Cash-Balance Conversion May Add Up to Age Discrimination

The Internal Revenue Service has indicated that conversion from traditionalpension plans to another type of pension, the cash-balance plan, may result indiscrimination against older workers who have had longer terms of service intheir companies. Cash-balance plans combine the features of 401(k) plans andtraditional pension plans, and are based on a worker’s average salary over theduration of employment with the company, rather than the number of years he orshe has worked. Funds accumulate faster in early years of employment than intraditional plans, and employees have a guaranteed payout that they can take asa lump-sum payment or roll over into another benefit plan or an IRA, should theychange jobs.

This kind of portability appeals to a workforce that is increasingly moremobile. The Employee Benefits Research Institute, a nonprofit researchorganization based in Washington, D.C., reports that only 9.5% of employeesremain in the same job for 20 years or more. Cash-balance plans are consideredby some employers to be a valuable recruitment tool reflecting this trend.

Such major companies as Citigroup, Glaxo Wellcome, and American Express haveor are in the process of switching to cash-balance plans. But the IRS andseveral congressional representatives are concerned that such conversions mayrob long-term workers of the meaty accruals that, in a traditional pension plan,typically build most quickly in the years leading up to retirement. If along-term worker’s traditional pension is supplanted by a cash-balance plan,in which accrual is more evenly distributed, the loss of accelerated benefitsmay mean less accrual for an older employee (longer service) than for a youngeremployee (shorter service) — hence age discrimination. And that spells troublefor companies, who must obtain approval of pension plan changes from the IRS fortax purposes.

An internal memorandum from the IRS district director’s office inCincinnati, released by Representative Bernard Sanders (I-Vt.) on September 7,1999, requests advice from the IRS National Office in Washington D.C. on theproposed conversion of one company’s plan from a traditional defined-benefitplan to a cash-balance plan. The district director cites suspicion of violationof Section 411 of the Internal Revenue Service Code — i.e., age discrimination– because the plan’s benefit-accrual rate decreases for employees as they getolder. In addition, the plan is labeled a “backloaded interest creditplan,” “Credit interest plan” is government-speak for”cash-balance plan,” and “backloaded” means that most ofthis cash-balance plan’s accrual impermissibly credits the majority of thepension in the later years of employment, which is also against IRS guidelines.

Despite the fact that a final decision by the Washington, D.C., office of theIRS on the district director’s findings is pending, Corporate America hasfound that there’s much to debate regarding cash-balance conversions. NealSchelberg, partner, employee benefits and executive compensation group with NewYork City-based law firm Proskauer Rose LLP, explains, “[The memo] really
raises for the first time significant legal issues that are related tocash-balance conversions.” These issues include, not only the thornyquestion of tax qualification by the IRS, but the possibility of litigation bylong-term employees who feel they aren’t receiving the benefits due them.

IBM Employees Protest Conversion
Employees at Armonk, New York-based IBM are up in arms about their company’srecent conversion from a traditional pension plan to a cash-balance plan.According to a recent report in USA Today, many long-term employees at thecomputer hardware giant claim that the conversion could cause a loss of overhalf the accrual they would have received with the traditional plan. Theseoutraged employees, the report says, are forming unionization committees,decrying the new plan to the press and threatening class-action lawsuits.

However, Schelberg points out that a cash-balance plan doesn’tautomatically mean a dispute with the IRS or employees. “It’s importantnot to generalize,” he says. “Plans differ, and many of theseconversions from defined-benefit plans to cash-balance plans have receivedfavorable determinations from the IRS.” In the case of the company that wascited in the IRS memo, Schelberg notes that “the backloading issuebasically defines the problem. If an employer who’s in the midst of a conversionhas what appears to be a backloaded interest credit plan, consideration shouldbe given to changing that plan.”

And a review of a proposed cash-balance plan is definitely in order ifemployees who expected a certain benefit under a defined-benefit plan find theirfinancial expectations have adjusted downward because of a cash-balance planconversion. “The concept,” explains Schelberg, “is to mitigatethe loss for some individuals.”

Minimizing Conversion Problems
There are many ways employers can minimize or eliminate any negative effectsthat long-term employees may suffer as a result of converting to a cash-balanceplan. Companies may “grandfather” the affected employees in the oldpension plan; add additional years of service to a long-term employee’sopening balance under the cash-balance plan to acknowledge longer service;contribute to a 401(k) plan to offset loss of accrual; or provide stock optionsfor the same purpose. Such provisions can help a company comply with the IRS’requirements and prevent an appearance of discrimination.

Employee awareness during a conversion is also important. “Part of theissue is when conversions were done, employees who were being adversely affecteddidn’t understand how their benefit would be affected, or the technicalitiesof the conversion and its effect on their benefit,” says Schelberg.

Rochester, New York-based Eastman Kodak Co. will officially switch from atraditional pension plan to a cash-balance plan as of January 1, 2000. Toprepare soon-to-be converted employees for the change, Kodak provided them witha rainbow of information in various media, including a “decisionguide” personalized to each employee’s salary and benefits and detailingthe new plan versus the old plan, customizable plan software, seminars led byfinancial experts, a 24-hour hotline, a Web site with frequently askedquestions, and several company-newsletter articles. The information appearedearly in 1999 to allow employees plenty of time to consider the new plan. Kodakalso considered the advice of legal and financial consultants to steer clear ofdiscrimination. Even so, Kodak is still allowing current employees to choose forthemselves whether to stay with the old plan or go with the new. Says RitaMetras, director, total compensation, “We believe everybody will be atleast as well off, and some even better off, with the new plan. But we wanted toprovide as many options as possible.”

Schelberg adds that while employers who are converting their companies tocash-balance plans needn’t panic, they do need to be aware of the IRS’scrutiny and provide fairly for any employee who might lose out due to theconversion. “The sky isn’t falling,” he says, “but watch whereyou step.”

Impact: When converting from a traditional pension plan to a cash-balanceplan, make sure the new plan’s provisions avoid discrimination by providingequal benefits for both newer and long-term employees. Employees should knowwhat their choices are and how the conversion will affect their accruals.

Workforce, October 1999, Vol. 78, No. 10, pp. 22-24— Subscribenow!