Looking Under the Hood: Primer on Cash Balance Conversion Plans

Nolan v. Detroit Edison Company, et al., No. 19-1867 (6th Cir. 2021)
6th Circuit Gives Primer on Cash Balance Conversion Plans, and Remand for Retiree

Dated: March 23, 2021
Reversing in Part, Affirming in Part, and Remanding

I like to play the piano. And by like, I mean I would like to, but most of the time I’ll get a couple bars in before my two toddlers arrive to provide their own accompaniment. One time, I pulled the panels of our piano off so they could see the hammers and action, and in doing so stumbled into a useful compromise: anytime I want to play the piano, they can ask to take the panels off, and vice versa. It works because kids are just like us: they love to “look under the hood.”

If you’ve ever felt daunted by the complexity and internal structure of a defined benefit retirement plan (especially one with different benefit formulas), this decision provides a good, long look inside that black box. The Court considered the appeal of Leslie Nolan, a now retired employee of Detroit Edison Company. Ms. Nolan claimed the Company misled employees like herself into voluntarily converting their age and service pensions into newly offered ‘cash balance’ pensions. Ms. Nolan argued the Company failed to disclose that employees who did so risked: (1) adding no value to their ultimate pension benefits for the remainder of their employment; or (2) devaluing their already accrued benefit, if interest rates fell.

Detroit Edison began offering a ‘cash balance’ benefit to pension plan participants in 2002, and the materials it provided to participants at that time implied their prior (age and service) accruals would be “frozen and protected,” while the employees also accrued annual cash balance credits (and interest credits thereon) for the duration of their employment.

Ms. Nolan dubbed this “the A + B Promise,” and successfully argued (to the standard required to overturn dismissal) Detroit Edison had breached Plan terms when it instead awarded her only the accrued value of her pension as of the 2002 conversion, taking none of her subsequent cash balance accruals into account in its calculation of her monthly annuity. On this first count, the Court agreed and reversed the lower court’s decision to dismiss, finding that the Plan failed to properly characterize how the value of employees’ benefits would (and would not) ultimately increase. Most significantly, the Plan did not explain that a “wear away period” might gobble up some or all of the value of an employee’s future accruals.

In the 1990s, many employers began converting their defined benefit plans from traditional into cash balance plans to reduce their pension costs… [A] move from traditional to cash balance plans tends to involve “wear away,” which “occurs when an employee continues to work at a company but does not receive additional benefits for those additional years of service.” Amara v. CIGNA Corp., 775 F.3d 510, 516 (2d Cir. 2014). This happens when the cash balance benefit never exceeds the already-earned annuity benefit under the traditional formula. Zelinsky Paper at 702... “[A]fter the cash balance conversion, the employee’s actual pension entitlement does not grow until her hypothetical account balance under the cash balance methodology equals (‘wears away’) and begins to exceed the value of the benefit she had earned previously under the traditional pension formula.” Id. It can take years for the cash balance benefit to catch up to the traditional plan benefit. Id. at 703–04.

In her second and third counts, Ms. Nolan argued the Plan had failed to disclose changes made to the Plan, as required under ERISA Sections 102 and 204(h). The Court ultimately reversed the lower court’s dismissal of the second count, but affirmed the dismissal of the third, noting a “good faith standard” statutorily applied in 2002.

In addition to the Plan’s nondisclosure of a “wear away period,” Ms. Nolan argued in her second count that the Plan had also failed to disclose the potentially devaluing effect falling interest rates may have on employees’ “frozen and protected” prior accruals, when converted to a hypothetical cash balance (i.e., not part of the ‘A + B Promise’).

When a higher interest rate is used to convert a lump sum into an annuity, the calculation will lead to a higher annuity than if a lower interest rate is used. If the same interest rate that was used to compute Nolans’s initial cash balance benefit were also used to convert the protected benefit back to an annuity, then the result would be her initial $1,581.19 annuity. Use of a lower rate to convert the lump sum to an annuity yields a smaller annuity.

This being an appeal of the lower court’s dismissal, the Court doesn’t quite immerse itself in the merits of the case, and applies a different standard of review than might apply in subsequent proceedings. But for anyone looking to better understand the functioning (or trappings, according to Ms. Nolan) of cash balance plans that increasingly make up the majority of private employer defined benefit plans, this decision might be as satisfying as watching the hammers move as your dad stumbles his way through Clair de Lune.

Blog Posts are intended to bring attention to developments in the law and are not intended as legal advice for any particular client or any particular situation. Please consult with counsel of your choice regarding any specific questions you may have.