, which may be tied to age and years of service. Interest credits may be at a fixed interest rate, or tied to an extrinsic index. Although compensation credits cease when a participant terminates employment, interest credits continue until the date the pension benefit is distributed to the participant.

Other hybrid plans such as pension equity plans (commonly referred to as “PEPs”) provide a benefit that equals a percentage of final average pay, with the percentage based on points earned by the participant each year. Many of the issues raised with cash balance plans (particularly, age discrimination claims) have been raised with PEPs and other hybrid plans.

Under ERISA and the Internal Revenue Code of 1986, as amended (the “Code”), benefits paid from cash balance plans (and other defined benefit plans) must be paid as a life annuity commencing at normal retirement age unless the plan permits benefits to be paid in other forms, such as a lump sum.⁵ If a cash balance plan permits benefits to be paid as a lump sum, the plan must calculate a participant’s hypothetical account balance at normal retirement age (using the plan’s interest credit rate) and then discount that benefit to its present value at the date of distribution (using the statutory interest rate).

Issues Covered By the Act and Cooper.

The Act addresses on a prospective basis several issues pertaining to cash balance and other hybrid plans, including, without limitation: (i) the rate of benefit accrual; (ii) an interest requirement; (iii) conversions; (iv) elimination of the “whipsaw” effect; (v) vesting; and (vi) mergers and acquisitions.⁶ The Cooper decision, discussed below, only addresses the first of these issues.

Rate of Benefit Accrual.

Since 1986, the Code, ERISA and the Age Discrimination In Employment Act (“ADEA”) have contained parallel provisions prohibiting age discrimination in benefit accruals under a defined benefit pension plan by providing that “the rate of an employee’s benefit accrual may not be reduced, because of the attainment of any age.”⁷ The plaintiffs’ bar contends that cash balance plans violate these statutes even though compensation credits earned by older employees will be equal to or greater than the compensation credits earned by younger employees, because younger employees’ compensation credits may grow to a larger sum at retirement age due to the additional time in which interest credits accrue.

In fact, dozens of lawsuits have been filed against plan sponsors and fiduciaries nationally asserting this claim as a result of the district court decision in Cooper,⁸ wherein the court concluded that IBM’s cash balance plan was age discriminatory because the projected benefit (at normal retirement age) earned in earlier years by younger people is greater than for older people in light of the accrual from the continued crediting of interest. If universally followed, it would have undermined the legality of all cash balance plans, not just the one sponsored by IBM.

Fortunately for plan sponsors and fiduciaries, the Seventh Circuit reversed the district court’s decision in Cooper and held that merely because a younger person has more time to accrue interest before normal retirement age (all other things being equal), a cash balance plan formula should not be treated as age discriminatory. In so holding, the Court reasoned that the age discrimination provisions for defined contribution and defined benefit plans (as applied to cash balance plans) both essentially make reference to the “contributions” to a participant’s account as opposed to the benefit payable from a participant’s account. Further, the Court observed that there is nothing in the legislative history to suggest that Congress set out to prohibit plans from providing younger workers, who have statistically more time left before retirement, with the opportunity to earn more interest than older workers.

The Act now makes it clear that hybrid plans will not be treated on a going-forward basis as violating the age discrimination provisions under the Code, ERISA and ADEA if a participant’s “accrued benefit,”⁹ determined as of any date, would be equal to or greater than that of any similarly situated (i.e., identical in every respect except for age) younger individual who is or could be a participant.¹⁰ The Act gives examples of what it means to be identical “in every respect” and includes “period of service, compensation, position, date of hire, work history, and any other respect except for age.” To achieve this result, these statutes provide that in determining whether a plan is age discriminatory, benefits may be calculated in ways other than as an accrued benefit (i.e., an annuity payable at age normal retirement age), such as by using the balance of a hypothetical account or the current value of the accumulated percentage of the participant’s final average compensation.

Interest Requirement.

The Act further provides that in order to satisfy the benefit accrual rules, the interest credit under a cash balance or other hybrid plan cannot be at a rate that is greater than a market rate of return. A plan is permitted to provide for a reasonable minimum guaranteed rate of return or for a rate of return that is equal to the greater of a fixed or variable rate of return. Interest credits of less than zero cannot result in a participant’s account dropping below the aggregate amount of contributions credited to the account.

There are a number of open questions regarding what constitutes a “market rate of return,” the method of crediting interest and the method for crediting negative returns without reducing the aggregate amount of contributions credited to an account. The Act permits Treasury to issue regulations that will provide rules governing the calculation of a market rate of return and regarding permissible methods of crediting interest.

Special rules concerning the interest rates and mortality tables apply upon a plan termination. Among other things, these rules require the averaging of interest rates over a five-year period ending on the termination date in the case of a plan that uses a variable rate.

Conversions.

As part of the conversion from a traditional defined benefit plan to a hybrid plan, some plan sponsors set participants’ opening hypothetical account balances below their accrued benefit. The net result is that participants will fail to accrue an increase in benefits until their hypothetical account balance and subsequent accruals exceed their former accrued benefits--that is, the difference “wears away” over a period of time. Although the terms of the plan in these cases provide that a participant would never receive less than the accrued benefit in effect immediately before the conversion, the plaintiffs’ bar has argued in several cases that this practice violates the Code and ERISA’s prohibition on decreasing a participant’s “accrued benefit.”

The Act effectively prohibits new hybrid plans from instituting a wear-away insofar as it requires that in a conversion to a cash balance plan, the minimum benefit provided cannot be less than a participant’s benefit prior to the conversion plus the benefit earned after the conversion. In calculating the minimum benefit under the converted plan, early retirement benefits and retirement-type subsidies relating to pre-conversion service must be included if the participant has met the requirements for entitlement to such benefit or subsidy. The Act also calls for Treasury to issue regulations designed to prevent plan sponsors from indirectly implementing wear-away provisions through multiple plans or amendments.

Whipsaw.

As discussed above, if a plan permits benefits to be paid in a lump sum, the plan must calculate a participant’s hypothetical account balance at normal retirement age and then discount that benefit to its present value at the date of distribution. If the interest rate that applies under the plan is higher than the rate that is used to discount the participant’s benefit back to present value (set by the Code), distribution of the amount in the participant’s hypothetical account balance causes an impermissible forfeiture under ERISA. This phenomenon is known as “whipsaw.” To avoid whipsaw, many plans set the interest crediting rate at the rate equal to or higher than the present value rate, the latter of which causes the distribution of a lump sum to exceed the participant’s hypothetical account balance and creates an anomalous result.

Under the Act, the whipsaw problem has been eliminated, so that a hybrid plan may pay out a participant’s account balance in a lump sum provided that the plan uses a market rate of interest, as described above. The Act also permits a plan to use a reasonable minimum interest rate without incurring a whipsaw problem.

Vesting Requirement.

Under the Act, the cash balance or other hybrid pension plan must provide for three year vesting with respect to the participant’s accrued benefit derived from employer contributions.

Mergers and Acquisitions.

No later than twelve months after the Act’s enactment, Treasury is directed to issue regulations addressing the application of these rules to cash balance and other hybrid plan conversions covering employees who become employees by reason of a merger, acquisition or similar transaction.

Effective Dates.

In general, the provisions under the Act are effective on and after June 29, 2005, although the provision relating to minimum value and the directive to issue regulations relating to mergers and acquisitions are effective on the date of the Act’s enactment. The interest credit and vesting rules for existing plans generally apply to years beginning after 2007, although an employer may elect to have the rules apply to any period after June 29, 2005. Additional delays may apply for collectively bargained plans.

The Act expressly provides that nothing in it should be construed to infer the treatment of hybrid plans or conversions to such plans under the rules prohibiting age discrimination as in effect before the Act is effective. In addition, no inference is to be drawn with respect to the application of the minimum benefit rules to hybrid plans before the provision is effective.

Implications for Plan Sponsors and Fiduciaries.

With the passing of the Pension Protection Act of 2006, Congress has finally affirmed the legitimacy and the legality of cash balance and other hybrid plans and has provided plan sponsors and fiduciaries with a level of comfort that these plans may be created and maintained in the future. Further, the Seventh Circuit’s decision in Cooper provides an additional layer of comfort for those plan sponsors that had converted their plans to a cash plan or other hybrid plan prior to the Act’s effective date. Although the Cooper decision is not binding on any court outside the Seventh Circuit, combined with the passage of the Act, it certainly “tips the balance” in favor of concluding that cash balance and other hybrid plans are not age discriminatory. It is by no means guaranteed, however, that such claims will not continue with respect to plans in existence prior to Act’s effective date. In fact, both age claims discussed above are on appeal to the Third and Ninth Circuit Courts of Appeal¹¹ where the issues will be addressed with respect to cash balance plans in existence before the effective date of the Act.

Further, as the IRS has not issued any determination letters for cash balance plans since its moratorium beginning in September 1999, it is not entirely clear when and under what circumstances the IRS will review submissions for favorable determination letters and issue such letters.

What is clear is that additional guidance is necessary and will likely follow with respect to certain aspects of the Act (but not necessarily all). In the interim, plan sponsors and fiduciaries should continue to monitor case law developments and begin to review their existing cash balance and other hybrid plans as well as any conversions to these plans in light of the changes under the Act.

¹ In June 2004, Treasury withdrew its proposed cash balance regulations in order to provide Congress with an opportunity to review and consider a legislative proposal on cash balance plans. See Prop. Treas. Reg. §1.411(b).

² Cooper v. IBM Personal Pension Plan, 274 F. Supp. 2d 1010, 30 EBC 2571 (S.D. Ill. 2003).

³ See, e.g., Cooper v. IBM Personal Pension Plan, No. 05 Civ. 3588, 2006 U.S. App. LEXIS 20128, 38 EBC 1801 (8/25/06), 151 PBD, 8/8/06 (7th Cir. Aug. 7, 2006); Campbell v. BankBoston, 327 F.3d 1, 30 EBC 1001 (1st Cir. 2003) (questioning the validity of legal challenges to cash balance plans under ERISA §204(b)(1)(H)); Hirt v. The Equitable Retirement Plan for Employees, Managers and Agents, No. 01 Civ. 7920, 2006 U.S. Dist. LEXIS 49145, 140 PBD, 7/24/06 (S.D.N.Y. July 20, 2006); Richards v. FleetBoston Fin. Corp., 427 F. Supp. 2d 150, 37 EBC 1449 (D. Conn. 2006); Register v. PNC Fin. Servs. Group, Inc., No. 04 Civ. 6097, 2005 U.S. Dist. LEXIS 29678, 36 EBC 1321 (E.D. Pa. Nov. 21, 2005), appeal pending, 06 Civ. 5445 (3d Cir.); Wells v. Gannet Retirement Plan, 385 F. Supp. 2d 1101 (D. Colo. 2005); Tootle v. ARINC, Inc., 222 F.R.D. 88, 93, 32 EBC 2665 (D. Md. 2004); Engers v. AT&T Corp., No. 98 Civ. 3660, 2001 U.S. Dist. LEXIS 25885 (D.N.J. June 6, 2001); Eaton v. Onan Corp., 117 F. Supp. 2d 812, 191 PBD, 10/2/00 (S.D. Ind. 2000).

⁴ Pub. L. No. 109-280.

⁵ Code §§411(a), 417(e).

⁶ Sections 701 and 702 of the Act.

⁷ 29 U.S.C. §1054(b)(1)(H)(i); 26 U.S.C. §411(b)(1)(H); 29 U.S.C. §623(i).

⁸ See, e.g., supra at n.5.

⁹ A participant’s accrued benefit will not be age discriminatory under the Act solely because a cash balance plan provides for: (i) offsets generally permitted under tax-qualified plans; (ii) permitted disparity (i.e., Social Security integration of contributions and benefits); and (iii) periodic adjustment of the accrued benefit by means of the application of a recognized investment index and methodology. Further, in determining a participant’s “accrued benefit” as of any date for purposes of this requirement, the subsidized portion of any early retirement benefit or retirement-type subsidy is disregarded. For older participants who ultimately receive subsidized benefits, this approach may result in an unintended windfall to them. As a result, this provision may have the perverse effect of discouraging employers from adopting early retirement enhancements in their cash balance plans.

¹⁰ Section 701(a)(1), 701(b)(1) and 701(c)(1) of the Act (amending ERISA §204(b), Code § 411(b), and ADEA § 4(i), respectively).

¹¹ See Register v. PNC Fin. Servs. Group, Inc., No. 04 Civ. 6097, 2005 U.S. Dist. LEXIS 29678, 36 EBC 1321 (E.D. Pa. Nov. 21, 2005); Hurlic v. S. Ca. Gas Co., No. 05 Civ. 5027 (C.D. Cal. Oct. 18, 2005).