The firm, Watson Wyatt Worldwide, says that even Social Security would likely fail to meet the proposed rules, though it would be formally exempt from compliance.
"The proposed regulations are well intentioned and offer some positive news for plan sponsors, including a rejection of the charge that cash-balance plans inherently violate age discrimination," says Eric Lofgren, Watson Wyatt's director of benefits consulting. "But the rules would disallow some plans, such as pension equity plans, that can be more favorable to older workers. The letter and spirit of the proposed regulations appear to conflict in some areas."
Pension-equity plans are a variant of defined-benefit plans, in that they are designed to "split the difference" between the traditional and cash-balance approaches. "In many ways the advantages and disadvantages of traditional defined-benefit and cash-balance plans are opposites of each other," says Lofgren. "The pension-equity design seeks to retain some of the advantages of traditional plans for long service and older workers while introducing the availability of lump sums and portability that is so attractive to younger workers."
The Internal Revenue Service and Treasury Department issued the proposed regulations in December. Written comments on the regulations are due by March 13, and a public hearing is set for April 9.
The new rules provide a "safe harbor" that allows cash-balance plans to comply with age discrimination laws, basically by using standards commonly applied to defined contribution plans, such as 401(k) plans. Under these standards, if the contribution rate an employer applies to older employees equals or exceeds the rate for younger employees, the plan normally passes. Simplifying somewhat, if younger employees receive a two percent contribution, older employees must also get two percent or more.
This safe harbor applies to cash balance plans under the proposed rules, and defined contribution plans have a similar standard. All other defined benefit pension plans - including pension equity plans - would have to satisfy a "general rule" that is much different. Rather than looking at contribution rates, the general rule compares how much employees accrue each year when expressed as an annuity payable at normal retirement age, typically 65.
If a younger employee accrues an annuity starting at age 65 of one percent of final average pay, the older employee generally must also accrue as much or more. The problem is that the cost of an annuity starting at age 65 can be more than ten times greater for a 65-year-old than for a 25-year-old. This is because of the time value of money - with the 25-year-old, the underlying assets of the annuity have an additional 40 years to appreciate before payouts begin. 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.
If a defined benefit plan does not meet the specific cash balance safe harbor, and provides, say, three or six times the benefit at age 65 than at 25, it could very well fail.
"Age discrimination for all plans should be judged on the same basis - that which is allowed under the proposed regulations for defined contribution and cash balance plans, which represent more than 75 percent of all retirement plans today. There shouldn't be a second and tougher rule for the remaining 25 percent of all plans," says Lofgren. "A pattern of benefits is either age discriminatory or it is not. It shouldn't depend on how you write the benefit formula or 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."
The application of the proposed regulations to Social Security produces a surprising result. Social Security benefits are adjusted for wage growth before retirement, so the benefit accrued by a younger worker can be worth more than the benefit earned by an older, but otherwise identical, worker. The younger worker has more years of pre-retirement increases included in his or her benefit. Under the proposed regulations, that pattern would presumably be deemed age discriminatory, according to Lofgren.
"The complexity of the laws governing retirement plans has led to many unintended consequences over the years," says Lofgren. "But a strong defined benefit system has never been more important. The stock market decline has taken a severe toll on 401(k) plan balances, and corporate scandals have shredded some employees' retirement hopes altogether. It's time to rationalize the laws governing pension plans and reverse the decades-long dramatic decline in the defined benefit system."
- More on the proposed regulations from Watson Wyatt
- News story on the proposed regulations
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Bush administration's proposed regulations governing age discrimination in retirement plans would disallow some plans that are actually more generous to older workers than those that would comply under the new rules, according to a consulting firm.