First, a warning.
If your eyes glaze over at discussing the difference between cash balance plans and defined benefit plans, this post is not for you. However, for those employers who are considering converting their retirement plans or who have done so, a new case released this morning provides some much-needed guidance in Connecticut about the legality of doing so, with a well-reasoned opinion to boot. It also provides a bit of a primer to people who’ve heard "something" about retirement plans, but have been curious about what the big deal was with converting from traditional pension plans to newer reitrement plans.
In Custer v. SNET (download here), federal judge Stefan Underhill has upheld SNET’s conversion to a cash benefit plan from 1995. In doing so, he methodically deconstructs the Plaintiff’s arguments (while still acknowledging that this area of law is developing). His discussion on the background on the case — for those who need a bit of re-education in the area — is particularly instructive.
First, he discusses the two types of retirement plans.
ERISA’s statutory structure contemplates two types of retirement plans; defined contribution plans and defined benefit plans. 29 U.S.C. §1002(34) – (35). A defined contribution plan is “a pension plan which provide[s] for an individual account for each participant and for benefits based solely upon the amount contributed to the participant’s account, and any income, expenses, gains and losses, and any forfeitures of accounts of other participants which may be allocated to such participant’s account.” 29 U.S.C. § 1002(34). By contrast, “a defined benefit plan is any retirement plan that is not a defined contribution plan.” Id. (citing 29 U.S.C. § 1002(35)). A typical defined benefit plan grants retirees a percentage of their final salary for the remainder of their lives.
Cash balance plans generally share certain attributes with both defined contribution plans and defined benefit plans. Like a traditional defined contribution plan, participants in a cash balance plan accrue benefits in an “account.” Unlike a traditional defined contribution plan, however, a participant’s account in a cash balance plan is not “real;” it is a mathematical construct to determine the size of a plan participant’s lifetime annuity that the employer will pay out when the participant retires. The account is not capitalized in the sense that neither the participant, nor the employer, is actually setting aside money. Instead, the employer is simply accruing an obligation to pay out benefits at a future date.
So, what did SNET do? On July 1, 1995, SNET converted its defined benefit plan to a cash balance plan.
Under SNET’s cash balance plan, each participant’s cash balance account is comprised of three parts: the opening account balance; accrued service credits; and accrued interest credits.The opening balance is generally based on the participants’ benefits under the old plan as of July 1, 1995. Participants then earn service credits at the end of each month based upon their level of pay and years of service.
Finally, participants earn interest credits annually based upon fixed negotiated percentages. … [Central to this argument is that] if a younger participant remains employed through retirement age, he will thus accrue more total interest per service credit than similarly situated older workers. …
Perhaps as an incentive to take early retirement, as part of the switching to the new plan, SNET front-loaded some retirement benefits. … As a practical matter, participants thus receive 110 percent of their benefits under the old plan until the value of the cash account under the new plan catches up to and exceeds their permanent enhanced benefit.
The parties, and other courts, refer to the catch-up period as the “wear-away” period because, plaintiffs argue, the benefits that participants can receive but will not increase during that period. The period is more aptly named a “catch-up” period, however, because it is the period during which employees’ benefits under the cash balance plan catch up to their front-loaded permanent enhanced benefit.
The first question for the court was whether the interest credit portion violates ERISA. The court said no. It suggests that cash benefit plans, in general are not age-discriminatory "because cash balance plans are functionally equivalent to defined contribution plans, at least with respect to accruing benefits." The court then uses various support for its conclusion including :
I similarly hold that the interest credit formula of SNET’s cash balance plan is not actually age-discriminatory, and that it merely accounts for the time value of money. As set forth in greater detail below, an employee’s benefits are not calculated based upon whether that employee is older or younger, but are instead calculated based upon whether he is a newer or more senior employee. The critical determinant of an employee’s benefits are his years to retirement, not his age. The fact that age may often have a loose correlation with an employee’s years to retirement does not necessarily make a plan age-discriminatory. In fact, a cash balance plan would more likely violate ERISA § 204(b)(1)(H)(i) if it did not account for the time value of money.
The court also dismisses the employees’ argument that the plan "wears away" at their benefits.
Plaintiffs’ allegation that “an older worker has to wait more years after the conversion to the cash balance formula to actually begin earning new retirement benefits,” however, is not accurate. The “wear-away” period is not necessarily longer for older workers; it is longer for workers that have greater frozen benefits. Under the old plan, the size of a worker’s frozen benefits is a function of a worker’s salary and years of service, not his age….
Because a workers’ frozen benefits are not a function of the worker’s age,the size of the “wear-away effect” is not a function of the worker’s age. For example, the size of the “wear-away” period for an older worker with a given salary and years of service will not be greater than the length as a younger worker’s “wear-away” period with the same salary and years of service to the company. Indeed, a participant’s age, as opposed to his salary and years of service, has no impact on the length of the “wear-away” period.
Moreover, employees are not actually “losing” benefits during the “wear-away” period. SNET chose to calculate the permanent enhanced benefit by starting with an employee’s account balance under the old defined benefit plan, and increasing the balance immediately by ten percent. If SNET had chosen to evenly distribute the ten percent increase over the period of time during which the value of an employee’s cash balance account caught up to the permanent enhanced benefit, then an employee’s benefits would not remain stagnant, but would constantly increase (even if at a lower rate than the employee was previously receiving under the old plan). SNET should not be penalized for front-loading the ten percent increase in benefits, as opposed to spreading that ten percent increase out over a period of years.
As you can see from the above, the issues with conversions are technical and, perhaps cumbersome. But for employers who have converted their plans or who are considering doing so, the case provides a roadmap to avoiding some legal pitfalls in the future.