COMMENTS CONCERNING
AGE DISCRIMINATION ISSUES IN
CASH BALANCE PENSION PLANS
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IV. Single Sum Distribution Issue
- Issue: Does the method of calculating the single sum distribution in a cash balance plan
discriminate because of age in a prohibited manner?
Under Notice 96-8, cash balance
plans that define the benefit as the account must convert the account to an annuity
commencing at normal retirement age for purposes of complying with the accrual rules and
for other specified purposes. Under this theory, when the cash balance plan pays a single
sum benefit, that normal retirement age annuity must be converted to single sum benefit
using the interest rate and mortality table prescribed by section 417(e) of the Code.
Under the Notice, a cash balance plan cannot pay the account—what has been promised
to the participant&151;unless the plan uses a "safe harbor" interest credit
rate. If a plan sponsor uses an interest credit rate that exceeds the safe harbor rate,
then Notice 96-8 provides that the plan cannot be a qualified plan, and an additional
amount must be paid to participants in excess of the account (see analysis below for full
explanation of the calculation of the additional amount and the consequences of a failure
to pay such amount). Younger employees appear to benefit more than older employees in
cases where single sum payments are made in excess of the account, and as a result, a
concern has been raised that this effect is discrimination because of age.
However, in fact, many cash balance plans are designed to pay the account to the
participant and no more, and that expresses the basic promise made to the participant.
Nonetheless, many plans adopted prior to Notice 96-8 offer or offered interest credits at
rates in excess of what became the safe harbor rates, on the theory that the higher rates
gave a greater benefit to participants. The higher rates better reflected what
participants could earn in a short-term GIC fund in a savings plan; this similarity
facilitated participant communications.
- Analysis
- Background
The Service used Notice 96-8 to address a common feature of cash
balance plans—the single sum distribution of the hypothetical account balance after
the employee’s termination of employment. Under the Notice, it is not always
appropriate simply to pay out the hypothetical account balance. The Service explained that
the first step in calculating the amount of the distribution is to project the
employee’s hypothetical account (including all future interest, consistent with the
frontloading requirement) to normal retirement age. Next, under the Notice, the plan has
to calculate the present value of that projected hypothetical account balance. For this
purpose, the interest rate applicable under section 417(e) of the Code must be used.
A potential problem with paying out the account balance arises if the plan uses an
interest rate for annual interest credits that is higher than the Code section 417(e)
rate. In that event, calculation of the present value of the projected forward amount will
produce a number that is higher than the hypothetical account balance. In the Notice, the
Service used the example of a plan providing fixed interest credits of 8 percent per year
at a time when the 417(e) rate is 6.5 percent. A 45-year old employee with a hypothetical
account balance of $45,000 terminates employment and requests a single sum distribution.
Projected forward with future interest credited at 8 percent, the $45,000 hypothetical
balance becomes $209,743 at the employee’s normal retirement age. If that amount is
then discounted back to age 45 at the 417(e) rate of 6.5 percent, the present value equals
$59,524 -- far exceeding the hypothetical account balance of $45,000.
Thus, if the plan were simply to pay the employee his hypothetical account balance of
$45,000, the Service would view it as an impermissible forfeiture of $14,524. This result
is often referred to as the "whipsaw" effect of the project forward/discount
back requirement, as the plan is "whipsawed" into paying more than promised to
the employee. A related problem occurs if the interest rate used to project forward to
normal retirement age is lower than the section 417(e) rate. In that situation, use of the
higher rate on the "return trip" (the discount back to present value
calculation) could result in a present value amount that is lower than the hypothetical
account balance. To avoid an impermissible forfeiture of part of the accrued hypothetical
account balance, the plan in that case would have to pay out the higher amount.
To address the need to relate the project forward interest rate to the 417(e) rate
required for the discount back, Notice 96-8 went on to list a number of "safe
harbor" interest credit rates. The list of permissible rates was designed to assure
that the future interest credits could, without violating the benefit accrual rules of
section 411 of the Code, be projected to normal retirement "using a rate no greater
than the applicable interest rate under section 417(e)(3)." If a plan is amended to
use an approved rate, it can make a single sum distribution in an amount equal to the
hypothetical account balance without risking a violation of section 417(e) of the Code or
an impermissible forfeiture under section 411(a) of the Code.
- Analysis
The analysis of this "whipsaw" issue is similar to the
analysis of the interest credit issue. In these project forward/discount back
calculations, the younger employee receives a higher present value for his hypothetical
account balance not because of his age, but because of the number of years he has to
normal retirement age under the plan, which is not an age that is the same in every plan
but rather is a proxy for presumed date of payment. The greater the number of years for
interest to be credited forward, and then discounted back using the favorable interest
rate of section 417(e) of the Code, the greater the present value amount will be.
Note, however, that if the interest rates used for the projecting forward and the
discounting back calculations are the same, the younger employee will not be advantaged.
Absent a disparity in interest rates, the calculation will not produce a subsidy for the
younger worker. As a result, under Hazen Paper, no disparate treatment claim can be
raised. Under Hazen Paper, unless an employer is mindful of stereotypes or makes
inaccurate and denigrating generalizations about age when engaging in the particular
conduct, such employer cannot be considered to discriminate because of age under the ADEA.
It is difficult to imagine an employer with that in mind when it sets a high interest
credit rate, given the fact that higher interest credit rates tend to increase account
balances for all employees on a uniform basis.
It is important to recognize that the only time a younger employee actually receives
more money from a cash balance plan than the money an otherwise identically-situated older
employee receives is when a single sum payment is made using a higher interest rate for
the projection forward portion of the calculation than is used in the discount back
portion of the calculation. If Notice 96-8 did not create a problem for the cash balance
plan that credits accounts using a higher interest rate than the 417(e) rate when it tries
to pay the account balance as a single sum payment, the age discrimination issue some have
raised would not arise. Under the Hazen Paper analysis, therefore, the motivating
factor in the employer’s behavior can also be said to be government regulation, not
age. Even where employers make distinctions on the basis of age, employers are permitted
to make distinctions on the basis of age as long is there is a motivating factor other
than age, and here, the motivating factor is a need to comply with Notice 96-8.
As was suggested earlier in the discussion of the interest credit issue, if cash
balance plans were tested against the "equal cost or equal benefit" requirement
of section 4(f)(2)(B)(i) of the ADEA, the calculation of single sum distributions would
clearly be lawful. As long as the hypothetical annual contribution to the hypothetical
account is calculated on an age-neutral basis, the employer will meet the "equal
cost" leg of this test.
- Recommendations
The anomaly in some plans which results in the payment of
single sums in excess of the account is a function of Notice 96-8 and of years to assumed
payment, not a function of age. Accordingly, binding authority should be issued to clarify
that this feature of cash balance plans (where it exists) should not be considered
discriminatory because of age.
One of the consequences of Notice 96-8 is that it provides a disincentive to plan
sponsors from giving participants better benefits by making the use of above-market
interest rates more expensive than they would be if the "up and back"
calculation did not result in a lump sum higher than the account balance. Ways of
expanding the safe harbor interest rates should be explored. In addition, if the
principles announced in Notice 96-8 are to become law, binding authority should be issued
and should contain transition rules enabling sponsors to shift from higher interest credit
rates to safe harbor rates. Some plan sponsors with older plans would be interested in
amending plans to conform to Notice 96-8, but until the safe harbors are finalized, it not
clear what approach is appropriate.
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