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Ruling against a cash balance plan's method of determining lump sums and reversing an earlier district court decision, two federal courts of appeal have held that lump sum distributions cannot be determined simply by reference to the cash balance account. Although the rulings, Lyons v. Georgia-Pacific and Esden v. Bank of Boston, have significant implications for employers, it's not yet clear exactly how they will affect cash balance plan operations.
Lump Sum Calculations
Cash balance pension plans typically define benefits in terms of a lump sum rather than as an annuity for life. Both court cases concerned a classic cash balance plan issue—calculating the lump sum benefit. Although benefits accrue and are communicated to participants as an account balance, cash balance plans are pension plans and thus subject to IRS requirements governing how benefits are calculated.
Cash balance benefits usually are credited with interest at a rate specified by the plan. Under Georgia-Pacific's plan, lump sum distributions were based on the value of the participant's cash balance account at the time of distribution. The participants, however, claimed that their lump sum benefits should be calculated under IRS regulations.
IRS Regulations
Applying IRS regulations—which were designed to protect participants in traditional pension plans rather than cash balance or hybrid plans—would mean projecting the cash balance account to normal retirement age at the plan's interest crediting rate, and then discounting that amount back to the date of distribution at the statutory interest rate. The Georgia-Pacific plan's interest crediting rate was the PBGC rate (the rate used by the PBGC to value certain annuities) plus an additional .75 percent. At the time Mr. Lyons received his distribution, the statutory interest rate was the PBGC rate. Under the regulatory procedure, the projection forward at a higher interest rate would uniformly result in much larger lump sum benefits than the current value of the cash balance account.
The district court had ruled that the law required the use of PBGC rates only in calculating small lump sum benefits in involuntary distributions, and that any expansion of that requirement was invalid (see Watson Wyatt Insider, June 1999). But the court of appeals reversed that ruling, requiring the employer to use the projection/discount method to determine participants' lump sum benefits.
The Bank of Boston plan credited interest by reference to the three-month Treasury bill rate, but with a minimum interest rate of 5.5 percent and a maximum of 10 percent. While the Bank of Boston plan provided for the projection/discount method of determining a participant's lump sum benefit, it used 4 percent to project the participant's cash balance account. The court of appeals ruled that the plan could not use a rate lower than the rate that would be credited to the participant's account if the benefit were left in the plan.
Implications
If other courts follow suit, the rulings have serious implications for cash balance plans, especially for distributions before 1995. In 1994, the General Agreement on Tariffs and Trade (GATT) changed the interest rate used to calculate lump sum distributions. So employers today generally use GATT rates instead of PBGC rates to calculate current lump sum distributions. The Georgia-Pacific court noted that GATT's changes to the statutory regime for determining lump sums could be sufficient so that the projection/discount method might not apply to larger lump sum benefits.
More importantly, many cash balance plans are using an interest-crediting rate derivative of GATT rates. The IRS has indicated that certain rates based on Treasury bills of different maturity periods may be considered equivalent to GATT rates. If those GATT rate "equivalencies" are upheld, projecting to normal retirement age and discounting back to the distribution date would break even—leaving the lump sum equal to the cash balance account.
Regardless of GATT's effect on cash balance lump sums, it's not clear how the decisions will play out. Both plan sponsors may appeal, and prior courts so far have not been eager to depart from the terms of the plan in determining benefits. However, the IRS regulations have been amended to reflect GATT, and still apply the same requirements to determining all lump sums, even those in cash balance plans.
October 2000
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