United States: Employee Benefits Report: The Pension Protection Act of 2006—Cash Balance/Hybrid Plan Legislation

The Pension Protection Act of 2006 (the "PPA," the "Act") was signed by President Bush on August 17, 2006.  The Employee Benefits practice group of Thelen Reid & Priest LLP has issued a series of reports that summarize selected provisions of the Act.  The following is the second in the series and discusses changes to cash balance and hybrid plans.

Under the PPA, hybrid plans (called "applicable defined benefit plans") are generally defined as plans under which the accrued benefit is calculated as the balance of a hypothetical account maintained for the participant or as an accumulated percentage of the participant's final average compensation.  A cash balance plan is the most frequent example of an applicable defined benefit plan.

Under a typical cash balance plan, a percentage of compensation (a pay credit) is credited to a hypothetical account for each participant. Those amounts are then credited with interest (an interest credit) until the account is paid out, typically as a lump sum at termination of employment. The design mimics a typical defined contribution plan.  However, a cash balance plan is a defined benefit plan because interest credits are determined without regard to the performance of fund assets.  The employer benefits from any surplus and must make up any shortfall.

Three areas of cash balance plans have been problematic: age discrimination, whipsaw and wearaway.  The Act deals with all three areas and also imposes vesting requirements.

Age Discrimination.  The Act provides that a plan does not violate age discrimination rules if a participant's accrued benefit is equal to or greater than that of any similarly-situated younger individual.  The accrued benefit may be expressed as an annuity payable at normal retirement age, the balance of a hypothetical account, or the current value of the accumulated percentage of the employee's final average compensation.  These provisions are effective for periods beginning after June 29, 2005 . The new rules are not to provide any inference regarding the provisions of prior law, allowing litigation to proceed.  Litigation has been mixed, but a three-judge panel of the 7th Circuit Court of Appeals earlier this week ruled that IBM's cash balance plan did not discriminate against older workers, reversing the District Court.

Whipsaw.  In a cash balance plan, a participant's benefit is generally thought of as the balance in his or her hypothetical account.  If a participant terminates prior to normal retirement age and elects to take a lump sum distribution, one would assume that the plan would pay the participant the amount credited to the participant's account, just as would a defined contribution plan.  However, the IRS has taken the position that the plan must project the participant's accrued benefit to normal retirement age and then discount the benefit back to the date of payment at the 30-year Treasury rate.  If the plan credits interest at a higher rate than the 30-year Treasury rate, the participant would be entitled to a lump sum that is greater than the current account balance.  The plan would be "whipsawed."

Effective upon enactment, the PPA allows payment of the current account balance.

Effective for years beginning after December 31, 2007, for plans in existence on June 29, 2005 (with a collective bargaining delay to as late as plan years beginning in 2010) and effective for periods beginning on or after June 29, 2005 for new plans, interest credits may not exceed a market rate of return and may not reduce the account below the aggregate pay credits.

Wearaway.  When a traditional defined benefit plan is converted to a cash balance plan, the IRS currently allows a plan to freeze accrued benefits and then offset the frozen benefits against future accruals.  This is referred to as "wearaway."  Wearaway has been used in some conversions to eliminate early retirement subsidies and for other purposes.  Under the PPA if, after June 29, 2005, a traditional defined benefit plan is converted to a cash balance plan, each participant's accrued benefit under the terms of the plan after the amendment must be at least the sum of (a) the participant's accrued benefit for years of service before the effective date of the amendment, determined under the terms of the plan as in effect before the amendment, plus (b) the participant's accrued benefit for years of service after the effective date of the amendment, determined under the terms of the plan as in effect after the amendment.

Vesting.  Consistent with the vesting requirements the Act imposes on defined contribution plans, the Act provides that hybrid plans must provide for 100% vesting after three years, effective for years beginning after December 31, 2007, for plans in existence on June 29, 2005 (with a collective bargaining delay to as late as plan years beginning in 2010) and effective for periods beginning on or after June 29, 2005 for new plans.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.