“Anti-Cuback” Rule May Prevent Decrease in ERISA Pension Plan Benefits Due to Change in Plan Interpretation

The “anti-cutback” rule of Internal Revenue Code section 411(d)(6) prohibits reductions in protected benefits of an ERISA pension plan. This rule typically applies to reductions caused by a formal amendment to the terms of a pension plan. A recent court decision illustrates how this rule may also apply to a less formal change in the interpretation of the meaning of pension plan terms.

Cottillion v. United Refining (W.D. Pa. 4/8/13) involved a dispute over calculation of early retirement pensions. The employer interpreted ambiguous pension plan amendments to cause an increase in the calculation of early retirement benefits. Later, the employer concluded this interpretation was wrong. The employer received IRS approval to correct the error and recoup past overpayments of benefits from participants. The affected participants sued, claiming the “correction” in plan interpretation was a benefit cutback prohibited by Internal Revenue Code section 411(d)(6). The court agreed with the participants.

This court decision means that ERISA pension plan sponsors may not avoid the “anti-cutback” rule of Internal Revenue Code section 411(d)(6) by writing ambiguous pension plan terms that are open to varying interpretations. An interpretation of ambiguous plan terms may create benefit rights that are protected from cutback under Internal Revenue Code section 411(d)(6).

(Note: Internal Revenue Code section 411(d)(6) does not apply to governmental pension plans.)

Poor Defined Benefit Pension Plan Investments: May Plan Participants Sue?

Fiduciaries of defined benefit pension plans should not to be lulled into comfort by a recent federal court decision that participants could not sue the fiduciaries of a defined benefit plan for a claim of poor investments and excessive investment fees. In David v. Alphin, (4th Cir. January 14, 2013), participants in a Bank of America pension plan sued plan committee members for breach of fiduciary duty and prohibited transactions caused by selecting and retaining Bank-affiliated mutual funds as plan investments. The participants alleged that many better investment options were available, and that most of the Bank’s affiliated mutual funds offered participants poor performance and high fees, causing multimillion dollar losses to the plan.

The court found that the participants lacked standing to sue because the defined benefit pension plan was overfunded and the plan would retain any surplus plan assets. The court concluded this was unlike a defined contribution plan, where excessive fees cause direct harm to participant accounts, because “the risk that … benefits will at some point in the future be adversely affected as a result of the alleged ERISA violations is too speculative.” For support, the court cited a U.S. Supreme Court decision, stating that “misconduct by the administrators of a defined benefit plan will not affect an individual’s entitlement to a defined benefit unless it creates or enhances a risk of default by the entire plan.” La Rue v. DeWolff, Boberg & Associates, Inc., 552 U.S. 248, 255 (2008).

For the following reasons, defined benefit pension plan fiduciaries should not assume that the David decision protects them from potential liability for poor investment management or excessive investment fees:

• This decision addressed a plan that was overfunded when the claim was filed.  Very few defined benefit plans are currently overfunded.
• The court acknowledged that the U.S. Department of Labor (DOL) would have standing to sue for a breach of ERISA, even if the participants would not. ERISA section 408(b)(2) fee disclosure and review requirements could provide basis for DOL enforcement action in this type of case.
• This decision did not consider a plan where funding more directly affects participant costs or benefits, such as (a) a contributory pension, where excessive plan expenses may lead to an increase in required employee contributions, or (b) a pension COLA or other benefit that is directly related to plan funding.

Pension COLA Reductions—Contract Breach or Justified Flexibility?

Is it legal to reduce pension cost-of living adjustments (COLAs) being paid to retirees? This question is a major issue, because of the value of COLAs for retirees and their high expense for pension plans. Recent reductions in retiree COLAs for several state and local government pension plans have brought legal challenges. The following paragraphs briefly examine how legal protections for COLAs differ in private sector and public sector pension plans. Recent cases offer less protection to public pension COLAs than previous cases, yet public pension COLAs still exist. In contrast, private plan COLAs have are rare, perhaps due to legal restrictions. Is a COLA that may be reduced better than none?

(a) Broad Level of Protection: Past State Court Decisions Protect Governmental Pension COLAs for Past and Future Accruals. Because state laws vary, there is no single “general rule” for public sector pension COLAs. However, some past state court decisions give public sector COLAs surprisingly broad protections. At least one decision prohibits COLA reductions for past and future pension accruals for active employees, e.g., Calabro v. City of Omaha, 247 Neb. 955, 531 N.W.2d 541 (1995). Another decision prohibits COLA reductions for employees who have worked for a “legally significant period of time” Nash v. Boise City Fire Department, 104 Idaho 803, 663 P. 2d 1105 (1983). These decisions protect COLAs not only for current retirees but also for benefits earned in the future by active employees, so that COLAs may only be cut back for newly hired employees or employees who have worked for less than a “legally significant period of time.” These decisions seem almost naïve in the simplicity with which they create potentially huge future COLA liabilities for state and local pension plans.

(b) Medium Level of Protection:  ERISA Protects Private Sector Pension COLAs for Past Accruals. Unlike the COLA rules for public sector plans that were created by state courts, laws affecting private sector COLAs have been studied, written and revised over time by Congress, the IRS and the U.S. Department of Labor as well as federal courts. The resulting laws, which are more exacting than state court decisions, prohibit reductions in COLAs for past benefit accruals (with limited exceptions for very poorly funded plans). This approach allows reductions in COLAs for benefits earned in the future but not the past. Hickey v. Chicago Truck Drivers, 980 F. 2d 465 (7th Cir. 1992). The laws for private sector pensions also address the question:  May a pension plan avoid this prohibition on COLA reductions by adopting a temporary or “ad hoc” COLA, or does that make the benefit too unreliable because it may be renewed (or not) at the discretion of the plan sponsor? Treasury regulations adopted in 2005 allow only limited use of “ad hoc” COLAs, by prohibiting a COLA (or other benefit) reduction if it is part of “a pattern of repeated plan amendments providing for similar benefits in similar situations for substantially consecutive, limited periods of time.” (Treas. Reg. section 1.411(d)-4 Q&A-1(c)(1).) In simpler (but less precise) words, a private sector pension plan may adopt a temporary COLA once or twice, but the COLA becomes a protected, permanent pension benefit after it is renewed several times.

(c) Low Level of Protection: Recent State Court Decisions Allow Public Pension COLA Reductions for Retirees. Recent state court decisions uphold COLA reductions for public sector pensions, reasoning that (1) the governing pension documents do not state that COLAs are protected contractual rights, and (2) the COLAs are not a protected benefit because they have been repeatedly adopted in varying forms over time. Justus v. Colorado (District Court for Denver City and County, 2011) and Swanson v. Minnesota, (Ramsey County District Court, 2011). Could these decisions approving “ad hoc” COLAs create a precedent that undermines the broader security of public sector pension benefits (a concern that tax regulations governing private sector pensions attempt to address with more detailed regulation)? Or do these decisions allow benefit flexibility that is necessary to continue to pay benefits from underfunded public pension plans (applying less stringent rules than apply to private sector pensions)? Which approach serves the interests of pension plan sponsors and participants more fairly and effectively? One thing is certain: future pension law developments will offer more examples of the trade-off between pension viability, flexibility and security.