COMMENTS CONCERNING
AGE DISCRIMINATION ISSUES IN
CASH BALANCE PENSION PLANS
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II. Background
- Factual Background and Notice 96-8
Cash balance plans are defined benefit pension
plans under the Internal Revenue Code of 1986, as amended (the "Code") and the
Employee Retirement Income Security Act of 1974, as amended ("ERISA"), because
they do not meet the laws’ definitions of defined contribution or individual account
plans, which must provide for an individual account for each participant and for benefits
based solely upon the amount contributed to that account, plus its share of income,
expenses, gains, losses and forfeitures.1
They are unlike traditional defined benefit plans, however, which typically provide a
fixed annual retirement benefit equal to the product of the number of years of the
employee’s credited service, his final (or career) average salary, and a percentage.
For example, a traditional plan might provide for an employee to receive one and one-half
percent of his final average pay times his years of service, up to a maximum of 30 years
of service. This would result in a maximum annual pension benefit equal to 45 percent of
the individual’s final average salary.
Cash balance plans are not designed to target a percentage of final (or career) average
pay in the same manner as traditional defined benefit plans. Instead, the benefit under a
cash balance plan is based upon a hypothetical investment account established for the
employee, plus hypothetical investment earnings on such account. Employee accounts receive
hypothetical allocations each year and hypothetical earnings credits. Annual allocations
may be based on a percentage of pay or another factor. Earnings credits may be determined
using a set interest rate, or may be pegged to a variable outside index, such as one-year
Treasury securities. (For the sake of simplicity, the Comment will refer to these account
additions as "interest credits," although there are some cash balance plans
which base earnings credits on equity indices, such as the return on the S&P 500 index
or the return of a specified mutual fund which holds equity securities.)
The employee’s benefit is "defined" and communicated as the amount held
in the hypothetical account, regardless of the actual earnings of the plan over the years.
The cash balance plan looks like an individual account plan in the sense that the benefit
is equal to an account balance, but the employee is not entitled to the gains that exceed
the interest credit. On the other hand, the employee does not suffer investment losses;
the employer is obligated to fund the defined benefit even if the plan does not obtain the
investment experience equal to the earnings credits that are made to the
participants’ hypothetical accounts.
In Notice 96-8, 1996-1 C.B. 359 (the "Notice"), the Service discussed its
views regarding possible guidance relating to the application of the benefit accrual rules
of section 411(b)(1) of the Code to cash balance plans, but did not expressly address age
discrimination concerns. In the Notice, the Service expressed its view that the accrued
benefit in a cash balance plan must be expressed as an annuity commencing at normal
retirement age, at least for the purpose of applying the accrual rules. The Service
further stated that because retirement benefits at normal retirement age under a cash
balance plan are based on the hypothetical account balance including the interest credits,
future guidance might provide that the benefits attributable to the interest credits must
be taken into account in determining whether the accrual rules are satisfied.
The Notice described two methods under a cash balance plan pursuant to which
participants can accrue benefits attributable to interest credits. Under the Notice, in a
"frontloaded" interest credit plan, benefits attributable to future interest
credits with respect to a hypothetical allocation will accrue at the same time that the
benefits attributable to the hypothetical allocation itself accrue. In a
"backloaded" interest credit plan, future interest amounts would only be
credited to an employee’s account as the employee earns future service. In that case,
the benefits attributable to the interest credits would not accrue until the account is
credited. The Service noted that future guidance might provide that backloaded plans
"typically will not satisfy any of the accrual rules in section 411(b)(1)(A), (B) or
(C)," thus implicitly approving only frontloaded cash balance plans. The Notice
stated that because backloaded plans typically would not satisfy the accrual rules of
sections 411(b)(1)(A), (B), or (C), the Service intended only to address frontloaded
interest credit plans in future guidance. The extent to which the Notice is binding on
taxpayers has been unclear at best, as the Notice is simply a statement of intention to
issue proposed regulations. No such regulations have yet been proposed.
- Policy Considerations
Cash balance plans have attracted significant public
comment only in the past year or so, although the first favorable determination letter was
issued in 1985. In light of the history of governmental acceptance of these plans, it may
be worthwhile to review some of the reasons that such plans in the past have found such
acceptance, in addition to some of the policy-related concerns that have been raised by
the media and in class action litigation.
While the fact that cash balance plans are defined benefit plans makes them
controversial, it is also seen as one of their strengths. Defined benefit plans provide a
"safety net" type benefit which, unlike the benefit under a defined contribution
plan, cannot be eliminated or reduced by poor investment experience of the plan. Other
attractive features of a defined benefit plan are that the employer rather than the
employee bears mortality risk, and that benefits can be offered in a defined benefit plan
that are unavailable in a defined contribution plan, such as cost of living increases,
past service benefits, and ancillary death or disability benefits. Accordingly, it may be
worthwhile as a public policy objective to enhance the attractiveness of sponsoring
defined benefit plans to private sector employers, and cash balance plans have been touted
by some as a means of keeping employers in the defined benefit plan system.2
Despite the advantages of defined benefit plans, many employers see them as too
expensive to administer with design options that are too inflexible, and believe that many
employees do not appreciate or understand defined benefit plans.3
In contrast, cash balance plans have been popular with employers as a means of providing
portable and easily communicated benefits to workers through a defined benefit plan. Some
employers view cash balance conversions as an alternative to freezing or terminating their
defined benefit pension plans. In the absence of a cash balance alternative, it is likely
that some large employers will consider freezing or even terminating their defined benefit
pension plans, and a few will likely do so, despite the tax and other costs of terminating
a plan. In particular, as "new economy" employers without defined benefit plans
grow and acquire employers with defined benefit plans, freezing accruals for those already
covered with no additional expansion of coverage is likely to become the norm. In such a
scenario, plan terminations become more likely, and if an employer’s primary motive
in converting to cash balance is to reduce costs in general, in the absence of a cash
balance alternative, terminations become more likely.
In some cases, employers have reduced overall benefit expenses in connection with
adopting a cash balance plan, although in other cases, employers have combined a
conversion with an enhancement to a section 401(k) plan or other benefit enhancements.4 In particular, conversions typically
eliminate early retirement subsidies for future service. These subsidies were intended to
encourage older workers to retire prior to normal retirement ages.
There are concerns with the basic cash balance design, but much of the recent focus has
been on conversions. Although other concerns have been raised, two basic policy-related
themes have been raised in criticizing recent cash balance plan conversions:
- In many conversions, some workers receive less valuable pension benefits than they would
have received had the plans not converted, and this effect hurts older workers more than
younger workers in the same plan. At a time when Social Security and other benefits are at
risk, the minority of workers who are fortunate enough to have a defined benefit plan
should, under this theory, have their expectation of future benefits protected.
- Even where communications comply with existing law, the effect of the conversion has in
some cases not been understood by many workers. As a result, workers cannot plan properly
for the consequences of the conversion.
The second point, regarding communications, although important, is beyond the scope of
this Comment. The first point has more bearing on age discrimination issues, and will be
explored in more detail below.
- Legal Background
Many of the concerns relating to age discrimination may be
resolved with reference to a common legal background. Accordingly, the details regarding
the relevant law are summarized below.
- General Provisions of the ADEA
ADEA prohibits discrimination in employment
because of age. Section 4(a) of ADEA provides:
(a) Employer practices
It shall be unlawful for an employer—
(1) to fail or refuse to hire or to discharge any individual or otherwise
discriminate against any individual with respect to his compensation, terms,
conditions, or privileges of employment, because of such individual’s age;
(2) to limit, segregate, or classify his employees in any way which would deprive or
tend to deprive any individual of employment opportunities or otherwise adversely affect
his status as an employee, because of such individual’s age; or
(3) to reduce the wage rate of any employee in order to comply with this chapter.
(Emphasis supplied.)
The ADEA also contains a number of requirements expressly applicable to pension plans.
These include section 4(i)(1)(A) of the ADEA, which prohibits an employer from
establishing or maintaining "an employee pension benefit plan which requires or
permits… in the case of a defined benefit plan, the cessation of an employee’s
benefit accrual, or the reduction of the rate of an employee’s benefit accrual,
because of age…." Section 4(i)(2) of the ADEA provides:
Nothing in this section shall be construed to prohibit an employer, employment agency,
or labor organization from observing any provision of an employee pension benefit plan to
the extent that such provision imposes (without regard to age) a limitation on the amount
of benefits that the plan provides or a limitation on the number of years of service or
years of participation which are taken into account for purposes of determining benefit
accrual under the plan.
Thus, the ADEA prohibits the cessation of or reductions in accruals because of a
participant’s age, but it permits plans to place a cap on the service that will be
credited or the benefit amounts that will be paid for reasons other than age.
In addition to several other pension-specific provisions that are inapplicable here,
the ADEA contains two provisions recognizing the use of a normal retirement age in pension
plan design. Section 4(i)(8) of the ADEA states:
A plan shall not be treated as failing to meet the requirements of this section solely
because such plan provides a normal retirement age described in section [3(24)(B) of
ERISA] and section 411(a)(8)(B) of [the Code].
Section 4(l) of the ADEA states:
Notwithstanding clause (i) or (ii) of subsection (f)(2)(B) of this section-
(1) It shall not be a violation of subsection (a), (b), (c), or (e) of this section
solely because—
(A) an employee pension benefit plan (as defined in section [3(2) of ERISA] provides
for the attainment of a minimum age as a condition of eligibility for normal or early
retirement benefits; or
(B) a defined benefit plan (as defined in section [3(35) of ERISA] provides for—
(i) payments that constitute the subsidized portion of an early retirement benefit; or
(ii) social security supplements for plan participants that commence before the age and
terminate at the age (specified by the plan) when participants are eligible to receive
reduced or unreduced old-age insurance benefits under title II of the Social Security
Act…and that do not exceed such old-age insurance benefits.
Note that Section 4(f)(1) of the ADEA provides that employment actions based on
"reasonable factors other than age" are insulated from age discrimination
complaints, even if they would otherwise be prohibited under the ADEA.
- Other "Rate of Benefit Accrual" Statutes Related to Age
As stated
previously, section 4(i)(1)(A) of the ADEA provides:
Except as otherwise provided in this subsection, it shall be unlawful for an employer,
an employment agency, a labor organization, or any combination thereof to establish or
maintain an employee pension benefit which requires or permits ... in the case of a
defined benefit plan, the cessation of an employee’s benefit accrual, or the
reduction of the rate of an employee’s benefit accrual because of age.
Section 204(b)(1)(H) of ERISA provides:
Notwithstanding the preceding subparagraphs, a defined benefit plan shall be treated as
not satisfying the requirements of this paragraph if, under the plan, an employee’s
benefit accrual is ceased, or the rate of an employee’s benefit accrual is reduced,
because of the attainment of any age.
Section 411(b)(1)(H) of the Code provides:
(H) Continued accrual beyond normal retirement age.
(i) In general. Notwithstanding the preceding subparagraphs, a defined benefit plan
shall be treated as not satisfying the requirements of this paragraph if, under the plan,
an employee’s benefit accrual is ceased, or the rate of an employee’s benefit
accrual is reduced, because of the attainment of any age.
(ii) Certain limitations permitted. A plan shall not be treated as failing to meet the
requirements of this subparagraph because the plan imposes (without regard to age) a
limitation on the amount of benefits that the plan provides or a limitation on the number
of years of service or years of participation which are taken into account for purposes of
determining benefit accrual under the plan.
In summary, Congress placed the same prohibition against certain age discrimination
under defined benefit plans in three statutes. The ADEA furthermore grants the Secretary
of the Treasury the authority under the ADEA to construe the accrual requirements of both
the ADEA and the Code.5
The Secretary of the Treasury also has the authority to construe these requirements under
ERISA pursuant to Reorganization Plan No. 4.
Section 411(b)(1)(H)(i) of the Code is preceded by the heading, "Continued Service
Beyond Normal Retirement Age." The foregoing requirement can be read as applying only
to accruals after normal retirement age, and not before then. Although the similar
provisions of ERISA and ADEA did not have the relevant subheading, all three were enacted
as part of the Omnibus Budget Reconciliation Act of 1986 ("OBRA ‘86"), in
the sections of OBRA ‘86 which dealt only with benefit accruals beyond normal
retirement age, not just at any age. Moreover, there is substantial language in the
Conference Committee Report to OBRA ‘86 and other legislative history to that act
which would support that view.6
In contrast, Congress provided for different treatment for defined contribution plans.
Section 411(b)(2) provides that defined contribution plans comply with age discrimination
rules "if, under the plan, allocations to the employee’s account are not ceased,
and the rate at which amounts are allocated to the employee’s account is not reduced,
because of the attainment of any age." Although the defined contribution rules are
not directly relevant to a cash balance plan, they may be useful to keep in mind as the
analysis proceeds. If the principles of section 411(b)(1)(H) were applied to defined
contribution plans, those plans would likely be considered age discriminatory. The value
of a given amount of employer contributions declines as a participant ages, because the
allocation has a shorter period over which to accumulate investment earnings. Accordingly,
the rate of "accrual" under a defined contribution may appear to decline as a
participant ages. Section 411(b)(2) accordingly may provide the basis for the view that
Congress did not intend to outlaw account-based plans on the basis of age discrimination.
- Proposed Regulations under Section 411(b)(1)(H) of the Code
In 1988, the
Service issued proposed regulations that address selected aspects of age discrimination
under section 411(b)(1)(H) of the Code. The proposed regulations do not address cash
balance issues, as the regulations were issued before cash balance plans had acquired
significant popularity. The proposed regulations do not define "rate of accrual"
for purposes of section 411(b)(1)(H), and examples of discriminatory benefit formulas
cited in the regulations do not use the age 65 annuity as the basis for determining
whether age discrimination existed. In general, the proposed regulations provide that a
pension plan will not engage in age discrimination solely because of a positive
correlation between an increase in age and a reduction in or suspension of benefit
accruals. Prop. Reg. § 1.411(b)-2(a).
Although the proposed regulations do not address cash balance plans in particular, they
do address the distinction between age and years of service until retirement. In the
context of a plan using the fractional benefit rule of section 411(b)(1)(C) of the Code,
the proposed regulations state that such a plan "will not fail to satisfy [the rules
because the] rate at which a participant’s normal retirement benefit accrues differs
depending on the number of years of credited service a participant would have between the
date of commencement of participation and the attainment of normal retirement age."
Prop. Reg. § 1.411(b)-2(b)(3)(i). This distinction may be important in the analysis of
cash balance plans, as explained in more detail below.
- Final Regulations under Section 401(a)(4)
Regulations under section 401(a)(4)
of the Code provide safe harbors under which plans, if designed properly, may prove
compliance with the nondiscrimination rules under such section. One of those safe harbors
addresses cash balance plans. Treas. Reg. § 1.401(a)(4)-8(c). This was the first
generally applicable official recognition of cash balance plans (although favorable
determination letters had previously been issued). Apparently because some commentators
had raised questions about possible age discrimination issues under cash balance plans,
the Service explained, in the preamble to the regulations, that cash balance plans that
satisfied the safe harbor requirement were not age discriminatory in T.D. 8360 (56 FR
47524 – 47603, September 12, 1991):
The fact that interest adjustments through normal retirement age are accrued in the
year of the related hypothetical allocation will not cause a cash balance plan to fail to
satisfy the requirements of section 411(b)(1)(H), relating to age-based reductions in the
rate at which benefits accrue under a plan.
- Case Law
Two basic types of claims of age discrimination may be made under
ADEA – a "disparate treatment" claim or a "disparate impact"
claim. Very generally, a disparate treatment claim applies when an employer discriminates
against a member of the protected class because of age. The plaintiff must generally prove
that the employer had an intent to discriminate. A disparate impact claim is made when a
facially neutral policy or act by an employer has the effect of adversely affecting the
protected class and the policy or act does not have a business purpose. The plaintiff is
not required to prove that the employer had a discriminatory intent.
- Disparate Treatment
The primary Supreme Court case involving a disparate treatment
claim in the context of a pension plan is Hazen Paper Co. v. Biggins, 507 U.S. 604
(1993). In deciding the case, the Supreme Court focused on the extent of the improper
intent needed to find a violation of the ADEA. The Supreme Court has made it clear that a
claim of age discrimination based on a disparate treatment theory cannot succeed under the
ADEA if the motivating factor for the challenged action was something other than age
itself. The employee’s protected trait had to actually play a role in the
employer’s decision-making process and must have had a "determinative
influence" on the outcome. The Court held that even a positive correlation between a
motivating factor and age is not sufficient to establish a violation. The Court found that
an employer’s decision to discharge an older employee to interfere with the vesting
of his pension benefits does not state an ADEA claim, though it might state a claim under
the antidiscrimination provision of ERISA. The Court overruled cases such as White v.
Westinghouse Electric Co., 862 F.2d 56, 62 (3d Cir. 1988) (firing of older employee to
prevent vesting of pension benefits violates ADEA) and Metz v. Transit Mix, Inc.,
828 F.2d 1202 (7th Cir. 1987) (firing of older employee to save salary costs resulting
from seniority violates ADEA).
The Court emphasized that the problem of inaccurate and stigmatizing
stereotypes—the primary concern behind the passage of the ADEA --disappears when the
employer’s decision is motivated by factors other than age, and that, therefore,
liability depends on whether age actually motivated the employer’s decision. In so
holding, the Court recognized the distinction between age and other factors relevant under
a pension plan, such as years of service:
On average, an older employee has had more years in the work force than a younger
employee, and thus may well have accumulated more years of service with a particular
employer. Yet an employee’s age is analytically distinct from his years of service. An
employee who is younger than 40, and therefore outside the class of older workers as defined
by the ADEA, see 29 U.S.C. §631(a), may have worked for a particular employer his entire
career, while an older worker may have been newly hired. Because age and years of service
are analytically distinct, an employer can take account of one while ignoring the other, and
thus it is incorrect to say that a decision based on years of service is necessarily
age-based.
A key element of a disparate treatment claim is the employer’s discriminatory
intent or "animus." In Goldman v. First Nat’l Bank of Boston, 985
F.2d 1113 (1st Cir. 1993), the plaintiff claimed that his employment was
terminated impermissibly by reason of age discrimination. Plaintiff furthermore claimed
that the employer’s conversion of its final average pay plan to a cash balance plan
was evidence of the discriminatory animus. The Court rejected that claim, finding that
there was "no evidentiary foundation for the premise that the new plan disadvantages
older employees." The court did not find that the plan was nondiscriminatory; rather,
the court said that the plaintiff had simply failed to present sufficient evidence.
Nonetheless, the court appeared to give some weight in its finding of no discriminatory
animus to the fact that the employer permitted employees age 55 with at least 10 years of
service or any employee with at least 20 years of service to remain under the prior plan
formula.
- Disparate Impact
The concurring opinion in Hazen Paper written by Justice
Kennedy (joined by two other Justices) suggested that it is not proper to carry over the
disparate impact theory from Title VII to ADEA. The theory for limiting the ADEA to
disparate treatment claims starts with the recognition that the ADEA was passed because of
congressional concern that older workers were disadvantaged as a result of inaccurate
stereotypes. Where an employment decision is motivated by factors other than age (and thus
devoid of the requisite intent for a disparate treatment claim), the rationale for the
ADEA is not implicated. See Mullin v. Raytheon Co. 164 F.3d 696, 700 (1st
Cir. 1999); cert. denied 120 S.Ct. 44 (1999). The courts have also found that the
language of 29 U.S.C. § 623(f)(1), permitting employers to take otherwise unlawful
actions "where the differentiation is based on reasonable factors other than
age," must be read to prohibit disparate impact claims. As Judge Selya commented in Mullin,
"if the exception contained in section 623(f)(1) is not understood to preclude
disparate impact liability, it becomes nothing more than a bromide to the effect that
‘only age discrimination is age discrimination’." Id. at 702.
Although the law on this issue is still developing, after Hazen Paper three
circuit courts have rejected the disparate impact theory in the context of ADEA. Mullin
v. Raytheon Co.; Salvato v. Illinois Dep’t of Human Rights, 155 F.3d 922
(7th Cir. 1998); Ellis v. United Airlines, Inc., 73 F.3d 999 (10th
Cir. 1996), cert. denied 517 U.S. 1245 (1996). Other circuits have questioned the
applicability of the disparate impact theory to ADEA claims. Gantt v. Wilson Sporting
Goods Co., 143 F.3d 1042 (6th Cir. 1998); Rhodes v. Guiberson Oil Tools,
75 F.3d 989 (5th Cir. 1996) (en banc) (concurring opinion); DiBiase v.
Smithkline Beecham Corp., 48 F.3d 719 (3d Cir. 1995), cert. denied 516 U.S. 916
(1995). Two circuits have recognized the theory. Smith v. City of Des Moines, 99
F.3d 1466 (8th Cir. 1996); Arnett v. California PERS, 179 F.3d 690 (9th
Cir. 1999), judgment vacated and remanded, 2000 WL 29629 (S. Ct. Jan. 18, 2000). In the
Second Circuit, recognition of the theory is unclear. Compare Smith v. Xerox Corp.,
196 F.3d 358 (2d Cir. 1999) (court found no need to decide the extent to which Hazen
Paper controls disparate impact claims) with Criley v. Delta Air Lines, Inc.,
119 F.3d 102 (2d Cir. 1997) (disparate impact may be shown only if plaintiffs allege a
disparate impact on the entire protected group). For further discussions, see Hyman v.
First Union Corp., 980 F. Supp. 38 (D.C. Cir. 1997) (disparate impact claim is
improper).
None of the foregoing cases have discussed cash balance plans. The conclusion one can
draw is that, in light of the law developing which appears to require a finding of
discriminatory intent, agencies should be careful to avoid prohibiting, on age
discrimination grounds, any category of benefit design which could be implemented with a
motive unrelated to age. Moreover, because the Supreme Court may ultimately decide whether
disparate impact claims exist under ADEA, the agencies may want to issue guidance that
distinguishes pensions or even cash balance plans as separate cases, so that any guidance
will be applicable regardless of any ultimate Supreme Court decision of this issue.
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