• Retirement Plan Changes Under the Pension Protection Act of 2006
  • August 23, 2006
  • Law Firm: Baker, Donelson, Bearman, Caldwell & Berkowitz, PC - Memphis Office
  • Introduction

    The Pension Protection Act of 2006 (the Act) became law on August 17, 2006. Extremely broad in scope, the Act changes many pension plan rules, both as administered by the Internal Revenue Service under the Internal Revenue Code, and by the Department of Labor under the Employee Retirement Income Security Act of 1974 (ERISA). The key tax law changes include a complete change in the funding rules, greater deductibility of pension contributions, faster vesting of employer contributions, expansion of permissible rollovers, revisions to the multi-employer plan rules and the taxation of distributions. ERISA is modified with regard to Pension Benefit Guaranty Corporation insurance and premiums, fiduciary duties, prohibited transactions, disclosure requirements, investment advice, funding and participant-directed investments.

    The non-pension provisions of the Act address incentives for charitable giving, the rules governing charitable organizations, donor-advised funds, rules regarding organizations which support charitable organizations, and others. These non-pension provisions are the subject of a separate Tax Alert also dated August 17, 2006 from Baker Donelson entitled "New Tax Act Impacts Charitable Organizations".

    Because of the length (907 pages) and scope of the Act, this Alert will summarize only the more important pension-related provisions of the Act. In the following months, we expect to address some of the provisions of the Act in greater detail.

    Defined Benefit Pension Plan Funding

    The Pension Benefit Guaranty Corporation (PBGC), a corporation within the U. S. Depart-ment of Labor, administers a mandatory insurance program for most defined benefit pension plans. The PBGC insures only a portion of a plan's benefits, depending upon a variety of factors. Under the Act, accelerated funding will be required for many plans in order to provide better security for full benefits, as well as to reduce the future liability of the PBGC.

    Under current rules, plans which are at least 90% funded have a lot of flexibility in the funding of benefits. If funding falls below 90%, special "deficit reduction" contributions are required. Contributions beyond those which are required are applied to a "credit balance" which can be applied against future funding requirements.

    For most plans, the current funding rules continue to apply until 2008. Beginning in 2008, a completely new approach will accelerate the rate at which pension plans are funded. Funded status will be determined by comparing the value of trust assets to the present value of the "target liability" (benefits earned before the current year) and the "target normal cost" (accruals expected in the current year) benefits. New "segmented" interest rates will be used to value benefits, along with new mortality tables specified by the IRS. The segmented interest rate will depend upon whether a benefit is expected to begin in 0-5, 5-20 or more than 20 years. To smooth the effect of relatively short-term swings in the market values of plan assets, a plan will still be allowed to use an asset value which is averaged over time. However, only a relatively short 2-year averaging period will be allowed (down from five years under current rules), and only if that average value is within 10% of current value. For plans with at least 100 participants, assets must be valued as of the first day of the plan year. All other assumptions will have to be reasonable and must be expected to be accurate. Credit balances will still be allowed to reduce current contributions (they will be called "carryovers" if generated under the current rules and a "pre-funding" balance if they arise under the new rules), but only if the plan is funded at 80% of target after subtracting the credit balance. The required contribution for any year will be the target normal cost (current year liability), plus the target liability (unfunded prior years liability) amortized over a relatively brief 7-year period, plus amortization of any funding waivers granted. Contributions normally will be due within 8.5 months after the end of a plan year, but quarterly contributions will still be required if a funding shortfall existed in the prior year. Plans with fewer than 100 participants will no longer be subject to the quarterly contribution requirement. Excise taxes and interest will still be due on late contributions.

    An "at risk" plan will require even more accelerated funding, if the employer had more than 500 participants in all defined benefit plans in the prior year. A plan will be at risk if, after subtracting all credit balances, the plan is funded below 80% of target, as well as below 70% of target if every worker who could retire within 10 years is assumed to retire at the earliest date with the most valuable option available. The 80% at-risk level will phase in, beginning at a lower 65% level in 2008 and increasing to 80% in 2011. Certain auto industry plans are exempt. Airlines and airline caterers are also exempt from these new rules, and can amortize funding shortfalls over a period of up to 17 years, provided accruals cease and other requirements are satisfied.

    Taxation of Top Executives on Certain Nonqualified Deferred Compensation

    The benefits which may be paid from nonqualified deferred compensation plans (e.g., from Supplemental Executive Retirement Plans or SERPs), may be affected by the funded status of tax-qualified defined benefit pension plans. Code Section 409A was amended to prohibit any set-aside of assets (such as to a "rabbi trust") to pay nonqualified deferred compensation benefits for any of the top five executive officers. This prohibition applies to assets set aside when any member of the controlled group is bankrupt, has an at-risk plan, or has a plan which is underfunded when it is terminated. Under those circumstances, Section 409A will treat any new amount set aside as taxable to the executive immediately, and will increase significantly the rate of income tax payable by the executive on the deferred compensation. The rate of income tax will increase by a minimum of 20% of the amount of deferred compensation. Under existing Section 409A Proposed Regulations, this may also cause other nonqualified deferred compensation amounts to be taxed similarly. If the employer provides a gross-up payment to cover the extra income tax payable by the executive, a deduction by the employer for the gross-up payment will be denied, and that payment will also be subject to the higher income tax rate. This change is effective immediately.

    Deduction Limits For Retirement Plan Funding

    Presently, deductions are denied and a 10% excise tax is payable for contributions in excess of a plan's current funding liability. To allow compliance with the new accelerated funding rules, and to encourage even better voluntary funding, the Act increases the limits on deductions for pension funding. Beginning immediately, while the current funding rules apply, the Act now allows an employer to contribute and deduct up to 150% of the current liability. When the new funding rules begin to apply, employers may contribute and deduct the target normal (current year) cost, plus 150% of the target (prior years) liability, plus an allowance for future pay and benefit increases, minus the value of assets.

    Plan Design Will Be Affected By Funding Levels

    If a plan's funding falls below 80% (or would fall below 80% as the result of an amendment), the plan may not be amended to provide a benefit increase unless either a contribution is made to fully fund the increase or to raise the plan's funding to at least 80%. If funding is somewhat lower (between 60% and 80%), lump sum payments may not exceed either the relatively low present value of the benefit which is guaranteed for that participant by the PBGC, or 50% of the present value of the full accrued benefit. The remainder of the benefit would be required to be paid as an annuity. In addition to these restrictions, if funding falls below 60%, the plan will not be allowed to pay shutdown or similar benefits, nor to accelerate payments (e.g., by adding lump sum payments), and all benefit accruals must stop as of the start of the year. These restrictions generally apply beginning in 2008. In addition, beginning in 2008 lump sum benefits will be required to be calculated using new assumptions which will tend to reduce the amount payable (and thus reduce the drain on plan assets). As a result, some participants who are near retirement may consider retiring before 2008. Beginning immediately, other new rules apply to determine whether pension benefits exceed the maximum allowed. Again, this may reduce the amount allowed to be paid.

    PBGC Benefit Insurance

    Plans which are subject to ERISA Title IV (generally, any defined benefit plan which is not a church or governmental plan) must pay premiums to the PBGC to insure a portion of the plan benefits. A flat rate premium (now about $30 per person per year) is paid by all plans, plus a $9 variable rate premium for each $1,000 of unfunded vested benefits. Beginning in 2008, the variable premium will be reduced to $5 per $1,000 for plans of employers with 25 or fewer employees. New methods will apply to determine the level of funding for variable premium purposes. After 2007, variable premiums can be due even if a plan has satisfied its current funding limit. If a plan is amended to increase benefits, the PBGC insurance on the increase is phased in over five years. A permanent rule now requires payment of special premiums of up to $3,750 per person if a plan transfers liabilities to the PBGC.

    Level of Pension Benefits Insured by the PBGC

    Benefits payable through the PBGC are now based on benefits earned as of the date the plan terminates, as well as other factors. Under new rules, if a plan terminates after an employer goes into bankruptcy, the bankruptcy date, rather than any later plan termination date, is used to identify the benefits which are insured.

    Notice and Disclosure to Participants of Pension Information

    Beginning in 2008, new annual disclosures to participants will be required, regarding the funded status of pension plans. Within 120 days after each plan year starts, participants must be told whether the plan is in danger and how to get additional information. Beginning in 2008, any plan which is less than 80% funded will be required to make additional disclosures. Effective immediately, if an underfunded plan terminates, disclosures to participants are required within 15 days after filing with the PBGC.

    Other Retirement Arrangement Rules

    Presently, only a participant or a surviving spouse may roll over a distribution to another plan or IRA. In a key change, after 2006 a non-spouse designated beneficiary may roll over a distribution to an IRA or other tax-qualified plan to avoid current taxation. The rollover IRA is then treated as an inherited IRA, and will be subject to the rules for distributions to beneficiaries.

    Essentially all of the key temporary changes made in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) (prior pension legislation) were made permanent. For example, a participant in a defined contribution plan can continue to be allocated a yearly total contribution equal to 100% of pay, rather than only 25% of pay.

    Employers which have both defined benefit and defined contribution plans can deduct an amount equal to the greater of the defined benefit plan's required contribution or 25% of participant pay. Under the Act, an employer will always be able to contribute and deduct at least 6% of payroll to defined contribution plans. Effective in 2008, any permitted contribution to a PBGC-covered plan is fully deductible, and is disregarded in applying the combined plan limit.

    After 2006, after-tax contributions may be rolled over from a tax-qualified plan to another tax-qualified plan or to a tax-sheltered annuity (403(b)) plan. After 2007, a participant in a qualified retirement plan, 403(b) plan or 457 plan may roll over a distribution to a Roth IRA.

    Hardship distributions are now permitted to be made based on an appropriate hardship of a participant's spouse or beneficiary. This change is voluntary and is available immediately.

    Special rules allow repayment of distributions to a person called up to active military reserve status before 2008, provided active status continues for at least 179 days. The provision is retroactively applicable to distributions after September 11, 2001.

    Investment Advice, Prohibited Transactions and Fiduciary Rules

    The new law addresses investment advice and clarifies some prohibited transaction and fiduciary rules. It creates a prohibited transaction exemption for investment advice provided to an employer sponsor of a retirement plan through a computer model that is certified by an independent party. This will allow a party in interest to provide investment advice using an objective computer model of investment alternatives. The Labor Department is to issue further guidance.

    The Act extends fiduciary protection to situations where a participant does not make an investment choice and the plan sponsor makes a default investment consistent with regulations to be issued by the Department of Labor. This provision will permit employers to select a default investment that provides a more realistic possibility of growth for those participants who choose not to exercise their privilege to self-direct their accounts. This provision is effective for plan years beginning after 2006.

    Under the Act, a plan fiduciary is no longer protected from liability during blackout periods when a participant cannot self-direct, unless certain specific requirements regarding reasonable blackout periods are satisfied. This proposal is effective for plan years after 2007; after 2010 for collectively bargained plans.

    The new Act increases the maximum bond amount to $1,000,000 for plans that hold employer securities, for years after 2007. It also increases the maximum penalties for coercive interference with ERISA rights from $10,000 and one year in prison, to $100,000 and three years in prison, effective upon enactment. There are new rules regarding the "safest annuity available" standard, which is the correction period for certain prohibited transactions involving securities and commodities, and prohibited transactions relating to financial investments.

    Participation Rules Under Pension Plan Diversification

    Under current law, a plan that allows participants to invest in employer stock or receive employer contributions in the form of employer stock can restrict the ability of a participant to sell the stock. The new law requires such plans to allow the participant to diversify investments and employer securities at any time after the employee has been in the plan for three years. The rule applies to plans with publicly-traded employer securities. There is an exception for ESOPs that do not have elective, employee or matching contributions. The rules are generally effective for plan years beginning after 2006; after 2008 for collectively bargained plans.

    The new law provides a safe harbor for non-discrimination testing by plans that have automatic enrollment. If such a plan satisfies new elective contribution, matching contribution and non-elective contribution requirements, it will be able to take advantage of a special matching safe harbor for non-discrimination testing. The new provisions also address employer concerns regarding automatic enrollment in connection with state garnishment laws and fiduciary liability. It extends the time to make corrective distributions to 100 days after the end of the plan year for eligible automatic plan contribution arrangements.

    The Act allows a small employer (500 employees or fewer) to establish a combined defined benefit and 401(k) plan. Previously, a 401(k) arrangement could not be combined with a defined benefit plan, and instead had to be structured as two separate plans. The defined benefit accrual could not be conditioned on elective deferrals to the 401(k) arrangement. Under the new rules, the plans can be combined, subject to minimum accrual requirements for the defined benefit plan. The defined benefit component may be a cash balance plan, with the accrual being in the form of a minimum pay credit.

    Faster vesting is required for employer non-elective contributions for plan years beginning after 2006; after 2008 for collectively bargained plans. In a defined contribution plan there must now be a three-year cliff vesting, or two-through-six year phased vesting for all employer contributions, including non-elective employer contributions and matching contributions.

    There are also new rules for distributions to individuals during working retirement which will permit in-service distributions from defined benefit plans after age 62.

    Spousal Pension Protection

    The Pension Protection Act requires the Department of Labor to issue regulations that will prevent a domestic relations order from being denied treatment as a qualified domestic relations order merely because it is issued after or revises another order, or because of the time it is issued. There are also new rules for divorced spouses in connection with retirement annuities. The new Act requires plans that are already required to offer the qualified joint survivor annuity to offer, as an option, a joint and survivor annuity benefit that provides at least a 75% survivor benefit. This provision is effective for plan years beginning after 2007; after 2008 for collectively bargained plans.

    New Administrative Provisions

    The Act provides new rules that allow the IRS to design, modify and waive income and excise taxes in connection with the Employee Plans Compliance Resolution System. It also provides new rules regarding the notice and consent for distributions.

    The Act provides reporting simplification for one-person plans with less than $250,000 in assets, and simplified reporting for plans with fewer than 25 participants, for years beginning after 2006. It also provides for certain voluntary early retirement incentive and employment retention plans for local education agencies and other entities. There are new rules in connection with anti-cutback rule application for amendments made to comply with the new Act. The new Act prohibits states from reducing unemployment compensation due to pension distributions that were rolled over and are not taxable.

    Funding Rules for Multi-Employer Defined Benefit Plans

    A multi-employer plan is a plan established pursuant to a collective bargaining agreement between more than one unrelated employer and a union. The collective bargaining agreement will determine the amount of employer contributions required to be made to the plan and the plan document will determine the level of benefits to be paid. Multi-employer defined benefit plans are, however, subject to funding rules similar to single employer defined benefit plans. Actuarial assumptions are used to determine standard funding and past service liability is amortized over a period of years. The new law reduces the amortization period to no more than 15 years (as opposed to more than 30 years under prior law). Under certain circumstances, however, the plan may apply to the Secretary of the Treasury for an automatic extension of the amortization period for up to five years. The Secretary of Treasury may also grant an additional extension of such amortization period for an additional five years. The interest rate used for funding waivers and extensions of amortization periods is now the plan rate. Under the new law, each of the assumptions used by the plan's actuary must be reasonable, as opposed to a standard which provided that the assumptions overall must be reasonable. These provisions are effective for plan years beginning after 2007.

    The new law now defines underfunded multi-employer plans as plans in "endangered status," "seriously endangered status" and "critical status." The plan actuary must now certify to the Secretary of Treasury and to the trustees of the plan whether the plan is in "endangered" or "critical" status for the plan year.

    A plan is in "endangered status" if the plan's funded percentage for the plan year is less than 80%, if the plan has an accumulated funding deficiency or is projected to have an accumulated funding deficiency in any of the six succeeding plan years. A plan is in "seriously endangered status" if the plan's funded percentage for the plan year is less than 70%. A plan is in "critical status" for a plan year if the funded percentage of the plan is less than 65% for the plan year, and contributions projected to be made in the six succeeding plan years are less than the present value of all benefits projected to be payable under the plan during that period. A plan that is in "endangered" status must establish a funding improvement plan designed to increase the funded percentage of the plan over a 10-year period; a "seriously endangered" plan must adhere to a 15-year funding improvement period. After a funding improvement plan is adopted, the trustees must notify the bargaining parties of the details of the funding improvement plan and annually update any schedule of contribution rates to reflect the experience of the plan. During the funding improvement plan period, the trustees may not accept collective bargaining agreement provisions that allow a reduction or suspension in contributions. Nor may the trustees amend the multi-employer plan to increase liabilities of the plan except as required as a condition of qualification under the Internal Revenue Code. Should the trustees fail to adopt a funding improvement plan, an ERISA penalty of up to $1,100 per day may apply. If the funding improvement plan requires an employer to make additional contributions to the multi-employer plan, such employer is subject to an excise tax should it fail to make such contributions.

    Contributing employers to a multi-employer plan that is in "critical status" will be required by the new law to make additional contributions to assist in funding the plan. In addition, the trustees may make reductions to adjustable benefits (i.e., benefits other than normal retirement benefits) to reduce plan liabilities. Notice of any such reduction must be provided to interested parties. A multi-employer plan in "critical status" must adopt a rehabilitation plan, which provides for annual standards to be met to rehabilitate the plan over a 10-year period. Like an "endangered" plan, a multi-employer plan in "critical status" may not accept collective bargaining agreement changes that provide for reductions or suspensions in contributions during the rehabilitation period. Further, a plan in "critical status" may not be amended during the rehabilitation period in a way that is inconsistent with the rehabilitation plan. Should the trustees or the bargaining parties fail to adopt a rehabilitation plan, ERISA imposes a penalty of up to $1,100 per day. There are also similar excise taxes on employers failing to meet the required contributions as there are to plans in "endangered status." ERISA has been amended to allow an employer that has an obligation to contribute to a multi-employer plan in "endangered" or "critical" status to bring a cause of action against the multi-employer plan if a funding improvement or rehabilitation plan is not established. These provisions are effective for plan years beginning after 2007.

    There are modest changes to the withdrawal liability rules. Under the new law, each year the trustees must determine whether the plan will be insolvent in any of the next five plan years rather than three plan years as under previous law. The new law extends certain limited exceptions to the withdrawal liability rules to employers in the building and construction industries. This exception allows employers to have what is known as a "free look." Under the new law, in the event that there is a dispute between an employer and the plan, in limited circumstances, regarding whether withdrawal liability occurred, the employer may elect to hold withdrawal liability payments until a final decision is rendered with respect to the dispute.


    The new law expands certain notice requirements to provide more detailed information to plan participants and beneficiaries and the PBGC, including annual funding notices and annual reports for both single and multi-employer plans. In addition, the funded status of a multi-employer plan must be more detailed for the labor organizations and employers required to contribute to the plan. The annual funding notice, which replaces the summary annual report for defined benefit plans with more than 100 participants, must include the following information: (1) a statement of the number of participants who are retired or separated and receiving benefits, the number of participants entitled to future benefits and the number of active participants; (2) a statement of the funding policy of the plan and the asset allocation of investments; (3) a detailed explanation of any plan amendment, scheduled benefit increase or reduction, or other event taking place that will have a potential effect on plan liabilities or assets for the year; and (4) a statement that a person may obtain a copy of the plan's annual report through the Department of Labor's website or the plan sponsor's intranet site.

    Notices must also contain statements regarding funding percentage (for defined benefit plans) and assets and liabilities under the plan. The notice must be provided within 120 days after the end of the plan year to which it relates.

    The trustees or administrator of a multi-employer plan must, under the new law, provide a contributing employer with an estimate of that employer's withdrawal liability upon written request. Annual report information must be filed with the Secretary of Labor in an electronic format that accommodates display on the internet.

    The rules have changed somewhat for significantly underfunded plans with respect to reporting to PBGC. Under the new law, reporting to PBGC is required if the funding target attainment percentage at the end of the preceding plan year is less than 80% (with exceptions for small plans) as opposed to less than $50,000,000, under prior law. Employers are now required to provide additional notice to affected parties in the case of a distressed termination.

    Under other provisions of the new law, participants are entitled to divest themselves of publicly-traded employer securities held by certain plans, and employers must now provide notices to interested parties in connection with that right. A failure to provide such notice may result in a civil penalty against the plan administrator of up to $100 per day.

    Expanded information must be included in periodic benefit statements for both defined contribution plan participants and defined benefit plan participants. With respect to defined contribution plan participants, the new benefit statements must be provided quarterly to participants who direct the investment of their accounts and annually to other participants, and must include the value of each investment to which assets in the individual's account are allocated, including the value of any assets held in the form of employer securities. The statement must also provide an explanation of any limitations or restrictions on any right of the individual to direct an investment, and an explanation of the importance of a well balanced and diversified portfolio for the long-term retirement security of participants and beneficiaries, along with information directing the participant to the Department of Labor website for sources of information on investing and diversification. The Department of Labor is directed, within one year after the date of enactment, to develop one or more model notices that may be used by plan administrators to comply with this requirement.

    There are also expanded notices of the blackout periods under the Sarbaines-Oxley Act of 2002. Generally, these requirements are effective for plan years beginning after 2007.

    Benefit Accrual Standards

    The new law makes it clear that cash balance and other hybrid plans do not, by their terms, violate the age discrimination rules if benefit accruals are equal among participants who are similarly situated except with respect to age.

    Under the new law, hybrid plans must meet certain requirements with respect to interest credits and vesting requirements. When a plan converts to a hybrid plan, the accrued benefit of any participant must not be less than the sum of the participant's accrued benefit for years of service before the conversion, plus the participant's accrued benefit for years of service after the conversion. In each, the accrued benefit is determined under the plan as in effect at the relevant time. In general, the effective date of this provision is for periods beginning on or after June 29, 2005.