By Alvin Lurie
In August the 7th Circuit Court of Appeals reversed a lower court decision which for three years had cast a long shadow of uncertainty on the employee-benefits sector of the economy. The appeals court upheld the design of IBM�s pension plan as not unlawfully discriminatory against older workers. The episode demonstrates how much damage a single lawsuit can inflict, even one that proves unsuccessful in the end.
First, some background. For many years the design of pension plans has been shifting away from the "defined benefit" format that was once typical. Employers came to dislike such plans because they can impose devastating new funding liabilities in certain situations, as when interest rates sink while the stock market declines. Employees do not find such plans as suitable as they once did because they no longer expect to follow the model of lifetime one-workplace employment for which the plans were originally designed. On the other hand, "defined-contribution" plans, under which the employer sets aside a certain sum of money and does not promise that it will result in any particular level of benefits later, leave the employee exposed to the vicissitudes of the investment market, and also do not benefit from the umbrella of federally mandated pension insurance.
To address these problems, there was developed what is called the "cash balance" variety of retirement plan. The details of these plans are somewhat complex, but in a nutshell the plan maintains at any given time a hypothetical cash value representing each particular worker�s benefit accumulation, calculated according to a transparent formula. In contrast to defined-benefit plans, this benefit is often made available as a lump sum on an employee�s departure from service; in contrast to defined-contribution plans, the employee is spared the risk of market gyration, which the employer instead agrees to bear. To accomplish these objectives, cash-balance plans employ formulas which combine "compensation" credits, which accumulate based on such factors as salary level and number of years worked, with interest credits, which apply an interest element (e.g., 6% a year) to the passage of time since a compensation credit was earned. This overall combination of features has proved attractive to employers and employees, overcoming the drawbacks of the defined-benefit plan while preserving the powerful security advantage it afforded, the combined guarantee of benefits by the employer and by the government's Pension Benefit Guaranty Corporation.
As cash balance plans grew in popularity, they became the subject of considerable criticism, stoked in particular by a series of articles in the Wall Street Journal's news columns. Critics were angered that when companies converted defined-benefit plans into cash-balance plans, some workers experienced cuts in their future expected pension increments. It should be noted that it is not unlawful for employers to reduce future pension earnings, that is, benefits based on work not yet performed. Some members of Congress and others, however, seized the opportunity to denounce companies in language that strongly suggested that existing, accrued benefits were being cut.
Although in general there was and is no legal bar to companies' scaling back their promises of future pension benefits, an exception comes if the changes can be challenged as violating age-discrimination law. Andto greatly simplify a complicated matterthis was a case where the adoption of neutral formulas can create a spurious appearance that younger workers are being given a better deal. In particular, an IRS rule requires companies to project benefits to participants' normal retirement age (generally 65), which meant a 45-year-old worker would be allotted twenty years' worth of interest credits, a 55-year-old worker only ten years'. This of course merely reflected the time value of money; the situations of the two were not really comparable, since the 45-year-old would have to wait an extra decade before receiving the pension. And supposing both employees were to depart the company in a year's time, rather than working until 65, the phantom interest credits would evaporate, along with any claim of unfairness, if they both received their benefits in the same year. To build into the model 20 years of interest credits for the 55-year-old, when he faced only 10 years of deferral, would in fact be to discriminate in his favor.
In the first case (Eaton) to raise these points, decided in 2000, a federal district judge in Indiana ruled against the claim of age discrimination, in an extensively reasoned opinion. That seemed to put the issue decisively to rest, and before long thousands of companies converted their traditional defined-benefit plans to cash balance plans. But then three years later, another federal district judge, Patrick Murphy, in southern Illinois, was presented with the same claim. Without discussing or even citing the earlier decision, Murphy struck down the IBM cash balance plan as an illegal exercise in age discrimination. Since there was nothing distinctive about the IBM plan, the decision acknowledged that all such plans might be vulnerable to suit.
The kindest view of Murphy's opinion would be to call it a mechanical reading long on literal-mindedness, short on policy sense. It would have doomed cash balance plans, which pension practitioners had embraced as the only institutional innovation that could save the defined benefit model from extinction.
The implications for pension plan sponsors were staggering. IBM alone estimated its exposure from the litigation at $6 billion, and copycat litigation soon sprang up which threatened (and continues to threaten) substantial damage awards against many other employers. Thousands of employers, with millions of participants, have adopted cash balance plans, and pose tempting targets for the plaintiffs' bar that has been mining this terrain.
Moreover, IBM and the other companies risked tax disqualification of their plans, with dire consequences. The Internal Revenue Code contains the identical wording as the statute at issue in IBM, and the sanction for violating it is disqualification.
IBM, of course, appealed. And yet the looming threat of liability was enough to play havoc with the world of pension administration. Many employers terminated or froze their plans, and many others which had been on the verge of adopting such plans pulled back. An alarmed business community began pressing for legislation to correct the judge�s reading of the law. That measure, which was included in a more general pension reform bill in Congress, was endangered for a while as both parties insisted on loading it up with extraneous provisions disliked by the other side (estate tax repeal for the Republicans), a minimum wage boost for Democrats). At last, this August 3, a clean bill received final Congressional approval. Since members had declined to give it retroactive effect, it could only safeguard plans with respect to actions they took following the new law�s effective date (and then only if they complied with certain preconditions). IBM and other plan sponsors would still face ruinous liability based on actions taken before then.
But four days later, on August 7, the 7th Circuit announced its reversal of the IBM decision. (President Bush, anticlimactically though usefully, signed the pension reform bill into law 10 days after that.) The panel's ruling was unanimous and made short shrift of the trial judge's handling of the time-value issue:
"Nothing in the language or background of ...[here the court cites the statute in issue] suggests that Congress set out to legislate against the fact that younger workers have (statistically [so in the opinion]) more time left before retirement and thus a greater opportunity to earn interest on each year�s retirement savings. Treating the time value of money as a form of discrimination is not sensible."
Another quote will sum up the court's sound grasp of the policy angle:
"Litigation cannot compel an employer to make plans more attractive (employers can achieve equality more cheaply by reducing the highest benefits than by increasing the lowest ones). It is possible, though, for litigation about pension plans to make everyone worse off. After the district court's decision IBM eliminated the cash-balance plan for new workers and confined them to pure defined-contribution plans. Whether that is good or bad (for employees or society as a whole) is not for us to say. What we can and do conclude, however, is that the decision may again be made freely, governed by private choice rather than legal constraints."
Not all is yet settled: there is of course a remote possibility of review by the Supreme Court, and other circuit courts might consider the issue anew. But the strength of the 7th Circuit�s reasoning will probably carry the day.
Whether it will discourage the initiation of suits attacking the operation of plans before the new law's effective date is problematic, particularly in light of a decision in the Southern District of New York decided after the IBM appeal that explicitly rejected the 7th Circuit's opinion. The reasoning was as flawed as that of the lower court in IBM, and is itself a trial court decision. But it will doubtless motivate some litigants to continue to beat the discrimination drum at least until its inevitable appeal to the 2nd Circuit and predictable reversal there.
Businesses planning complex strategies and making long-term promises desperately need certainty about what the law requires of them. Yet our law often withholds from them that certainty. The resultsas in this casecan be costly indeed, not for employers alone, but for participants, when the escalating costs of retirement benefits are giving pause to increasing numbers of employers as to whether to provide them at all.
Alvin D. Lurie was the first Assistant Commissioner of Internal Revenue charged with administering employee plans and exempt organizations following enactment of ERISA, and is a practicing tax lawyer in New York. He has written frequently on pensions.