Cash Balance Plans Land in Court
Rev. 08/14/03, E-mail Alert 2003-15

On July 31, the Federal District Court in the Southern District of Illinois ruled that IBM had discriminated against its older workers when it converted its traditional pension plan into a cash balance plan. The ruling is of immense importance because it brings into question the validity of any cash balance plan that is created by a conversion from a traditional defined benefit plan, which is how many cash balance plans have been created.

IBM ruling encompassed two changes in its pension plan
The court ruled on two changes in the IBM defined benefit plan. First, IBM changed its traditional defined benefit plan on January 1, 1995 to a pension equity formula, which IBM named the “Pension Credit Formula.” A pension equity formula plan is a variation of traditional defined benefit plans. Whereas traditional defined benefit plans use an annuity form of distribution, the pension equity plan uses a lump sum distribution as its primary form of benefit distribution. In a pension equity plan the participants accrue lump-sum credits for each year of participation. The participant’s final average compensation is then multiplied by the lump-sum credits to arrive at the lump-sum benefit.

The court ruled that this violated ERISA §204(b)(1)(G) as employees that work the same number of years but that are of different ages and earn identical salaries accrue different retirement benefits under this formula. The court used the Pension Credit Formula in a hypothetical situation using employees with identical salary of $60,000 a year who start work between ages 35 and 50 and calculating their benefits after 15 years of service.

The court ruling cited, for example, that an employee age 50 with 15 years of service would, using the base point formula in the plan, accrue a monthly benefit of $1,099.10 at age 65 whereas an employee age 35 with 15 years of service (terminating at age 50) would accrue a monthly benefit of $1,259.22 at age 65. (Further mathematical details are on page 7 of the attached court ruling on the IBM pension plan.)

The second change that the court ruled on was the July 1, 1999 amendment in which IBM amended its pension plan to a cash balance plan. The cash balance ruling case is between pages 16 and 20 and for anyone who has any involvement with cash balance plans this is definitely worth the reading time.

Although the accrued benefits under the defined benefit plan as of the date of the conversion to a cash balance plan were not reduced, the future rate of benefit accruals that would have been earned under the traditional defined benefit plan would have been larger than under the cash balance plan. This was calculated by measuring the rate of benefit accrual, as the rate at which an employee accrues a benefit payable in the form of an annuity that commences at the normal retirement age of the plan, in this plan age 65. The court ruled that this would violate ERISA §204(b)(1)(H)(i).

IBM has announced their plans to appeal this ruling. IBMs arguments are also contained in the attached court ruling.

McKay Hochman Commentary: In effect, the ruling seemingly aborts a company’s ability to convert a traditional defined benefit plan into a cash balance plan. If the IBM ruling is not overturned and if there is no Congressional action to clarify the cash balance plan legality, all conversions to cash balance plans may be deemed illegal. Thus, it would not be surprising if there is an explosion of litigation by employees of other employers who have converted their plans. Accordingly, the safest approach would be to temporarily stop the conversion of traditional defined benefit plans into cash balance plans until this is resolved further.

Xerox cash balance case
On August 1, the 7th U.S. Court of Appeals held that Xerox’s cash balance plan violated ERISA rules because it required an employee retiring before age 65 to take a lump-sum distribution that did not properly account for future interest on the employee’s retirement benefits. This amounted to $300 million dollars to be paid to former employees. The Xerox plan court ruling is attached. Xerox will likely appeal this case.