Human Capital & Careers

Court Shoots Down IRS Pension Analysis

A California appeals court says the IRS was wrong about ERISA's anti-backloading rule.
Marie LeoneAugust 21, 2008

A U.S. Court of Appeals sided with corporations yesterday when it rejected an Internal Revenue Service interpretation of pension plan rules. At issue was whether pension plans that use so-called cash balance formulas violate provisions of the federal Employee Retirement Income Security Act (ERISA) and California state employment law.

A cash balance plan is a defined-benefit plan that maintains account balances, but still let employers shoulder the risk. They have become more popular of late, as big companies phase out traditional pension plans and adopt the cash balance variety or 401(k)s. Indeed, the number of defined-benefit pension plans overall has been cut in half between 1995 and 2005, shrinking from 58,000 to just 29,000, according to a 2007 study conducted by actuarial consultancy Milliman.

The recent case, heard in California’s Ninth Circuit, involves a pension plan sponsored by Southern California Gas Company, and amendments the utility made to the plan in 1998 — that plaintiffs claim violated employment laws. The California court joined four other circuit courts in deciding that cash-balance plans are not anti-age discriminatory, and that the plans do not violate ERISA’s “anti-backloading” provisions.

The anti-backloading rule protects workers from companies that try to game the pension system by “providing inordinately low rates of accrual in the employee’s early years of service” — a time when the worker is most likely to leave the firm. Those companies then attempt to concentrate the accrual of benefits in the employees’ later years, when they are more likely to remain with the company until retirement.

In its decision, the appeals court agreed with the lower court’s dismissal of the claims. However, the higher court also noted that SCGC did violate ERISA’s notice requirement, and found that the district court was in error when it dismissed that claim.

Furthermore, the appeals court disagreed with the Internal Revenue Service’s interpretation of the anti-backloading rule, specifically the calculation of frozen accrued benefits based that were based on the amended plan documents. According to a revenue ruling released in February, SCGC was in violation of IRS anti-backloading rules.

In fact, the judges said that the IRS’s “reasoning was unpersuasive,” and declined to “defer to the IRS’s interpretation. They noted that although the IRS applied a tax code provisions that paralleled ERISA’s anti-backloading rule, it was not prudent to apply the rules simply because both provisions addressed a situation which related to the use of two pension formulas and a “grandfather” clause.

According to the court documents, the judges found that the IRS gave no compelling reason why the SCGC plan should be subject to the revenue rule in this case, other than to say that the situations are similar.

Corporate advocates applauded the court’s decision. The ERISA Industry Committee “has long argued that the IRS’s interpretation was inconsistent with the statue and called into question many long-established plan designs that benefit plan participants by providing a benefit that is the greater of two formulas. The Ninth Circuit wisely rejected the IRS’s interpretation as flawed,” commented Mark Ugoretz, ERIC president, in a statement.

According to court documents, the plan amendments worked like this: Prior to July 1, 1998, the SCGC plan required participants’ retirement benefits to be calculated according to a “pre-conversion formula.” That formula entitled participants to a single-life annuity, payable monthly, beginning at normal retirement age. On July 1, 1998, SCGC changed the plan, and as a result the benefits for non-union employees were calculated using a cash-balance formula.

Similar to the older formula, the payout is made in one single-life annuity beginning at the normal retirement age. Among other changes, the amended plan provided for a five-year grandfather provision that allowed eligible employees to continue accruing benefits under the older formula until June 30, 2003, at which time the participant’s accrued benefits under the old plan were frozen.

The amended plan stated that if the employee does not begin receiving a benefits payout on or before June 30, 2003, the amount of the accrued benefit is determined by a “wear-away provision.” Based on the wear-away provision, benefit at age 65 is a single-life annuity equal to the greater of the actuarial equivalent of the retirement account under the cash-balance formula, or the actuarial equivalent of the frozen accrued benefit under the older formula.

The plaintiffs, who were eligible to take advantage of the grandfather provision, continued to accrue benefits under the old formula until June 30, 2003. But under the wear-away provision, the plaintiffs’ estimated annuity payments based on the old formula (the frozen benefits) were greater than the estimated annuity payments based on the cash-balance formula. So the employees did not accrue additional benefits during the affected periods, which led them to cry foul, and charge the company with violating federal and state laws.