Cash Balance Pension Plans: Selected Legal Issues

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Over the past few years, cash balance pension plans have received significant congressional and
public attention. Issues that have been controversial include the negative effect of a plan
conversion on older employees due to wear-away, the whipsaw effect that may occur when
computing a lump-sum payment of benefits prior to normal retirement age, and the practice of
providing the “greater of” benefit to plan participants as part of a conversion to a cash balance
plan. This report provides an overview of these issues and a discussion of how the Pension
Protection Act (P.L. 109-280), as well as IRS guidance, affect them.

n the past several decades, plans have been developed that are modifications of the traditional ¹
defined benefit plan. These plans are referred to as hybrid plans because they are defined
benefit plans that conceptualize the benefits in a manner similar to defined contribution ²I

plans. One type of hybrid plan is the cash balance plan. A cash balance pension plan is a defined
benefit plan that resembles a defined contribution plan because the employee’s promised future
benefits are stated as an account balance. The account is hypothetical (each participant does not
actually have an account) and is used to reflect the amount of benefits the individual has accrued.
The account consists of employer contributions that are a percentage of annual compensation
(called pay credits) and interest earned on those contributions (called interest credits).
An employer may choose to adopt a cash balance plan as a new retirement plan or may convert its
traditional defined benefit plan to a cash balance plan. During the past two decades, numerous
employers have converted or considered converting their plans. A conversion is subject to the
rules that apply to any plan amendment, including the anti-cutback rule. Under that rule, an
amendment may not (1) decrease an accrued benefit or (2) eliminate or reduce an early retirement
benefit or retirement-type subsidy with regard to service that has already been performed, except ³
in limited circumstances and with prior approval by the Treasury Secretary. The plan amendment
may only reduce future benefit accruals since these benefits have not yet been earned. Any
amendment that significantly reduces the rate of future benefit accrual requires clearly-written ⁴
notice to affected participants.
Cash balance plans and other hybrid plans have been the subject of controversy. Three issues
have received recent public and congressional attention: the negative effect of a plan conversion
on older employees due to wear-away, the whipsaw effect that may occur when computing a
lump-sum payment of benefits prior to normal retirement age, and the practice of providing the ⁵
“greater of” benefit to plan participants as part of a conversion to a cash balance plan. While the ⁶
Pension Protection Act of 2006 (P.L. 109-280) clarified the law with respect to cash balance
plans and added various new requirements that these plans must meet, certain questions remain
with respect to these three issues.
In a conversion from a defined benefit plan to a cash balance plan, an employee’s accrued benefit
will typically be converted into a hypothetical opening account balance. If this opening account

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balance is less than the present value of the benefits the employee has already accrued, then the
employee may experience a period of wear-away. Wear-away occurs during the time it takes the
account balance under the cash balance plan to surpass the accrued benefit the employee has
already earned under the defined benefit plan. During this period, an employer may not be
required to make new contributions to an employee’s cash balance plan account until the account
balance catches up to the previously accrued benefit. Because of wear-away, an employee may
have to work several years before accruing any additional pension wealth under the cash balance ⁷
plan. This issue, while still pertinent, has become somewhat less controversial due to changes
made by the Pension Protection Act.
Critics have argued that the wear-away concept violates the anti-cutback rules of the Employee ⁸
Retirement Income Security Act (ERISA). In Campbell v. BankBoston, the First Circuit Court of
Appeals addressed this issue and held that the occurrence of wear-away due to a conversion from
a defined benefit plan to a cash balance plan did not violate the anti-cutback rules. The court
stated that the anti-cutback rules protected Campbell’s accrued benefits but not his future
expected benefit. Therefore, according to the court, ERISA allowed BankBoston to amend or
terminate future accruals so long as Campbell received the pension benefits previously accrued.
The Pension Protection Act of 2006 amended ERISA, the Internal Revenue Code (IRC), and the
Age Discrimination in Employment Act (ADEA) to include new restrictions on plan ⁹
conversions. These restrictions are intended to eliminate the wear-away of pre-conversion
benefits. The Act provides that when a traditional defined benefit plan is converted into a cash
balance plan, each participant must receive the sum of (1) the pre-conversion accrued benefit
determined under the prior plan formula plus (2) the post-conversion accrued benefit determined
under the cash balance plan formula. A newly converted plan must also credit a participant with
the amount of any early retirement benefits or retirement-type subsidies if the participant has met
the requirements for the benefit or subsidy under the prior plan. The wear-away provision is
applicable to plan conversions adopted after June 29, 2005. Thus, for plans that converted to a
cash balance plan prior to this date, issues regarding wear-away still remain and may still be ¹⁰
evaluated by the courts.
In general, cash balance plans are designed so that employees who leave employment prior to
normal retirement age may receive a lump-sum payment of their accrued benefits at the time of
termination, as opposed to waiting until normal retirement age. Depending on how the value of
the lump-sum payment is determined, there may occur what is known as the whipsaw effect. The
basic issue, arising prior to the enactment of the Pension Protection Act, is whether the lump-sum
payment equals the current account balance or the present value of the accrued benefits expressed
as an annuity beginning at normal retirement age.

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In the past, some employees argued that the lump-sum payment must equal the present value of
the accrued benefit expressed as an annuity beginning at normal retirement age. This is based on
the argument that ERISA and the IRC require that a lump-sum payment of an accrued benefit in a
defined benefit plan be the actuarial equivalent of that benefit, determined according to ¹¹
statutorily-prescribed interest rate and mortality assumptions. Under this argument, the
employee’s lump-sum payment in a cash balance plan must be calculated by (1) projecting the
hypothetical account balance to normal retirement age by adding future interest credits, at the
interest rate specified in the plan, to the account, (2) converting the balance to an annuity payable
at that age, and (3) determining the present value of that annuity using the statutorily-prescribed
interest and mortality assumptions. The lump-sum distribution is then the present value of the
annuity. In 1996, the IRS released proposed guidance on how to compute the lump-sum payment ¹²
under a cash balance plan and used this method.
The whipsaw effect arises if the interest rate used to project the account balance to normal
retirement age [the “projection rate”] is higher than the interest rate used to determine the present
value of the annuity beginning at normal retirement age [the “discount rate”]. In such a situation,
the value of the lump-sum payment (i.e., the present value of the annuity) will be greater than the
employee’s account balance. This result will be common if it is required that the projection rate
be the rate specified in the plan for the interest credits. This is because many plans use an interest
rate for the interest credit that is higher than the statutorily-prescribed discount rate.
Some employers argued that since the benefits of a cash balance plan are expressed as the
employee’s hypothetical account balance, the amount in the account should be distributed as a
lump-sum payment. In other words, they claim the lump-sum distribution does not have to
include the present value of the post-termination interest credits. Some of these employers have
argued that the method outlined in the IRS proposed guidance is incorrect. Others have followed
that method, but used the statutorily-prescribed discount rate as both the projection rate and the
discount rate. This method results in the value of the lump-sum payment equaling the current
value of the employee’s hypothetical cash balance account.
Prior to the Pension Protection Act, three U.S. courts of appeals had considered the issue, and all
three held that ERISA required plans follow the procedure described in the IRS proposed ¹³
guidance and use the plan’s interest rate as the projection rate. For many plans, this meant that
the lump-sum payment was required to be greater than the amount of the hypothetical account
balance at termination.
The Pension Protection Act of 2006 contains a provision intended to eliminate the effects of ¹⁴
whipsaw. Under the Act, a cash balance plan may pay out to an employee a lump sum
distribution equal to the participant’s hypothetical account balance. The Act requires that the plan
must use a market rate of interest to calculate the lump-sum (as opposed to the 30-year Treasury
rate under prior IRS guidance). The whipsaw provision applies to distributions made after August

¹¹^ER^I^S^A^{§ 2}⁰³⁽^e⁾^{; I}^R^C^§§⁴¹¹⁽^a⁾^a^{nd 4}¹⁷⁽^e⁾^.
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¹⁴^ER^I^S^A^{§ 2}⁰³⁽^f⁾^{; I}^R^C^§⁴¹¹⁽^a⁾⁽¹³⁾^.

17, 2006.¹⁵ Thus, litigation may still ensue regarding lump sums paid to employees before the Act
was passed.
One method of plan conversion from a traditional defined benefit plan to a cash balance plan
involves calculating the benefit for employees under both the traditional defined benefit plan
formula, as well as the cash balance formula, and then providing benefits under whichever
formula that yields the greater amount, either on a permanent or temporary basis. While this
“greater of” method has been considered a favorable option for employees, it has been publicized
that the IRS, in issuing determination letters to employers who converted their plans, indicated
that using this two-formula method could violate rules designed to prevent an employer from
“backloading” a participant’s benefit accruals (i.e., providing disproportionately higher benefit
accruals to participants for later years of service than for earlier years). ERISA and the IRC ¹⁶
provide that defined benefit plans must satisfy one of three benefit accrual rules, and the
regulations accompanying these rules provide that when a plan has multiple benefit formulas
available to a participant, a plan must aggregate these formulas in order to determine whether one ¹⁷
of three permissible accrual rules have been satisfied. The IRS allegedly took the position that if
a plan used both the traditional defined benefit plan and the cash balance plant formulas
simultaneously, an impermissible spike or drop in the accrual rate of a participant’s benefits could ¹⁸
result.
While the Pension Protection Act addressed plan conversions from a traditional defined benefit
plan to a hybrid plan, such as a cash balance plan, it did not require or prohibit any specific
conversion methods. However, in February 2008, the Treasury Department and IRS issued ¹⁹
Revenue Ruling 2008-7, which addressed how the accrual rules apply to a “greater of” scenario.
Under the facts of the ruling, as part of a conversion from a traditional defined benefit plan to a
cash balance plan, participants who met certain age and service requirements were
“grandfathered” into the traditional defined benefit plan, while other employees began
participating in the new cash balance plan. In its analysis, plan participants were split into various
groups, including (1) those who were employed after the plan conversion and would only receive
benefits under the new plan; (2) those who received benefits under the old plan, and benefits
under the new plan, as they did not meet the age and service requirements imposed by the plan;

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and (3) those who were “grandfathered” into the old plan. The ruling concluded that the plan
satisfied one of the three accrual rules with regard to each group of participants. An important
part of the ruling’s explanation includes the idea that while benefit formulas must be aggregated
for determining whether a plan meets the accrual rules, all participants in the plan do not have to
satisfy the same accrual rule, so long as one of the three permissible rules for each participant ²⁰
group is satisfied.
The ruling also provides temporary relief from plan disqualification (i.e., a loss of favorable tax
status) for other cash balance plans that provide “greater of” benefits, so long as the benefits
provided under each plan formula, standing alone, meet one of the accrual rules. This temporary
relief is only available to plans that have received a favorable determination letter and meet
certain other conditions. According to the ruling, plans that meet these conditions will not be
considered as violating the accrual rules until January 1, 2009. The Treasury Department and IRS
have issued a press release indicating that they anticipate proposing amendments to the
regulations dealing with the situation presented in the revenue ruling, as well as other similar
“greater of” formulas. It is anticipated that the regulations will apply to plan years beginning in ²¹

2009.

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