• Sweeping Pension Reform Package Overhauls Plan Funding and Disclosure Rules
  • August 23, 2006 | Authors: M. Sean Sullivan; Shannon Leigh Goff
  • Law Firm: Waller Lansden Dortch & Davis, LLP - Nashville Office
  • On Thursday, Aug. 17, 2006, President Bush signed into law the Pension Protection Act of 2006, the first comprehensive pension legislation in more than 30 years. The impetus for this legislation was a confluence of recent events - plan funding crises of several major airlines and manufacturers, the collapse of corporations such as Enron and WorldCom, declining stock market values - that turned Congress's attention to waning security in retirement benefits. The Act is a comprehensive reform package aiming to strengthen traditional pension plans and enhance retirement savings benefits.

    I. Defined Benefit Plan Changes

    Funding Obligations. The Act requires most defined benefit pension plans to become fully funded over seven years. A pension plan's funding status will be determined by comparing the value of the plan's assets against the plan's liabilities, calculated according to certain rules under the Act. If the plan is less than fully funded, the funding shortfall is amortized over seven years. Pension plans that are less than 80 percent funded are prohibited from using credit balances for funding or promising new or enhanced benefits. Pension plans that are less than 60 percent funded are restricted from offering lump-sum benefit payments, and new accruals are frozen. The Act also contains special funding relief for certain airline pension plans.

    Deferred Compensation Restrictions. The Act restricts the use and funding of nonqualified deferred compensation arrangements by employers with severely underfunded defined benefit pension plans. Assets that are set aside or transferred to a trust arrangement to pay nonqualified deferred compensation during a restricted period - when the plan is in "at-risk" status, when the employer is in bankruptcy, or during the 12-month period beginning six months before an involuntary or distress termination of the plan - will violate Section 409A of the Internal Revenue Code. Accordingly, such amounts are subject to current income inclusion and a 20 percent excise tax. Plans are deemed "at risk" if they fall below 70 percent funded status using worst-case scenario assumptions (i.e., employers cannot count credit balances and must assume employees retire at the earliest possible date and take the most expensive benefits).

    Hybrid Plans. In recent years, employers began converting traditional pension plans into hybrid plans - part pension, part savings plans - rather than eliminate pension plans altogether. This trend was slowed by litigation alleging that benefit reductions deriving from conversions to hybrid plans equated age discrimination. The Act clarifies rules governing hybrid plans, including cash balance plans, in light of these recent developments. Under the Act, hybrid plans with vesting schedules and interest crediting rates that meet specified standards are prospectively protected against age discrimination challenges.

    II. Defined Contribution Plan Changes

    Automatic Enrollment 401(k) Plans. The Act endorses the use of automatic enrollment in 401(k) plans by removing any perceived state law impediments. Under an automatic enrollment 401(k) plan, employees must affirmatively opt-out in order not to participate, and employers make default investment decisions according to Department of Labor regulations. The Act also creates a new nondiscrimination safe harbor for 401(k) plans for plan years beginning after 2007. A plan is deemed to satisfy the nondiscrimination rules for elective deferrals and matching contributions if it provides a minimum match of 100 percent of elective deferrals up to 1 percent of compensation, plus 50 percent of elective deferrals between 1 percent and 6 percent of compensation. This new safe harbor is available only if the contributions rate for automatic enrollees is at least 3 percent during the first year of participation, 4 percent during the second, 5 percent during the third and 6 percent thereafter. The plan may specify a higher percentage, up to 10 percent. Notice of the plan's automatic enrollment provisions must be provided to all employees.

    Company Stock. For plan years beginning after 2006, the Act requires that any defined contribution plan that holds publicly traded employer securities must permit participants with at least three years of service to diversify account balances invested in those securities into at least three investment options with materially different risk and return characteristics. Other investment options generally offered by the plan also must be available to these participants. In certain circumstances, employee stock ownership plans (ESOPs) are exempt from these diversification requirements.

    Investment Advice. The Act amends the prohibited transaction rules of the Employee Retirement Income Security Act (ERISA) to permit fiduciary advisors to provide plan participants with investment advice through eligible investment advice arrangements. "Fiduciary advisors" include registered broker/dealers, certain bank trust departments and qualified insurance companies. "Eligible investment advice arrangements" are either general advice arrangements (those that do not provide for fees that increase depending upon the type of investment selected), or arrangements based on computer models that meet certain design requirements.

    Hardship Distributions. The Act permits hardship distributions from a 401(k), 403(b) or 409A plan for a qualifying event affecting a beneficiary of a plan participant, even if that beneficiary is not a spouse or dependent.

    III. Provisions of the Act Applicable to All Plans

    Bond Requirements. ERISA requires that every fiduciary and every other person who handles plan funds or other plan property be bonded. The Act raises the maximum bond required for plans holding employer securities from $500,000 to $1 million.

    Criminal Penalties. The Act also increases the criminal penalties for coercive interference with an individual's ERISA rights from $10,000 and one year of prison to $100,000 and ten years in prison.

    IV. Additional Provisions of the Act

    Long-Term Care Insurance. The Act provides for increased flexibility and favorable tax treatment of annuity and life insurance contracts with a long-term care insurance option. The Act authorizes a new bundled insurance product which allows annuities to be used to provide coverage for long-term care, life and other insurance products.

    COLI. The Act also amends the tax treatment of certain company-owned life insurance (COLI). Under the Act, if an employer owns a life insurance policy on the life of a former employee, proceeds in excess of the premiums can be included in the employer's gross income. An employer that owns one or more COLI policies must file an annual report detailing those policies.

    Permanency of Prior Law. The Act makes permanent the provisions in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) that apply to retirement savings, including catch-up contributions, increased contribution limits and benefits, and greater portability for participants in 403(b) and 457 plans. Further, the Roth 401(k) and 403(b) option for employee-share contributions has been made permanent under the Act.

    Access to Plan Information. Several provisions in the Act address access to plan information. The Act requires that certain disclosures on Form 5500 annual reports be posted on the Internet for plan years beginning after 2007. The Act also requires that plan administrators provide periodic benefit statements to participants with investment rights on at least a quarterly basis for plan years beginning after 2006.

    This comprehensive Act contains a number of additional significant provisions. Employers and plan sponsors should review existing plans and funding arrangements for compliance with the new rules under the Act to determine whether modification is necessary.