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Watson Wyatt’s Position on the Recently Proposed U.S. Retirement Plan Age Discrimination Regulations

The Internal Revenue Service (IRS) and U.S. Treasury Department released proposed regulations concerning age discrimination in employer-sponsored retirement plans in December 2002. We believe the regulations are well-intentioned and offer some long overdue and positive news for plan sponsors, rejecting the charge that cash balance plans inherently violate age discrimination through the introduction of a specific cash balance safe harbor. Essentially all defined contribution plans are similarly blessed. And Treasury has indicated a welcome openness to adding a safe harbor for pension equity plans. However, in our opinion, the basic structure of the regulations is flawed by the use of an overly restrictive general rule that applies to all plan types that are not eligible for a safe harbor. A number of defined benefit design approaches that tend to benefit older workers more than cash balance or defined contribution plans do not seem to comply with the proposal, such as pension equity plans, indexed plans and variable annuities. It is our belief that Social Security would fail to comply!

A great many defined benefit plans also seem to fail in their treatment of participants above age 65. Plan amendments from one acceptable design to another often fail because the amount of the change doesn’t meet either the general rule or a safe harbor. Finally, though the cash balance design is validated, a great many cash balance conversions do not meet the new proposed rules for conversions.

In short, these proposed regulations are unfairly restrictive and tend to push pension design into two vanilla buckets: a) traditional defined benefit, or b) cash balance/defined contribution.

How Are The Regulations Flawed?

First, the good news. Defined contribution plans continue to comply with the age discrimination requirements because the proposed regulations look at the comparative contributions for younger and older participants. If the current year individual contribution rate for older employees equals or exceeds the rate for younger employees, by and large the plan passes. For example, if younger employees garner a 2% contribution, older employees, quite simply, must also receive 2% or more. This structure is generally followed in today’s defined contribution plans. The safe harbor rules for cash balance plans are essentially the same as for defined contribution in this regard.

The general rule for defined benefit plans is quite different. To simplify, one must compare the accruals of an annuity at normal retirement age, typically 65, for workers at different ages. So if a younger employee accrues an annuity starting at age 65 of 1% of final average pay, the older employee generally must also accrue as much or more (subject to caveats such as service caps, etc). The problem is that the cost of an annuity starting at age 65 can be more than 10 times more for a 65-year-old than for a 25-year-old. So the general rule for defined benefit plans, in effect, requires more than ten times the added value for a 65-year-old as for a 25-year-old to avoid age discrimination.

While most defined benefit plans are subject to this restrictive general rule, cash balance and defined contribution plans have a simple parity safe harbor, where the contribution at age 65 needs to be only the equivalent of the age 25 contribution rate -- not ten times larger.

If a defined benefit plan approach does not meet the specific cash balance safe harbor, and provides, for example, three or six times the benefit at age 65 than at age 25, it fails. This is illustrated in the chart below. In our opinion, if the equal contribution approach is a fair standard for age discrimination for the 75% of all plans today that are defined contribution or cash balance, it is a fair age discrimination standard for the remaining 25% of all retirement plans as well.

       The blue line does not comply with the proposed IRS regulations, even though the red line does

Why did the IRS take this approach? It is not clear. What is clear from the chart above, however, is that certain plan designs will now be arbitrarily unacceptable despite falling well within the bounds of what is otherwise allowed. The proposed regulations clearly will remove design flexibility from the system. Traditional defined benefit plan sponsors who want to have an accrual pattern halfway between traditional defined benefit and defined contribution would probably feel they have no choice but to go all the way to cash balance or defined contribution if they want to change their design. We believe the defined benefit system, in which the employer retains the investment risk and the ability to provide for retroactive benefit accruals, must remain a key part of the U.S. retirement system.

How to Fix The Proposed Regulations

The proposed regulations need three conceptual changes:

1. Age discrimination for ALL plans should be judged on the same basis. There shouldn’t be a second, tougher rule for some 25% of plans. A pattern of benefits is either discriminatory or it is not; it shouldn’t depend on how one writes the benefit formula nor require ten times the increase in value for a 65-year-old as for a 25-year-old in order to comply. That simply isn’t fair.
   
   
2. Pension equity plans, in particular, should be generally acceptable.
   
   
3. In addition, the proposed regulations must be improved in: a) their treatment of plan changes, so that a change from one complying formula to another also complies, b) their treatment of accruals after normal retirement age, and c) other technical aspects.

With these suggested changes, many plans that have never been questioned in the past will again be compliant. And Social Security might pass age discrimination standards, too.

We sometimes fail to realize that our retirement system in the United States has been very dynamic during its evolution, responding to the conditions and needs of employers and workers over the decades. As this system has evolved, however, a very substantial body of regulations has grown up around it to control the operation of retirement plans. The net effect of these regulations has been to limit the dynamism of the pension system. But the labor markets (and the resulting pressures on pension design) continue to change because of forces outside the control of the regulatory environment. If pension regulations cannot be adapted to changing labor market imperatives, they may limit the utility of pensions in meeting the needs of both employers and workers and may produce adverse macroeconomic effects as well.

The importance of a strong defined benefit system has never been greater. Employees have seen their 401(k) accounts decrease sharply after three straight years of equity-market losses. Corporate scandals have shredded some employees’ retirement hopes altogether. It is time to make sponsoring defined benefit plans less burdensome to companies and to reverse the decades-long decline in the defined benefit system.