Client Service August 22, 2016

PPA Reduced Lawsuits Against Cash Balance Plans

It also provided guidance about how to convert a traditional pension to a cash balance plan.
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When cash balance plans were first developed in the 1980s, plan sponsors were immediately drawn to them, says Alan Glickstein, a senior retirement consultant with Willis Towers Watson in Dallas.

“As many as 30% of large plan sponsors gravitated to them,” he says. “The thing that makes cash balance plans attractive is their simplicity. It is hard for a young person to relate to an annuity in a traditional pension plan. For the same reason that 401(k) plans have become so popular, with a cash balance plan, everyone knows how much is in their account. For many companies and participants, that transparency is crucial, and if you leave the company, the cash balance plan account is portable.”

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Kevin Wagner, a senior retirement consultant with Willis Towers Watson in Detroit, adds: “If you go back 30 years, every defined benefit plan was a traditional pension plan.

However, nearly as soon as cash balance plans were developed, participants began suing them, with the majority of the cases based on age discrimination. With cash balance plans, plan sponsors set an interest crediting rate for accounts. “The plaintiffs said, if you look at the investment horizon of a 20-year-old and a 40-year-old, each of whom will retire at age 65, the 20-year-old has a 45-year trajectory for receiving interest, while the 40-year-old has only 25 years, so you are discriminating by age,” says David Godofsky, a partner and head of the employee benefits and executive compensation group at Alston & Bird in Washington, D.C.

When the Pension Protection Act (PPA) was passed in 2006, it specifically said that as long as the rate of interest you are delivering to the participants is not higher than the market rate, then you are not discriminating by age, Godofsky says. “If you had a guaranteed higher rate of interest, the degree to which it would be worth more for the 20-year-old than the 40-year-old is, in fact, age discrimination,” he says. “Shortly after the PPA was passed, appellate courts started saying that age discrimination doesn’t make any sense because the accounts are just receiving compound interest. If Congress had never passed the PPA, the courts would have eventually solved the age discrimination problem anyway, but the PPA came in with a clear solution.”

NEXT: Addressing other types of lawsuits

The second type of lawsuit that cash balance plans faced before the passing of the PPA was what is known as the “whipsaw” effect, which essentially had to do with how the beginning balance transferred from the traditional pension to the cash balance plan is calculated, says Daniel Schwatz, an employee benefits attorney and officer in the employee benefits practice group at Greeensfelder, Hemker & Gale, P.C. in St. Louis. He explains: “The PPA said that as long as the plan uses the market interest rate to calculate the balance, and not a higher interest rate, then the whipsaw effect is eliminated.”

Godofsky adds: “Shortly after cash balance plans came into existence 30 years ago, the Internal Revenue Service (IRS) issued guidance that said you may not be able to pay an individual in a cash balance plan a lump-sum equal to their account balance. Their logic was that there is a minimum lump-sum rule in the Employee Benefit Security Act (ERISA) and the Internal Revenue Code (IRC). The IRS said the lump-sum must be computed with a mortality and interest rate so that participants are not lured into taking a lump-sum that is lower than the annuity. The idea behind whipsaw is to take the balance and convert it into an annuity and then back to a balance, and if that number is greater than the original account balance, you have to pay them the larger amount.”

A third breed of lawsuits that cash balance plans faced regarded what is called “wear away,” which dealt with the transition from traditional pension plans to cash balance plans, says Jon Waite, chief actuary and director on the advisory team at SEI Institutional in Oaks, Pennsylvania. “The wear away happened when plans transitioned from a traditional pension plan to a cash balance plan,” Waite says. “Employers said, ‘We will give you and account balance to start off in your new cash balance plan, and it will be the better of the benefit in the frozen plan or the cash balance plan. Of course, the frozen pension plan would have a much higher balance, so you ended up with participants who, for several years, accrued no benefit because they were catching up to the old balance. The PPA came in to fix that anomaly by mandating that the frozen benefit be converted to an account balance plus new accruals so that everyone receives some accrual each year.”

Particularly by permitting cash balance plans to convert the hypothetical account balance into benefits other than a lump-sum, the PPA has successfully eradicated lawsuits against the plans, says Robin Schachter, a partner with Akin Gump Strauss Hauer & Feld LLP in Los Angeles. “That provision in the PPA resolved a lot of issues for both plan sponsors and participants and reduced a lot of litigation and uncertainty,” he says.

While the PPA essentially negated these three types of lawsuits against cash balance plans, there is a fourth type that these plans have faced that cannot be legislated, Schwartz says, and that is the failure to properly communicate to participants how their traditional pension plan is being converted to a cash balance plan. “It would be very difficult to legislate how you put this in your benefit materials,” he says. “While the other types of cash balance plan lawsuits—very technical cases dealing with age discrimination and conversion rights—have essentially disappeared since the passing of PPA, there could still be lawsuits alleging that a benefit was taken away without proper explanation,” and this is an area of which plan sponsors and their advisers need to be mindful.

Client Service August 22, 2016

DB Pension Funding Still a Battleground Post-PPA

Starting with the Pension Protection Act, the U.S. Congress has tweaked and amended pension funding rules a handful of times in recent years, but has it worked?
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The Pension Protection Act of 2006 (PPA) defined specifically how defined benefit (DB) plans should measure funded status—using high-quality corporate bond interest rates and a specific mortality table, explains Matt McDaniel, U.S. head of DB risk at Mercer in Philadelphia.

It also prescribed a calculation for minimum required contributions each year, and plan sponsors had seven years to get their plans fully funded.

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However, since PPA’s passage, the rules have already been tweaked a number of times. “These tweaks probably wouldn’t have been needed, if we hadn’t gone into a recession. The PPA was reasonable at the time,” McDaniel says.

Shelby George, senior vice president of Advisor Services at Manning & Napier in Rochester, New York, explains that each year, DB plan sponsors are required to make a certain level of contributions based on three factors—one being interest rates. When the financial crisis of 2008 hit, not only did assets decrease as the market went down, but interest rates went artificially lower due to Fed practices, so employers had to make higher contributions.

Funding plans was more difficult for plan sponsors, McDaniel adds.

So, in 2008, the Internal Revenue Service (IRS) allowed for a longer period of smoothing assets than originally allowed in the PPA, so a higher asset value could be used to calculate funding, says Ned McGuire, vice president and a member of the pension risk solutions group of Wilshire Consulting in Santa Monica, California. In 2009, the IRS offered flexibility in using segment rates or the corporate bond yield curve. Sponsors could switch between them, decrease their liabilities and lower contributions.

McGuire also notes that in 2010, the Preservation of Access to Care for Medicare Beneficiaries and Pension Relief Act allowed DB plan sponsors to amortize payment over nine or 15 years rather than the seven years required by the PPA. This reduced required minimum contributions. In 2012, the Moving Ahead for Progress in the 21st Century Act (MAP-21) changed the corridor of interest rates that could be used to calculate funded ratios. This increased the discount rate used, lowered pension liabilities and lowered required contributions, McGuire explains. In 2014, the Highway and Transportation Funding Act (HATFA) extended provisions of MAP-21. And, finally, in 2015, the Bipartisan Budget Act further extended MAP-21 provisions, but it also increased Pension Benefit Guaranty Corporation (PGBC) premiums.

NEXT: Should the PPA be amended permanently?

With market volatility and relief for DB plan sponsors in required minimum contributions, DB funding rates have decreased since passage of the PPA. McDaniel says Mercer tracks on a monthly basis mark-to-market funded status on a U.S. Generally Accepted Accounting Principles (GAAP) accounting basis, because with PPA rules and funding relief, there are so many levels of smoothing, so PPA funded status doesn’t give a true look at what a plan’s status is. According to Mercer, at the end of 2006 DB plans were about 98% funded. McDaniel says this improved a bit in 2007, but today the average funded status is at 79%.

McGuire says, since 2008, the Wilshire Corporate Pension Funding Study has shown year-end ratios around the low 80s. “It has been stagnant over the 10 years since the PPA was passed,” he says.                                                                                                                         

McDaniel believes Congress keeps extending pension funding relief less because plan sponsors need it, and more because pension relief is a revenue raiser for the U.S. budget. “Smaller contributions means smaller tax deductions. I think that has been the motive of at least the last two rounds of relief,” he says.

McDaniel adds that if interest rates increase again to somewhere near a more historical norm, he believes relief won’t be needed. But there are not a lot of signs that rates will skyrocket quickly.

George says instead of focusing on congressional action, DB plan sponsors should focus on their responsibility, understand their objectives and come up with strategies for portfolio construction and contributions. “Funding relief allowed employers to use a higher interest rate, so with lower required contributions, employers were in a better financial position and could better manage contributions. But plans still need to get to 100% funding eventually. It is a mistake to assume that because there is funding relief, plan sponsors should contribute the minimum. There should be a broader discussion about what sponsors should do about contributions,” she says.

McDaniel notes that the latest relief allows for fairly low cash contributions, but less-funded DBs are punished by higher PBGC variable rate premiums, which he says will more than quadruple over a four- or five-year period. Because of this, many plan sponsors are not taking the relief, he notes.

“I don’t think the PPA should be amended permanently—we do want contributions tied to inherent funded status. But, it has just been difficult to adhere to the rules with rates sliding down so significantly,” McDaniel says. “The PPA is not inherently flawed. One of the things it did was unmask some of the financial volatility of pensions that was previously hidden by smoothing over a long time.”

But, he concludes, now plan sponsors feel pain much sooner and are less interested in sponsoring plans.

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