- Pension Protection Act of 2006 Makes Sweeping Changes to Retirement Plans
- August 22, 2006 | Authors: Steven D. Kittrell; Jeffrey R. Capwell; Larry R. Goldstein
- Law Firms: McGuireWoods LLP - Washington Office ; McGuireWoods LLP - Charlotte Office ; McGuireWoods LLP - Chicago Office
The Pension Protection Act of 2006 (“PPA”) was signed into law today by President Bush. It makes some of the most significant changes to the law governing retirement plans since the Employee Retirement Income Security Act of 1974 (“ERISA”) was enacted.
The PPA is the Congressional response to a number of retirement policy concerns. The most significant concern was the perceived need to shore up funding of defined benefit pension plans. Congress has also recognized that because 401(k) plans are now the principal employer-sponsored retirement vehicle, employee savings through such plans must be increased and employees should be offered greater assistance in investing their account balances prudently. In addition, the PPA makes permanent the increased contribution and benefit limits that were enacted by Congress as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”).
The PPA covers many other areas as well, incorporating provisions which had been included in various bills introduced in Congress over the last few years.
The following is an overview of some key PPA provisions, primarily in connection with single-employer retirement plans. The McGuireWoods Employee Benefits Group will be making available a more comprehensive analysis of the PPA and will be sponsoring a telephone conference to discuss key implications of the PPA on September 12, 2006. Our analysis of the PPA will be distributed to teleconference registrants before the date of the teleconference. To register for the teleconference, visit our events section online.
Defined Benefit Plan Funding
Current law for funding defined benefit plans generally will remain in effect until plan years beginning in 2008. Complex new funding requirements will be imposed in 2008 and beyond. This summary only covers the highlights.
Each year from 2008 to 2015, a defined benefit plan will have to make a minimum funding contribution of the sum of:
The projected cost of future benefits that accrue during the year (the “normal cost”); plus
The “shortfall contribution,” which will amortize over 7 years any difference between plan assets and 100% of plan liabilities.
Observation: The requirement to fund at 100% of plan liabilities will substantially increase the short-term funding cost of many defined benefit plans. The PPA should result in much larger contributions during the 7-year amortization period.
Funding toward the 100% funding target may be deferred until 2011 for certain well-funded plans under limited cases. These plans also may be able to retain temporarily the use of credit balances for funding purposes. Otherwise, credit balances will generally be subtracted from assets and will be valued based on actual rates of return on assets.
One of the key issues for the PPA is the interest rate to be used in determining liabilities. The PPA introduces the concept of a “modified yield curve.” In general, the modified yield curve represents plan liabilities over 3 future periods: (1) 5 years or less, (2) 5 to 20 years and (3) more than 20 years. The modified yield curve would be based on A-, AA- and AAA-rated corporate bonds of corresponding maturities. Interest-rate and asset-value smoothing will be limited to a maximum smoothing period of 2 years with a narrower maximum and minimum corridor.
"At-risk" plans will have accelerated funding requirements before 2015, subject to a number of special rules. An at-risk plan is generally one where assets are less than (1) 70% of liabilities using special at-risk assumptions and (2) 80% of liabilities using regular assumptions (the 80% is phased in from 65% in 2008 to 80% in 2011). The special at-risk assumptions can include assuming the most expensive form of benefit payment is paid (usually a lump sum) and a special loading factor that results in larger liabilities.
Another major change will be restrictions on an employer’s ability to improve benefits, pay certain forms of benefits or even accrue new benefits when a plan is underfunded. Generally, this would apply between 2008 and 2015 before 100% funding is mandated. If a plan is less than 60% funded, the plan would be frozen for new benefit accruals, no lump sums could be paid and plant shutdown benefits would be restricted. Between 60% and 80% funded, benefits could not be increased unless the increase is paid for immediately and a plan could only allow partial lump-sum payments.
Commercial airlines may use a 10-year amortization period under the new rules to get to 100% funding. Alternatively, airlines can use a 17-year amortization period but would have to use more restrictive interest rate and asset valuation rules.
To support these increased funding requirements, maximum deductible contributions would be increased to 150% (currently 100%) of the excess of current liability over plan assets for 2006 and 2007. After 2007, contributions up to full funding would be allowed. In addition, a “cushion” contribution will be provided to allow additional funding by companies in good financial times.
Lump-sum benefit payments will have to be calculated using the modified yield curve interest rates and an IRS mortality table. There will be a 4-year phase-in of the new methodology beginning in 2008.
In general, multiemployer pension plans would remain under current funding rules. However, a funding improvement or rehabilitation plan could require additional contributions or benefit limits for some plans.
Cash Balance and Other Hybrid Plans
On a prospective basis, the PPA generally approves the concept of a cash balance or other hybrid plan design by eliminating the age discrimination concerns that have been the focus of litigation in recent years. Under the PPA, there is no age discrimination if pay and annual interest credits are the same for older and younger workers. Also, interest credits cannot be greater than a market rate of return. These rules are effective June 29, 2005.
The PPA also addresses the so-called “whipsaw” issue, whereby differences in the interest rate used for projecting a plan participant’s benefit versus the interest rate used to discount it for a lump-sum distribution could result in the participant receiving a benefit payment larger than his or her projected benefit under the plan.
The PPA eliminates this issue for distributions made after August 17, 2006, but does not extend relief to earlier distributions.
The PPA states that no inference should be drawn from changes to the law as to whether a plan discriminated on the basis of age before June 29, 2005. In addition, no inference can be drawn on the issue of whipsaw calculations for a lump-sum distribution made on or before August 17, 2006.
Beginning in 2008, participants in these plans must be fully vested after 3 years in all cases. Also, new interest credit rules will apply to deal with special situations, such as use of the greater of a fixed or variable rate.
Effective June 29, 2005, conversions of plans to a hybrid formula have to meet special requirements. In particular, there cannot be a “wear-away” of benefits.
Funding Limited for Nonqualified Deferred Compensation Plans
The PPA provides that beginning in 2008, a company that sponsors an “at-risk” pension plan cannot put additional funds into a trust for a nonqualified deferred compensation plan, such as a “rabbi trust.” The consequence of violating this requirement would be immediate taxation of certain participants’ deferred compensation benefits under Section 409A of the Internal Revenue Code of 1986 (the “Code”). The tax will apply to the named executive officers for proxy purposes and to any additional person who is an insider subject to Section 16 of the Securities Exchange Act of 1934 (the “1934 Act”). In addition to the current taxation of the deferred compensation benefits, the Section 409A penalty and interest provisions will apply.
Observation: This provision may make springing rabbi trust provisions even more problematic than under the current Section 409A rules.
Limited Movement to “Working Retirement”
In a small step toward phased retirement, the PPA would allow a defined benefit plan to start paying benefits to actively-at-work participants once they reach age 62. This provision will be effective for payments in plan years commencing after December 31, 2006.
As noted above, the PPA makes permanent the higher annual contribution limits for defined contribution plans and higher annual contribution limits for defined benefit plans that were enacted as part of EGTRRA. The PPA also makes permanent higher limits on 401(k) pre-tax employee contributions, higher limits on includible compensation for plan purposes, higher deduction limits for profit-sharing plans, the availability of catch-up contributions and Roth 401(k) accounts and the repeal of the multiple-use limit affecting 401(k) plans. These provisions were also part of EGTRRA and had been scheduled to expire at the end of 2010.
Automatic 401(k) Enrollment
The Internal Revenue Service (“IRS”) has permitted automatic enrollment of employees in 401(k) plans since 1998. The PPA adds a number of provisions to the Code and ERISA to facilitate and encourage automatic enrollment.
First, a new “safe harbor” is added to the Code to enable 401(k) plans which provide automatic enrollment to avoid having to satisfy the actual deferral percentage (“ADP”) and actual contribution percentage (“ACP”) tests. Under this new safe harbor, eligible employees who do not opt out must be enrolled for 401(k) contributions of up to 10% of compensation, with a minimum of 3% the first plan year and gradually increasing to at least 6% for the fourth and all future years.
The safe harbor is only available if the employer makes a matching contribution of 100% of the 401(k) contributions of each nonhighly compensated employee (“NCE”) up to 1% of compensation and a 50% match on any contributions of between 1% and 6% of compensation. Alternatively, a 3% nonelective employer contribution must be made on behalf of all NCEs, whether or not they contribute. These employer contributions must become fully vested for all employees who have completed at least 2 years of service.
Advance notice of the automatic enrollment procedures in the safe harbor must be given to eligible employees within a reasonable period before each plan year as to (1) exercising opt-out rights and (2) default investment elections.
Second, a provision has been added to ERISA to preempt any state laws which directly or indirectly preclude a plan from having an automatic enrollment feature. This includes automatic enrollment features which satisfy certain basic requirements (although not necessarily the new safe harbor in the Code). The preemption provision is designed to prevent the enforcement of state laws which prohibit deductions from an employee's wages (with certain exceptions) without his or her consent.
The new safe-harbor Code provisions on automatic enrollment take effect for plan years beginning after 2007. However, the ERISA preemption provisions became effective immediately upon the enactment of PPA.
Observation: Some employers hesitated to implement automatic enrollment based on concerns that state laws could be construed to prohibit payroll deductions in the absence of affirmative consent. The ERISA preemption provisions in the PPA should eliminate these concerns. Other employers may consider adding automatic enrollment features to their plans which are designed to satisfy the new safe harbor in order to avoid having to satisfy the ADP and ACP tests; they will want to compare the cost of this new safe harbor, in terms of employer contributions, with the costs of the existing safe harbors in the Code.
ERISA Section 404(c) generally provides that if a participant exercises investment control over the assets in his or her account in a defined contribution plan and the plan meets certain regulatory requirements, plan fiduciaries will not be liable under ERISA for any loss resulting from such exercise of investment control. In the preamble to its 1992 final regulations under these provisions, the United States Department of Labor (“DOL”) indicated that plan fiduciaries will not be relieved of responsibility for investment decisions under a plan unless those decisions have affirmatively been made by participants who have exercised independent control over their accounts.
The PPA modifies the provisions of Section 404(c) to extend relief from fiduciary liability in two specific circumstances in which participants do not make affirmative investment elections: default investments and asset reallocation. The default investment situation commonly occurs when a participant enrolls in a plan (or is automatically enrolled) but fails to direct how his or her contributions are to be invested. The PPA clarifies that Section 404(c) relief will be available to plan fiduciaries if participants are provided with notice of the plan’s default investment procedures and their ability to affirmatively elect an investment, and if the default investment meets certain requirements. The DOL is responsible for developing regulations that address these requirements.
The asset reallocation issue typically arises when a plan investment is eliminated or replaced, and amounts currently invested in that option need to be reallocated to another investment option or options under the plan. The PPA permits Section 404(c) relief to apply to reallocations that are made in the absence of affirmative participant investment directions so long as the participant’s original investment directions were the result of his or her independent exercise of investment control, and advance notice is provided to participants which explains the change in investment options (including a comparison of the old and new options) and how assets will be automatically reallocated in the absence of an affirmative participant direction. In addition, the risk and return characteristics of the new investment option(s) must be comparable to those of the old investment option(s).
These changes are effective for plan years beginning after 2006.
Observation: The new provisions will apply to any plan where a participant has the opportunity to direct the investment of his or her account in accordance with Section 404(c) but fails to do so. In recent years, some employers have changed the default funds in their plans from money market funds to funds having equity investments, such as “retirement-date” funds where the investment mix is tailored to the participant's anticipated retirement date. The new provisions may encourage other employers to take similar steps.
Employer-Provided Investment Advice to Defined Contribution Plan Participants
Many employers who offer employees the opportunity to direct the investment of their retirement plan accounts are concerned that the employees lack the know-how to invest prudently for retirement. Engaging a financial planner to provide advice to plan participants may present fiduciary responsibility concerns and possibly violations of the prohibited transaction rules in ERISA and the Code. For example, a financial planner who is a fiduciary under ERISA on account of providing plan investment advice for a fee may engage in a prohibited transaction if he or she accepts additional fees from the providers of the investment products he recommends.
The PPA attempts to deal with this issue in two ways. First, the PPA adds a new prohibited transaction exemption for advice given after 2006 pursuant to “eligible investment advice arrangements.” Second, the PPA amends ERISA to specifically provide that plan sponsors or other plan fiduciaries that contract with independent parties to provide for investment advice under such eligible investment advice arrangements will not be subject to fiduciary responsibility for the advice that the independent adviser provides and will not be required to monitor the specific investment advice it provides to participants. However, such plan sponsors/other fiduciaries will be required to prudently select the independent investment adviser and to periodically review its performance.
To qualify as an eligible investment advice arrangement, the arrangement must either (1) provide that any fees (including commissions or other compensation) received by the fiduciary adviser for investment advice or as to the sale, holding or acquisition of any security or other property for purposes of investment of plan assets do not vary depending on the basis of any investment option selected; or (2) use a computer model under an investment advice program in connection with the provision of investment advice by a fiduciary adviser to a participant. The computer model must meet certain requirements, including applying generally-accepted investment theories that take into account the historic returns of different asset classes over defined periods of time and utilizing relevant information about the participant and prescribed objective criteria to provide asset allocation portfolios comprised of investment options available under the plan. Also, such a model must operate in a manner that is not biased in favor of investments offered by the fiduciary adviser or an affiliate and must take into account all investment options under the plan in specifying how a participant's account balance should be invested.
Various other requirements must be met, including having the advice arrangement approved by a plan fiduciary other than the person offering the investment advice under the arrangement, any person providing investment options under the plan or any affiliate of either. Also, detailed notification must be provided to plan participants in advance of any investment advice being given.
The persons who can be fiduciary advisers under an eligible advice arrangement include registered investment advisers, banks, insurance companies and registered broker-dealers.
Observation: The investment advice provision is more expansive than some interest groups had wanted. While many groups supported a general protection for plan sponsors and other fiduciaries from liability for the advice provided by a prudently selected and monitored investment adviser, the prohibited transaction relief for advisers who may be affiliated with or compensated by funds that they recommend was more controversial. It is anticipated that the DOL will provide extensive clarifying guidance with respect to these provisions.
Diversification of Investments in Certain Defined Contribution Plans
When Enron Corp. and other companies collapsed several years ago, 401(k) plan participants whose accounts were invested in company stock suffered severe losses. In some cases, such as with employer matching contributions, there was no other investment option. The PPA seeks to prevent these situations from occurring in the future by requiring certain qualified plans to offer diversification alternatives effective for plan years beginning after 2006. Plans affected are defined contribution plans holding any publicly-traded employer securities. Employee stock ownership plans (“ESOPs”) are exempt if they do not provide for salary deferral, employee after-tax contributions or employer matching contributions.
The new provisions require that any participant or beneficiary having a 401(k) or employee after-tax contribution account invested in employer securities be permitted to direct the plan to divest any such securities and to reinvest an equivalent amount in other investment options. As to employer contribution accounts invested in employer securities, the same diversification rights are afforded to participants who have completed at least 3 years of service and to beneficiaries. The plan must offer not less than 3 investment options, other than employer securities, to which the participant or beneficiary may direct the proceeds from the divestment of employer securities. Each investment alternative must be diversified and must have materially different risk and return characteristics.
Observation: The new provisions resemble in some respects the diversification options which ESOPs must offer to participants who have attained age 55 and have completed 10 years of participation. However, survey data indicate that many plans have been modified in recent years to allow for immediate diversification. As a result, this provision may have little practical significance for many plan sponsors that offer employer securities as an investment option under their plans.
Faster Vesting in Defined Contribution Plans
The PPA requires defined contribution plans to vest employer nonelective contributions no later than under a 3-year “cliff” vesting schedule or a 2-to-6 year graded vesting schedule. Employer nonelective contributions will now be subject to the same minimum vesting schedule that is required for employer matching contributions. The new requirements apply to contributions for plan years beginning after 2006.
Except as discussed above for certain cash balance and other hybrid plans, minimum vesting in defined benefit plans will remain at either a 5-year cliff vesting schedule or a 3-to-7 year graded vesting schedule.
Observation: The new requirements will affect money purchase pension plans, profit-sharing plans, profit-sharing contributions to 401(k) plans, stock bonus plans and ESOPs. Rather than establishing a separate set of accounts for post-2006 employer nonelective contributions, some employers may instead extend the new vesting requirements to nonelective contributions for 2006 and previous years.
Expanded Rollover Opportunities
The PPA makes a number of changes to the rules governing the rollover of distributions from retirement plans. For distributions after 2006, a tax-free rollover can be made by a non-spouse beneficiary of a deceased plan participant. Previously, only spousal beneficiaries could make rollovers.
Effective for distributions after 2007, a direct rollover can be made from a qualified plan to a Roth IRA, provided certain conditions are met.
Charitable Contributions Directly from IRAs
The PPA provides a limited opportunity during 2006 and 2007 to direct distributions from an individual retirement account to certain qualified charities without incurring tax on the IRA distribution. The distributions are limited to $100,000 per year per taxpayer, and must be made on or after the date the taxpayer attains age 70½.
Additional Survivor Annuity Option
Effective generally for plan years beginning after 2007, the PPA requires that a plan offering a qualified joint and survivor annuity (“QJSA”) permit benefits to be paid in the form of a “qualified optional survivor annuity” (“QOSA”) at the election of the participant. A QOSA is an annuity for the life of the participant with a survivor annuity for the spouse which is equal to the applicable percentage equal to the applicable percentage of the amount of the annuity payable during the joint lives of the participant and the spouse and is also the actuarial equivalent of a single-life annuity for the life of the participant.
If the survivor annuity provided by the QJSA under the plan is less than 75% of the annuity payable during the joint lives of the participant and the spouse, the applicable percentage for the QOSA is 75%. If the survivor annuity provided by the QJSA under the plan is greater than or equal to 75% of the annuity payable during the joint lives of the participant and the spouse, the applicable QOSA percentage is 50%.
For collectively-bargained plans, these new requirements apply to plan years beginning on or after the earlier of (1) the later of January 1, 2008, and the last date on which an applicable collective bargaining agreement terminates (without regard to extensions) and (2) January 1, 2009.
Higher Bonding Limit for Plans With Employer Securities
Effective for plan years beginning after 2007, the PPA increases the maximum ERISA bond from $500,000 to $1 million for plans holding employer securities.
As particular provisions of the PPA take effect as to a qualified plan, the plan must be operated as if the amendment were in effect. Amendments themselves must be adopted, with retroactive effect, by the last day of the first plan year beginning on or after January 1, 2009, but governmental plans have an additional 2 years in which to amend.
Additional Disclosure Requirements
The PPA expands ERISA disclosure requirements in a number of areas. Of particular interest are new requirements to provide periodic benefit statements to retirement plan participants. There are separate requirements for defined contribution and defined benefit plans.
The administrator of a defined contribution plan is required to provide a benefit statement (1) at least quarterly to a participant or beneficiary who has the right to direct the investment of the assets in his or her account; (2) at least annually to any other participant or other beneficiary who has his or her own account under the plan; and (3) to other beneficiaries, upon written request, but limited to one request during any 12-month period. The statement must include the total account balance and the vested account balance (or the earliest date on which the account will be vested), as well as the value of each investment to which assets in the individual's account are allocated (determined as of the plan's most recent valuation date). A quarterly benefit statement provided to a participant or beneficiary who has the right to direct investments must also include (1) an explanation of any limitations or restrictions on any right of the individual to direct an investment; (2) an explanation, written in a manner calculated to be understood by the average plan participant, of the importance, for the long-term retirement security of participants and beneficiaries, of a well-balanced and diversified investment portfolio, including a statement of the risk that holding more than 20% of a portfolio in the security of one entity (such as employer securities) may not be adequately diversified; and (3) a notice directing the participant or beneficiary to the Internet website of the DOL for sources of information on individual investing and diversification.
The administrator of a defined benefit plan is required either to (1) furnish a benefit statement at least once every 3 years to each participant who has a vested accrued benefit under the plan and who is employed by the employer at the time the benefit statements are furnished to participants; or (2) furnish at least annually to each such participant notice of the availability of a benefit statement and the manner in which the participant can obtain it. The administrator is also required to furnish a benefit statement to a participant or beneficiary upon written request, limited to one request during any 12-month period. The statement must indicate, based upon the latest available information, the total benefit accrued and the vested benefits which have accrued (or the earliest date on which benefits will be vested). In the case of a statement provided to a participant other than at his or her request, information may be based on reasonable estimates.
The new requirements are effective for plan years beginning after December 31, 2006 except for collectively-bargained plans, which will not have to comply at least until plan years beginning after December 31, 2007.
Observation: Current law requires that benefit statements be provided only upon request, although most defined contribution plans, but only some defined benefit plans, now provide periodic statements automatically to all participants.