Cash balance plans violate age discrimination laws by favoring younger employees while reducing pension wealth of older workers who normally would do better under a conventional defined benefit plan.
Discussion papers from opposing camps examining the hot-button issues surrounding the trend toward conversion of traditional defined benefit plans to cash balance plans spell out arguments for both sides of the age discrimination question. In the end, the issue is no closer to being settled.
One of the authors, Edward A. Zelinsky, professor of law at Yeshiva University, New York, who sets forth a lengthy paper claiming flatly that cash balance plans violate age discrimination laws, says succinctly: "In simplest terms, human beings do not think like lawyers."
Mr. Zelinsky offers an explanation of the major issues connected with conversion, covering arguments both pro and con, before concluding cash balance plans are discriminatory because they work to the benefit of younger employees.
In a written response to Mr. Zelinsky's paper, a team of lawyers from the Washington law firm of Covington & Burling find exactly the opposite, claiming Mr. Zelinsky's findings are flawed and that cash balance plans "do not violate the age discrimination statutes under any reasonable interpretation of the law."
Critics of cash balance plans argue the conversion of traditional plans to cash balance is both unfair to older workers and not well understood by employees. Supporters say cash balance plans are better understood by participants, their design allows employers to retain the defined benefit structure, and the plans are more suitable for a younger, more mobile work force.
Traditional, final-average-pay defined benefit plans are "backloaded," which means the employee's last few years are particularly valuable because later, higher-salaried years result in increased benefits while significantly increasing the employer's pension costs.
"Because the employee earns his higher salary (and hence, his higher pension benefit) late in his career when he is close to retirement, there is little time for the employer's plan contributions to earn investment income," Mr. Zelinsky wrote in his paper. "Accordingly, the employer must itself fund relatively more of the higher pension entitlement, since there will be comparatively little investment growth to offset these higher costs," while contributing relatively little for younger employees because contributions will accrue investment earnings over a longer period.
Mr. Zelinsky provides several examples showing that converting traditional defined benefit plans works to the detriment of older, longer-service employees. In one, an older employee is covered by a formula guaranteeing an annuity equal to 50% of final average salary multiplied by a years-of-service formula with 17 years of employment. The worker is three years from retirement nearing his late-career high salary years, which would significantly increase his pension benefits. This worker then is covered by a cash balance plan for the final three years with an average salary of $60,000. The cash balance plan provides his account a pay credit of 10% of his compensation and an interest credit of 5% annually.
Under these assumptions, said Mr. Zelinsky, the employee would be entitled to an annuity of $14,167. Had the employee been permitted to earn the final years' pension benefit under the defined benefit plan, he would have received at retirement an annuity of $20,000 annually, reflecting the impact of his last three years under a final average formula.
"However, instead of this larger annuity, the employee will receive a cash balance benefit of $19,861 consisting of theoretical pay-based contributions and interest for his last three years of employment," according to Mr. Zelinsky. "In lump sum terms, the annuity to which the employee . . . is actually entitled for 17 years of conventional coverage is worth at retirement $130,280; had there been no conversion to the cash balance formula for his last three years, the larger annuity he would have earned would have been worth $183,920 at retirement. The difference in the present value of these two annuities ($53,640) exceeds the benefit from the cash balance plan by $33,780."
Mr. Zelinsky notes that employers may cushion or eliminate losses for older employees associated with conversion to a cash balance plan by offering various transition benefits. "However, in the absence of these or other ameliorative measures, in this example, the conversion . . . deprives the older employee of the pension impact of his late career years and thereby effects a significant reduction of the older employee's pension wealth in comparison to the pension he would have earned had he completed his career under the conventional defined benefit plan."
The Zelinsky paper puts forward three reasons plan sponsors abandon final-average defined benefit plans in favor of cash balance plans: to reduce costs; to "re-orient" pension benefits from older to younger workers; and, echoing claims by cash balance proponents, because employees understand individual accounts better than traditional pension plans and find them more suitable in today's mobile work force marketplace.
"It is expensive to provide traditional pension annuities for older workers since such older workers tend to be better paid, since they typically have higher years of service fractions as a result of greater seniority, and since older employees are relatively close to retirement, leaving comparatively little time for employer contributions to grow," he said.
He noted that replacing a defined benefit plan with a cash balance plan "reorients the employer's pension plan toward younger workers even if the employer achieves no overall contribution reduction, since young workers' pension entitlements typically climb as a result of the conversion . . . while older participants' entitlements decrease."
As a result, "generational redistribution occurs even if the employer keeps its aggregate pension costs the same as they were under the final average formula."
Mr. Zelinsky takes issue with claims that cash balance plans are more attractive to today's workers because of their individual account characteristics and portability. He said it is possible "with reasonable effort" to reconfigure defined benefit plans to create individual account balances and make benefits payable as lump sums.
"There is no need to convert to the cash balance format to present benefits in the language of individual accounts or to make benefits immediately distributable upon an employee's termination of employment," he said. "Every annuity-based pension benefit can be translated into its present value, which value constitutes a notational account balance, a lump sum equivalent of the annuity earned by the employee."
Because defined benefit plans can be made to look and act like defined contribution plans, Mr. Zelinsky suggests the underlying issue is neither ease of understanding nor portability, "but the intergenerational distribution of pension benefits: traditional pensions pay more for older workers; defined contribution formats (including cash balance plans) are better for younger persons."
Mr. Zelinsky also asks the pointed question: Why don't employers that do conversions simply adopt true defined contribution plans instead?
His answer: Terminating a defined benefit plan in anticipation of setting up a defined contribution plan results in vesting of all participants regardless of length of employment, while conversion to a cash balance plan "continues the plan with a different method of calculating benefits."
Termination of a fully funded defined benefit plan and replacing it with a true defined contribution plan also triggers a reversion tax or tax surcharge on surplus assets, while there is no tax penalty associated with converting to a cash balance plan.
Mr. Zelinsky stated that while theoretically possible to implement a cash balance plan that doesn't discriminate on the basis of age, "I conclude that most cash balance plans, as they exist today, violate the literal terms" of the Internal Revenue Code, the Employee Retirement Income Security Act and the Age Discrimination in Employment Act.
Disputing Mr. Zelinsky's conclusions are Richard C. Shea, partner with the law firm of Covington & Burling, and Michael J. Francese and Robert S. Newman, associates. In their response, the three focus primarily on the methods used for determining benefit accrual rates in cash balance plans. They claim the method Mr. Zelinsky used "was never intended to apply to accruals after normal retirement age, the wrong method for applying the age discrimination rules -- at any age."
The lawyers claim Mr. Zelinsky "misinterprets current law." They claim age discrimination statutes, particularly the Age Discrimination in Employment Act of 1967, prohibit defined benefit plans from reducing the rate of an employee's benefit accrual "on account of the attainment of any age." The key to Mr. Zelinsky's conclusions, they said, "is his insistence that rates of benefit accrual be expressed in the form of annuity benefits beginning at normal retirement age."
Only by using benefit accruals attained at normal retirement age does Mr. Zelinsky show that cash balance plans produce declining rates of benefit accruals as the employee approaches normal retirement age, they said.
However, they pointed out, age discrimination laws and legislative history "make clear" that Congress enacted the 1967 statute for defined benefit plans to protect employees who continue to work after normal retirement age. The law subsequently was amended in 1986.
"One point is crystal clear: Congress intended the 1986 Age Act to govern the rate of benefit accrual after normal retirement age," they said.
"The method for determining rates of benefit accrual proposed by Professor Zelinsky fails to implement the purpose of the age discrimination statutes. On the contrary, his method would undermine those statutes."
They state: "Applying Professor Zelinsky's method to accruals before normal retirement age would also cause most contributory defined benefit plans to fail the age discrimination rules -- a result Congress clearly did not intend."
The attorneys said it was unlikely that Congress intended to apply a "quantitative, computationally intensive method for determining benefit accrual rates in order to judge whether a defined benefit plan discriminates on the basis of age."
Rather, they said, Congress "probably intended what it said, namely, that defined benefit plans should no longer be able to specify an age after which an employee's benefit accruals will be reduced or eliminated."
Before being banned by Congress in 1986, they said, defined benefit plans "routinely" gave employees an accrued benefit equal to a fixed percentage of pay times years of service before age 65 and no benefit attributable to years of service after age 65.
Most cash balance plans provide the same pay and interest credits to all employees, they said. "Those cash balance plans that deviate from this norm provide pay and interest credits that are, if anything, more generous to older employees."
Stating flatly that "cash balance plans satisfy the age discrimination rules," they claim "even if Professor Zelinsky were right and cash balance plans did result in a decline in the rate of benefit accrual before normal retirement age, that decline would not violate the age discrimination rules because the decline is not `because of the attainment of any age.' On the contrary," they said, "the decline observed under Professor Zelinsky's method is solely attributable to the inflation protection automatically built into cash balance plans."
In conclusion, the three Washington lawyers said, "Given the problems with Professor Zelinsky's method of determining benefit accrual rates, and the fact the decline he observes in those rates before normal retirement age is not attributable to age, even under his method, the conclusion seems inescapable that cash balance plans do not violate the age discrimination statutes under any reasonable interpretation of the law."