COMMENTS CONCERNING
AGE DISCRIMINATION ISSUES IN
CASH BALANCE PENSION PLANS
I | II | III | IV | V | VI
VII. “Wear-away” Issue
- Issue: Does the “wear-away effect” which can result from cash balance plan
conversions discriminate because of age?
Under current law, qualified defined
benefit plans may be amended to reduce the rate of future benefit accrual, provided that
plan participants receive at least the benefit accrued to the date of the amendment. See
section 411(d)(6) of the Code and section 204(g)(1) of ERISA. In conversions of final
average pay plans to cash balance plans, plan sponsors must give participants, as a
minimum benefit, the benefit accrued to the date of the conversion, including service and
compensation up to the date of the amendment converting the plan. The sponsor must also
offer all rights and features, including early retirement benefits and optional forms of
benefit, associated with the accrued benefit to the extent required by section 411(d)(6)
of the Code.
Depending on the nature of the transition benefits and the new cash balance formula,
some participants in some cash balance plans may receive no additional benefit accruals
under the plan for some period of time. They will receive at least the benefit under the
old formula until the new formula provides a greater benefit. This phenomenon has become
known as the "wear-away" effect; this name results from the fact that as the new
benefit becomes greater than the old benefit, the new benefit will "wear-away"
the benefit under the prior plan formula.
There is an issue as to whether this effect discriminates impermissibly against older
workers. As will be illustrated in the examples below, wear-away is a function of factors
unrelated to age. Longer service, unexpectedly low interest rates, and higher accrued
benefits to the date of the change are all factors that create wear-away. The wear-away
effect does not on its face make distinctions on the basis of age, but for example, any
worker with greater accrued benefits is more likely to be affected by wear-away than
workers with smaller benefits, and older workers in many plans are more likely to have
greater accrued benefits than younger workers.
- Analysis
The "wear-away" issue is presented in a number of common
transition benefits, and is illustrated in the examples set forth below. The examples are
based on the following facts:
Common Facts. Company X is converting its final pay defined benefit plan to a
cash balance plan. The current final pay plan provides a benefit equal to 1 percent of
final pay times service, payable at age 65. For employees retiring at age 55 with at least
25 years of service, the plan provides a subsidized early retirement benefit. The benefit
is an unreduced pension at age 62 with a 3 percent per year reduction for each year prior
to age 62 that the benefit commences, to age 55. Thus, for instance, an employee retiring
at age 55 with 25 years of service would receive a benefit equal to 79 percent of the age
65 benefit.
The employer converts all participants to a cash balance plan with a uniform allocation
rate of 5 percent of pay and interest credits based on current GATT rates, preserving the
prior formula benefit only as a legal minimum. Every employee receives an opening balance
equal to the present value of his age 65 accrued benefit. Present value is based on
then-current GATT rates, which are GAM-83 and 5.5 percent interest. The value of the early
retirement subsidy is not included in the opening balance. Annuities under the cash
balance plan are determined by converting the account balance to an immediate annuity
using then applicable GATT rates.
- Issue 1: Basic Wear-away Problem
Assuming that interest rates remain constant,
the effect of this conversion methodology is that many longer service employees with the
largest benefits under the prior plan may experience a "plateau" in their
benefit when they attain early retirement age. The plateau results from the fact that that
the value of the frozen benefit under the prior plan formula will exceed the benefit under
the cash balance plan. Thus, for some number of years, the employee will accrue no
additional benefit.
Example 1. For example, assume an employee who is age 55 and has 25 years of
service and thus is currently eligible for early retirement. The employee earns $50,000
currently. For this employee, it is projected that the prior plan frozen early retirement
annuity benefit will exceed the cash balance annuity benefit payable at the same age
unless the employee works to age 64. (Projections in the following chart are based on 4
percent salary growth and constant interest rates.)
Age at termination |
Prior plan immediate annuity |
Cash balance immediate annuity |
Age 55 |
$9,875 |
$5,558 |
Age 56 |
$10,250 |
$6,153 |
Age 57 |
$10,625 |
$6,809 |
Age 58 |
$11,000 |
$7,532 |
Age 59 |
$11,375 |
$8,330 |
Age 60 |
$11,750 |
$9,210 |
Age 61 |
$12,125 |
$10,184 |
Age 62 |
$12,500 |
$11,262 |
Age 63 |
$12,500 |
$12,456 |
Age 64 |
$12,500 |
$13,780 |
Age 65 |
$12,500 |
$15,250 |
A younger employee, such as any employee under age 40 in this example is not projected
to experience any plateau at early retirement age.10
Older employees are expected to experience such a plateau, particularly those with longer
service. For instance, an employee who is 47 and who has 10 years of service at the time
of conversion is not projected to experience any plateau, but a 47 year old with 20 years
of service is projected to experience a plateau for about 4 years, from age 55 to age 59.
Longer service employees are therefore more adversely impacted than shorter service
employees at the same age.
Clearly, these wear-away periods do not exist "because of" the attainment of
any age, as section 411(b)(1)(H) would require. Other factors exist, although some older
employees with longer service may be adversely affected. Hazen Paper would preclude
a finding of age discrimination in this context on general principles.
- Issue 2: More Generous Transition Benefits for Some Employees Within the Protected
Group
Example 2. To avoid the plateau issues highlighted by Example 1, the employer
decides to calculate opening balances so that they equal the present value of the accrued
benefit payable at earliest retirement age. For example, if an employee is age 50 with 20
years of service, the employee’s earliest retirement age is 55. The employee’s
opening balance would be the present value of his accrued benefit payable at age 55 with a
21 percent reduction.
The effect of this transition approach is to enhance opening balances significantly
over what they would be if the opening balance was simply converted as the present value
of the age 65 accrued benefit, as under the transition approach expressed in Example 1.
However, the additional value depends on an employee’s age, and to a lesser degree,
service. Age 65 employees receive no additional value in their opening balance since their
earliest retirement age is age 65. Age 55 employees receive the highest additional value,
because the early retirement subsidy is most valuable at age 55.
To illustrate, the following table shows the enhancement as the increase in the opening
balance over the present value of the age 65 benefit for employees from ages 43 to 65,
each with 25 years of service.
Current age |
Increase to opening balance |
65 |
$0 |
63 |
$23,600 |
61 |
$39,900 |
59 |
$48,800 |
57 |
$55,000 |
55 |
$58,800 |
53 |
$52,500 |
51 |
$46,800 |
49 |
$41,900 |
47 |
$37,400 |
45 |
$33,500 |
43 |
$30,000 |
To the extent that this differential is based solely on age, older employees—those
in their 60s—may challenge the design on ADEA grounds on the theory that
the younger employees are receiving higher enhancements than they are. However, this
disparity results at least in part from differences in service as well. Furthermore,
section 4(l)(6) of ADEA provides that a plan shall not be treated as failing to meet the
prohibition on the reduction in the rate of benefit accruals described in section 4(l)(1)
of ADEA solely because the subsidized portion of any early retirement benefit is
disregarded in determining benefit accruals. Thus, the statute focuses on the normal
retirement benefit and not the subsidized benefit.
Often, companies will decide not to extend this type of enhancement to all employees.
Instead, companies might extend the full enhancement to employees within 5 years of early
retirement, and then provide a limited enhancement to younger employees within 5 to 15
years of early retirement, and no enhancement for employees more than 15 years from early
retirement. For instance, the 49 year old might get 90 percent of the enhancement, the 45
year old 50 percent and the 41 year old 10 percent. This is related to early retirement
age and is therefore correlated with age, but is primarily based on years to early
retirement and is intended to help the most adversely impacted in the protected group.
There should be no concern that this technique discriminates because of age, because
supplying additional benefits to older workers should not be suspect, but if there are
concerns regarding this type of approach, perhaps guidance should give it special
approval.
- Issue 3: Interest Rate Differential Exacerbates Wear-Away
Example 3. Long-term
interest rates in this example are currently 5.5 percent. The employer reasonably believes
that they are historically low and that they will go higher. If the opening balance is set
by calculating the present value of the age 65 benefit at 5.5 percent and then interest
rates go up, the opening balance plus future interest will exceed the original accrued
benefit (not counting any additional cash balance benefits). For instance, if an employee
were to terminate immediately after the conversion and leave his money in the plan, and
interest rates rose to 7 percent, his opening balance would grow at 7 percent and then
would convert to a much higher annuity than he had the day before the conversion. So, he
would end up with a much higher benefit even though he quit the day after the conversion.
To avoid this windfall, the employer decides to set opening balances by discounting
accrued benefits at the employer’s best estimates of future interest rates. The
employer reasonably believes that 7 percent is a reasonable estimate for future interest
rates and therefore sets opening balances as the present value of an employee’s
accrued benefit using 7 percent.
However, interest rates, at least in the next few years do not increase but instead
remain at 5.5 percent. This causes a wear-away of an employee’s benefit, particularly
the lump sum benefit. The lump sum minimum is the present value of the frozen accrued
benefit under the old plan, calculated using 5.5 percent. For most employees in this
example, the lump sum minimum will be larger than their cash balance benefit, even
including the additional cash balance credits that have been earned in the interim. So,
for most employees in this example, it will take a few years for the cash balance benefit
to catch up to the legal minimum lump sum.
Because this element of wear-away results in significant part from two factors which
are unrelated to age—service and unforeseen interest rates under section
411(b)(1)(H) and Hazen Paper— this element of wear-away should
not be considered age discriminatory under current law.
- Additional Comment
It should be noted that "wear-away" has been a
common means of transitioning benefits in cases where future benefit accrual rates must be
reduced by reason of changes in law or other compliance-related reasons. This technique
has been used since at least Rev. Rul. 81-12, 1981-2 C.B. 228, which addresses the effect
of plan amendments made to freeze benefits to change certain actuarial factors. Some of
the many examples in which Treasury has adopted "wear-away" as a permitted means
of transitioning benefits are Treas. Reg. § 1.401(a)(4)-13(c)(4) (determining benefits
eligible for compliance with the nondiscrimination rules under a "fresh start"
date); Treas. Reg. § 1.401(a)(17)-1(e)(5) (example 1 permits the "wear away" of
the existing accrued benefit to facilitate compliance with the limits on pensionable
compensation of section 401(a)(17) of the Code); and Rev. Rul. 98-1, 1998-2 I.R.B. 5
(facilitation of compliance with the changes to section 415(b) of the Code brought about
by the Retirement Protection Act of 1994). These examples suggest that wear-away is
consistent with the fundamental promise made to all employees regardless of age –
that benefits accrued to date cannot be taken away by plan amendment or otherwise, but
that employers have the right to amend plans to change future accruals. Moreover, these
permitted wear-aways are likely to have the same disparate impacts on older employees as
the wear-aways created by some cash balance conversions.
It should also be noted that the wear-away issue may have been addressed in the section
401(a)(4) regulations. If the wear-away issue is analyzed by looking at the cash balance
plan as a "new" plan, then those participants with the "frozen"
accrued benefit are receiving no accruals. This feature of a cash balance plan could have
been viewed as discriminatory under the final section 401(a)(4) regulations; however,
special rules were provided in the regulations to avoid this issue. Treas. Reg. §
1.401(a)(4)-13(f).
- Recommendation
Where wear-away results from or is exacerbated by factors
unrelated to age, current law allows this technique. In real cases, it is impossible to
determine that the wear-away results solely from age-related distinctions when other
factors play such a significant role. To avoid the need to deal with issues relating to an
employer’s intent, safe harbors should be established so that certain conversion
techniques that fundamentally favor longer service workers would be protected. In any
event, under section 411(b)(1)(H) and Hazen Paper, wear-away should be
discriminatory only if improper intent were established. As a result, if the Service or
the Treasury determines that wear-away should be curtailed generally, legislation would be
the preferred approach for so doing.
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