When Kathi Cooper joined IBM Corp. in 1979, she immediately took advantage of the company's pension plan. However, more than a decade after her start date, IBM changed its pension from a defined-benefit plan to a "cash-balance" plan. After taking a good look at IBM's new system, Cooper felt ambushed.
While IBM's former system allowed Cooper to accrue interest at a faster rate because of her seniority with the company, the new plan gave all employees, regardless of age, an equal interest rate.
In 2003 Cooper filed a class action suit, alleging IBM's new plan violated ERISA by discriminating against older employees. The 140,000 employees in the class sought $1.4 billion in damages.
The Southern District of Illinois agreed that the shift violated ERISA, granting summary judgment for the plaintiffs. The decision spurred an outcry from the more than 15,000 plan sponsors that use cash-balance plans. Ten companies filed an amicus brief supporting IBM's appeal, fearing that if the decision was affirmed it would force them to exit the voluntary employer-maintained, defined-benefit system "through plan freezes and terminations."
However, on Aug. 7, those fears were ameliorated when the 7th Circuit reversed the lower court's ruling, finding that cash-balance plans are age-neutral. And on Aug. 17, President George W. Bush signed into law the Pension Protection Act of 2006 (PPA), which confirmed the court's reasoning.
Although the ruling comes as a relief to plan sponsors, the 900-page PPA creates some ambiguity on exactly what steps in-house counsel need to consider before adopting a cash-balance plan or converting a plan under the new rules.
A Bright Spot
Under IBM's traditional defined-pension plan, the company provided benefits in the form of a lifetime annuity and cash-balance accumulation, meaning that employees' benefits increased at a faster rate as they aged. The cash-balance plan differs in that all employees receive the same pay credit and interest rate regardless of age. Cooper and other employees found that this method gave younger employees an unfair advantage.
Chief District Judge G. Patrick Murphy found that simple mathematics supported the plaintiff's claims. Taking the example of an employee who retires at age 50 after 20 years or service, Murphy concluded that he would have a larger annual benefit at 65 than someone whose 20 years of service concluded with retirement at age 65 since the former receives 15 years more interest than the latter.
However, 7th Circuit Judge Frank Easterbrook found the district court erred by assuming that this discrepancy is not counterbalanced by the fact that older workers generally draw higher salaries.
"This is the very first time that a court of appeals has recognized affirmatively that a cash-balance retirement plan is age neutral," says Edward Bright, partner at Thacher Proffitt & Wood.
This comes as a relief to the many plan sponsors that have replaced their traditional pensions with cash-balance plans. According to Pension Benefit Guaranty Corp. (PBGC), the total number of PBGC-insured defined-benefit plans decreased from 114,000 in 1985 to fewer than 32,000 in 2004.
"Your costs are contained and there is less risk with a cash-balance plan," says Thomas Vasiljevich, shareholder at Ogletree, Deakins, Nash, Smoak & Steward. "A traditional defined-benefit plan is subject to market fluxuations. Cash-balance plans take away some of that uncertainty."
Another reason cash-balance plans rose in popularity was due to the workforce becoming more mobile. According to Lynn Dudley, vice president of the American Benefits Counsel--an advocacy group of employer-sponsored benefit programs--IBM's workforce underwent a dramatic shift. In the 1960s, employees typically worked for the company for a 30-year span, but by the late 1980s, workers stayed with the company for only about 10 years on average. Since most employees accrued the bulk of their benefits in the last few years of their career, younger employees didn't pay attention to their pension benefits and had little incentive to stay on board.
"Employers felt that they were spending a lot of money for something that their employees didn't care about," Bright says. "With a cash-balance plan there is always a lump sum of money in an account that the employee knows is his or hers. From the employer standpoint they could communicate a tangible value to all of their employees."
Although the ruling ensures employers that use cash-balance plans will not be sued for age discrimination, the decision only applies to the 7th Circuit. Experts warn that the 3rd and 9th Circuits are more receptive to the arguments put forth by Cooper and may view cash-balance plans as discriminatory.
"We won't be done with this issue until the Supreme Court has an opinion," Dudley says. "And I suspect that eventually we will get there."
The Future Of Pensions
Regardless of how the courts rule on the issue, the PPA may ultimately push more companies towards cash-balance plans by making defined-benefit plans more costly.
"One of the most significant changes of the PPA is that it imposes additional funding requirements on defined-benefit pension plans," says Robert Zitko, a partner at Kirkland & Ellis.
According to Zitko, it is unclear whether companies will rely on the PPA to convert traditional pension plans to cash-balance plans or whether the additional funding requirements under the PPA will cause companies to move away from defined-benefit pension plans altogether.
"I think the PPA is going to provide some sort of safe harbors," Vasiljevich says. "But, frankly, employers are scared off even though this legislation makes cash-balance plans safer, I think that a lot of employers are still risk adverse given the litigious climate out there."
The greatest risk lies for those who must convert their existing cash-balance plans to the new standards.
"For companies that already have cash-balance plans, in-house counsel need to pay attention to whether their current plan complies with the statute," Bright says.