The U.S. Equal Employment Opportunity Commission

EEOC Office of Legal Counsel staff members wrote the following letter to respond to a request for public comment from a federal agency or department. This letter is an informal discussion of the noted issue and does not constitute an official opinion of the Commission.


ADEA: Comments on Cash Balance Regulation

October 8, 2002

William F. Sweetnam
Benefits Tax Counsel
Department of the Treasury
Washington, DC 20220

Dear Mr. Sweetnam:

This is in response to your letter of September 13, 2002, requesting comments from the Equal Employment Opportunity Commission (EEOC) on the Department of Treasury's proposed regulation interpreting sections 411(b)(1)(H) and 411(b)(2) of the Internal Revenue Code of 1986 (the Code). Code sections 411(b)(1)(H) and 411(b)(2), along with sections 204(b)(1)(H) and 204(b)(2) of the Employee Retirement Income Security Act of 1974 (ERISA), and section 4(i) of the Age Discrimination in Employment Act of 1967 (ADEA), were enacted by the Omnibus Budget Reconciliation Act of 1986 (OBRA 86).

The proposed regulation sets out general rules applicable to all pension plans and specific rules applicable only to cash balance pension plans. With regard to the general rules for all pension plans, we have no specific comments. Our comments regarding the rules applicable to cash balance pension plans are detailed below.

As an initial matter, because the draft we reviewed does not set forth the legal basis for the applicable cash balance rules, we decline to comment at this time on the proposed manner of measuring the rate of benefit accrual in cash balance plans. For the same reason, we also decline to comment on the proposed treatment of any wear-away caused by a conversion to a cash balance plan. We do, however, reserve the right to present such comments in the future.

Our remaining comments concern the provisions of paragraph 1.411(b)-2(b)(2)(iii)(E). That paragraph deals with the setting of a "hypothetical opening account balance" during conversion to an eligible cash balance plan. The paragraph provides:

A plan satisfies this paragraph (b)(2)(iii)(E) only if the balance in the participant's hypothetical account immediately after the amendment becomes effective is not less than the actuarial present value of the participant's benefit, determined immediately before the amendment becomes effective using reasonable actuarial assumptions.

Draft Regulation, pp. 38-39 (Emphasis added). The preamble discussion of this paragraph states:

These proposed regulations do not otherwise regulate the manner in which a converted plan establishes opening account balances. Thus, for example, a converted plan that sets the opening account balance at least equal to the present value of each participant's prior accrued benefit would be permitted to reconstruct the cash balance account that each participant would have had at the time of the conversion if the cash balance formula had been in effect for the participant's entire period of service. Such a reconstructed account balance could not, of course, be established such that the balance would be higher if the participant were younger.

Draft Regulation, pp. 20-21.

It is our understanding that this regulatory provision would permit an employer to provide all participants with the same opening account balance provided that balance was at least as great as the present value of the highest accrued benefit of any participant under the old plan. According to Treasury staff, only a small percentage (less than 10%) of current cash balance plans try to equalize opening balances in this manner.

In order to permit reconstruction of account balances, the proposed regulation defines the opening account balance as a year-one "accrual" that should be tested under the proposed cash balance accrual rules. In our view, however, the opening account balance in most conversions is not properly referred to as an accrual since there generally are no new benefits being earned during conversion, but rather a mere restatement of already accrued benefits. In contrast, if a plan wished to provide participants with transition credits over and above any already accrued benefits, those credits properly would be considered accruals subject to the cash balance accrual rules (barring higher accruals for younger workers than for older workers).

Indeed, one of the primary arguments in favor of using an opening account balance (instead of the "A + B" method, where the old benefit is frozen, the cash balance account starts at zero, and the two benefits are added together at retirement) is that the opening balance method allows a plan to keep a running total of all benefits earned, saving the expense and trouble of keeping multiple sets of records regarding a participant's benefits. The premise for this argument is that the opening account balance is a restatement of the value of the benefits already earned prior to the establishment of the cash balance plan. Moreover, because the opening balance is designed to represent the benefit already accrued in the old plan, it seems illogical to allow an employer to pretend that the cash balance plan was in effect prior to the effective date of the amendment actually converting to a cash balance plan. The reality is that the participants were not in a cash balance plan, and basing an opening balance on such a fiction is inappropriate and inequitable.

Our concern with permitting the equalization of account balances in this manner is that it permits employers to provide younger employees with a subsidy, or bump-up, that older workers do not receive. For two employees of different ages identically situated in years of service, salary history, and annuity entitlement in the old plan, the actuarial present value of the older employee's benefit in the old plan always will be higher than the actuarial present value of the younger employee's benefit using any interest rate higher than zero. This means that if opening account balances are equalized to the highest actuarial present value benefit in the old plan, a younger employee will receive a higher "bump up" in her opening account balance than a similarly situated older employee. In our view, favoring younger employees in this manner is not consistent with the OBRA 86 age discrimination rules. The issue is demonstrated in the following example: (1)

Three employees of a company converting from a final average pay defined benefit plan to a cash balance plan are age 54, 43, and 32. Each has the identical date of hire, job, and salary history. Each has 10 years of participation in the final average pay plan and has accrued a fully vested age 65 single life annuity of $10,000. In the new cash balance plan, all participants are guaranteed interest credits at the plan's interest rate until they retire, even if a participant leaves the company before age 65.

The actuarial present value of the benefits earned in the old plan by the 54 year old is $47,500; the actuarial present value of the benefits earned in the old plan by the 43 year old is $24,100; and the actuarial present value of the benefits earned in the old plan by the 32 year old is $12,600. Under the rules set out in the proposed regulation, however, the employer is permitted to set the opening balance of each of the three employees at $47,500, with interest credits guaranteed to age 65 and beyond. If each employee terminated employment immediately after the conversion and decided to wait for a deferred vested annuity at age 65, the age 65 annuity for the three employees based upon work done prior to the conversion would be:

Current Age Age 65 annuity
54 $10,000
43 20,100
32 40,400

Thus, the youngest employee would receive an annuity four times the size of the annuity of the oldest employee for exactly the same work.

We cannot accept the result that flows from the above example. The "bump up" in opening account balances benefits younger workers while providing no additional benefit to older workers. The youngest worker gets a bump up of $34,900, the middle worker $23,400, and the oldest worker $0. In our view, the only consistent approach would be to set the opening account balance of each employee at an amount equal to the actuarial present value of the participant's pre-conversion benefit using reasonable actuarial assumptions. It is our view that any benefits added to that amount ("transition credits") could properly be judged as a new accrual under the proposed cash balance plan accrual rules (i.e., permissible provided the credits given to an older worker were no less than the credits provided to any similarly situated younger worker).

It has been argued in other contexts that the result in the above example is legal because the 54 year old will get her benefit 22 years earlier than the 32 year old will get his. Thus, the argument goes, the actuarial present value of the accruals will be equal. We believe this argument is without merit. Nothing in the OBRA 86 accrual rules allows benefits in a defined benefit plan to be tested based upon the equality of the present value of the benefit. If such a rule were permissible, an employer in a final average pay plan could in 2003 give an accrual of 4% of final average pay to a 32 year old and an accrual of only 1% to a 54 year old (because the actuarial present value of the two benefits is identical). We do not believe, however, that such a result is permitted under the OBRA 86 amendments.

Accordingly, we request that Treasury amend paragraph 1.411(b)-2(b)(2)(iii)(E) to read:

A plan satisfies this paragraph (b)(2)(iii)(E) only if the balance in the participant's hypothetical account immediately after the amendment becomes effective is equal to the actuarial present value of the participant's benefit, determined immediately before the amendment becomes effective using reasonable actuarial assumptions.

Because the proposed regulation allows employers reasonable leeway in setting actuarial assumptions and transition credits, we believe that employers still retain much flexibility in determining how to set opening balances even if equalization of account balances is not permitted.

We would be pleased to discuss any matter raised in these comments with you. We appreciate your cooperation over the past three years when Treasury, IRS, Department of Labor, and EEOC staff worked together to analyze issues raised by cash balance pension plans and thank you for the opportunity to comment on the proposed regulation.

Sincerely,

-s-

Cari M. Dominguez
Chair

cc: Carol Gold, Director, Employee Plans
Alan Tawshunsky, Assistant Chief Counsel, Employee Benefits
Ann Combs, Assistant Secretary of Labor for Pension and Welfare Benefits


1. All numbers have been rounded to the nearest $100. We would be happy to supply the exact numbers and actuarial assumptions used in this example.


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