President Bush signed The Pension Protection Act of 2006 into law on August 17, 2006, resulting in sweeping changes in employee benefit plan rules. The law imposes new funding requirements for defined benefit pension plans, new limits on funding nonqualified deferred compensation plans, significant changes for defined contribution plans, guidance for cash balance plans, changes to notice and disclosure requirements for all plans, major changes to plan investment and fiduciary rules, and numerous other changes. This summary highlights some of the significant changes made by the Act and the impact of the changes.
Funding Requirements for Defined Benefit Plans
Single-employer and multiple-employer defined benefit pension plans currently must satisfy the ERISA and Internal Revenue Code minimum funding requirements. Beginning in 2008, the Act instead imposes new funding rules based on the plan’s current funding status. The plan’s “funding target” for a year is 100% of the present value of benefits that are accrued or earned at the beginning of the plan year. The sponsor’s required contribution for the year will be the amount sufficient to fund benefits that are expected to be accrued or earned during the plan year. If the plan’s funding level is not 100%, the plan sponsor will be required to make additional contributions to fund the shortfall over a seven-year period. A plan with a funding level of less than 80% is considered to be “at risk,” and the plan sponsor is required to make additional contributions. The Act provides that plans with 500 or fewer participants will not be considered to be “at risk.” The Act also includes transition rules providing that, for 2008, 2009 and 2010, if certain requirements are met, the 100% requirement is reduced to 92%, 94% and 95%, while the 80% requirement is reduced to 65%, 70% and 75%, respectively, for purposes of determining whether additional contributions are required. The Act also increases deduction limits for 2006 and 2007 to 150% of the plan’s unfunded current liability. Effective in 2008, the deduction limits are replaced with rules based on the new minimum funding requirements.
The Act also provides special funding rules for plans of commercial passenger airlines and companies engaged in catering services for commercial passenger airlines.
Under the Act, plans with more than 100 participants must use as the valuation date the first day of the plan year. As under prior law, averaging may be used to value plan assets. However, the averaging period is limited to two years, and the result must be between 90% and 100% of the current value of the asset. For determining the present value of benefits, interest rates continue to be based on long-term corporate bond rates for 2007. However, beginning in 2008, interest rates will be based on a corporate bond yield curve depending on the expected date of benefit payments.
To improve solvency of defined benefit pension plans, the Act changes the interest rate and mortality assumptions the plans must use in calculating immediate lump sum payments, with a phase-in of the rules between 2008 and 2011. Additionally, the Act imposes lower limits on the interest rate for converting benefit forms to a straight life annuity for the Section 415 limit. It also limits the ability of underfunded plans to pay accelerated benefits, such as a lump sum, or to be amended to increase the plan’s benefit liabilities. In some situations, underfunded plans are prevented from accruing additional benefits.
Although the existing minimum funding requirements are retained for multiemployer plans, the Act tightens the rules in some respects. The Act also imposes temporary rules requiring significantly underfunded plans to take action based on the level of underfunding to improve the funding status. These temporary rules are effective through 2014.
Beginning in 2009, plans insured by the PBGC must distribute an annual notice to participants to disclose the funded status of the plan and other information, such as the manner in which assets are allocated.
To improve the PBGC’s financial status, the Act made a number of changes. The PBGC’s guarantee of plant shutdown or other contingent benefits is phased in over a five-year period after the event occurs. This change is effective for events that occur after July 26, 2005. For bankruptcy proceedings that begin 30 days after enactment, the Act eliminates the guarantee for benefits accruing after an employer’s bankruptcy commences if the plan is terminated during the bankruptcy.
Penalties for At-Risk Defined Benefit Plans
The Act imposes significant penalties on executives whose nonqualified deferred compensation plans are funded while the corporation’s defined benefit pension plan is “at-risk” or the corporation is in bankruptcy. The executives affected include current and former employees who are the top five officers of the corporation or are one of the “Rule 16” officers under securities laws.
Joint and 75% Survivor Annuity Option Required
For plan years beginning after 2007 (with a delayed effective date for collectively bargained plans), to comply with the ERISA joint and survivor annuity requirements, plans will be required to offer as an optional form of benefit a joint and 75% survivor annuity in addition to the joint and 50% survivor annuity option. If a plan currently complies with ERISA by providing a joint and more than 75% survivor annuity, a 50% survivor annuity must be added as an optional benefit.
Phased Retirement Distributions
Defined benefit pension plans and money purchase pension plans currently are not allowed to provide for distributions before normal retirement age for a participant who remains employed. The Act amends ERISA and the Code to allow in-service distributions for a participant who attains age 62, regardless of whether there is any reduction in work schedule. The phased distribution rules are effective for distributions in plan years beginning after 2006.
Cash Balance Plans
The Act contains rules on conversion of defined benefit plans to hybrid plans, effective for conversions occurring after June 29, 2005, and contains provisions affecting cash-balance and other hybrid plans. All hybrid plans (including cash balance plans and pension equity plans) are deemed not to violate the ERISA, Code, and Age Discrimination in Employment Act rules if (1) the pay and interest credits of older workers are comparable to those of similarly situated younger workers, and (2) the interest credited does not exceed a market rate. Plans converting after June 29, 2005 will face new requirements.
EGTRRA Limits Are Made Permanent
Several EGTRRA changes which were scheduled to “sunset” in 2010 were made permanent by the Act, including:
- Catch-up contributions (participants age 50 and over)
- Increases to the limit on the amount of compensation that can be considered under a qualified plan (Code Section 401(a)(17) limit)
- Increases to the maximum amount that can be contributed annually under a defined contribution plan (Code Section 415(c) limit)
- Increases to the amount that can be deferred annually under a cash or deferred arrangement (Code Section 402(g) limit)
- Increases to the maximum annual benefit under a defined benefit pension plan
- Increases to contribution limits for Code Section 403(b) and 457 plans
- Increases to deduction limits
- Expanded rollover options
- Roth 401(k) accounts in 401(k) plans.
Additionally, the $2,000 saver’s tax credit for 401(k) contributions for low-income taxpayers was made permanent, and the income limits will be adjusted for inflation.
Changes for 401(k) and Other Defined Contribution Plans
With the goal of increasing savings in defined contribution plans, the Act makes several changes, including the following:
Accelerated Vesting for Employer Contributions. Under the Act, the vesting rule for all employer contributions will be the same as the vesting rule currently applicable for employer match contributions. Effective in 2007, all employer contributions must either (1) be 100% vested after three years of service, or (2) vest 20% per year beginning not later than the second year. The new vesting rules must apply to employer contributions beginning in 2007, although a plan sponsor may elect to apply the new vesting rules to the participant’s entire account (if the new schedule is more favorable to participants). Collectively bargained plans must adopt the new vesting schedule when the current bargaining agreement expires (but at least by 2009).
Automatic Enrollment in 401(k) Plans. The Act provides a new nondiscrimination safe harbor for 401(k) plans that include automatic enrollment and provide for minimum employer contributions. The new rules address concerns regarding the impact of state wage payment laws on automatic enrollment and fiduciary liability for default investments. For plans that meet the safe harbor requirements, plan fiduciaries will avoid fiduciary liability for the default investment if the funds are invested in accordance with safe harbor investment options specified by the Department of Labor in regulations to be issued within 180 days of enactment of the Act. It appears that the Department of Labor is considering a blended-type fund with a mix of funds rather than the typical “low risk” fixed income fund option. The safe-harbor investment option protection for fiduciaries will become effective January 1, 2007.
Effective immediately, for plans that use safe harbor investment options, automatic enrollment is exempt from state wage payment laws.
Except as specifically noted above, the rules regarding automatic enrollment will become effective beginning January 1, 2008.
Effective in 2008, a special matching safe harbor for nondiscrimination testing will apply if an automatic contribution arrangement meets certain requirements. The plan must provide that any participant who has not made a prior written election to participate or decline participation must be automatically enrolled with a contribution rate of 3%, increasing in annual 1% increments to 6% of pay. Plans may provide for automatic increases of up to 10% of pay. However, the plan is required to provide notice of the right to opt out of the automatic contributions and future automatic increases. The employer is required to match 100% of the first 1% of pay and 50% of the next 5%, with a maximum match of 3 ½% of compensation, or to make a 3% non-elective contribution for all eligible employees. Employer matching and non-elective contributions must be 100% vested after two years of service. This safe harbor differs from the existing 401(k) safe harbor, which requires a higher matching contribution and also requires immediate vesting of employer contributions. As a result, current safe harbor plans may wish to change to the new safe harbor in 2008.
Participants will have 90 days to withdraw automatic enrollment contributions to avoid the 10% penalty on premature distributions. The Act also expands the corrective distribution period for excess contributions and excess aggregate contributions resulting from failing nondiscrimination tests for plans with automatic deferrals. Rather than 2 ½ months after the end of the plan year, automatic enrollment plans have one year to make the distributions. The Act only requires distribution of income on excess amounts through the end of the year in which the amounts were contributed so that “gap period” income is not required to be distributed. Automatic contribution arrangements that comply with the rules for expanded protection under Section 404(c) of ERISA and satisfy the notice requirements concerning the 90-day window for early withdrawals may take advantage of the expanded corrective distribution period.
Safe Harbor for Section 404(c) Default Investments. Under ERISA Section 404(c), plan fiduciaries are not responsible for investment results of participants if certain requirements are met. However, Section 404(c) previously provided no protection unless the participant made an affirmative election. Effective January 1, 2007, 404(c) protection will apply to plans that provide a safe harbor default fund in the event that participants fail to make an investment election. As noted above, the Department of Labor is directed by the Act to issue regulations within 180 days of the enactment date defining the safe harbor fund, which likely will be a balanced or “lifecycle” fund rather than the typical fixed income fund option.
Protection under 404(c) is eliminated during blackout periods unless the plan provides the required blackout notice. The Act extends 404(c) protection in situations involving a “mapping” to new investment options. These changes become effective in plan years beginning after 2007 (for collectively bargained plans, not later than 2010).
Hardship Withdrawals Expanded. The Act directs the IRS to issue regulations within 180 days of enactment to expand the list of allowable hardship withdrawals to include payment of medical expenses or college tuition for any person who is the beneficiary of the participant, even if the individual is not a dependent for tax purposes. Plans are permitted, but not required, to make this change. This change will be effective following the issuance of Treasury regulations.
Rollovers Expanded. Effective in 2007, all beneficiaries, including trusts, will be allowed to roll over a distribution received after a participant’s death to a new type of “inherited IRA,” which will contain the minimum distribution rules that would have been applicable to the participant. Non-spouse beneficiaries must move the funds by a trust-to-trust transfer. Non-spouse beneficiaries may not move funds to other qualified plans.
The Act also allows rollover of after-tax contributions to a defined benefit pension plan or tax-deferred annuity effective in 2007. Additionally, direct rollovers from qualified plans to Roth IRAs (subject to the $100,000 income limit on conversions of traditional IRAs to Roth IRAs) will be allowed.
Increased IRA Contributions. Effective in 2007, the Act indexes income limits for IRA contributions for persons covered by an employer plan.
Quarterly Benefit Statements. The Act requires quarterly benefit statements for defined contribution plans with investment discretion effective for plan years beginning after 2006 (with a delayed effective date for collectively bargained plans). Plans without investment discretion may still provide annual statements. Although many defined contribution plans currently provide quarterly statements, the new rules require specific disclosure language, which will require modifications to current statement templates. The Department of Labor must provide model notices within 180 days of enactment of the Act.
Employer Stock Fund Diversification Requirement. The Act requires that plans that provide for employer contributions in publicly traded employer stock or that provide for automatic investment in such stock allow participants with three years of vesting service to transfer the funds to another investment option. The Plan must provide at least three diversified investment options in addition to the employer stock fund. A notice must be given to participants at least 30 days before the date on which they are eligible to diversify. The Act provides a $100 per day penalty for failure to provide the notice. ESOPs with no elective employee or matching contributions (as well as plans with only one participant) are not covered by this rule. Although the new rule is generally effective in 2007 (with a delayed effective date for collectively bargained plans), employers may choose to apply a three-year phase-in (1/3 per year) of the new rule for stock that the plan acquired before 2007 for participants who are not age 55 with three years of service before the 2006 plan year. For participants who are eligible to diversify on January 1, 2007, the notice must be provided by December 1, 2006.
Limited Exemption From Prohibited Transaction Rules for Investment Advice
The Act creates an exemption from the ERISA “prohibited transaction” rules to allow fiduciary advisors (e.g., banks, insurance companies, broker-dealers, and registered investment advisors) to provide investment advice to participants in qualified plans through either (1) fixed fee programs under which fees received by the advisor do not vary based on investment options selected by the participant, or (2) pursuant to objective computer models that are certified by an eligible investment expert (without a material affiliation or contractual relationship with the advisor) who satisfies other requirements specified by the Department of Labor. An auditor must certify annually that the model is appropriate, all advice given must be based on the model, and all transactions must be based on participant decisions. A notice must be provided to participants to disclose specific information for the exemption to be applicable. The plan sponsor or other fiduciary still must prudently select and monitor the advisor but will not have responsibility for the specific advice given.
The Act also includes several prohibited transaction exemptions for certain financial transactions by a plan if very specific conditions are satisfied (e.g., purchase or sale of shares by block trade; transactions effected through alternative trading systems; transactions with service providers for adequate consideration; foreign exchange transactions in connection with investments; and cross-trades of publicly-traded securities between a plan and an account managed by the same investment manager). The Act provides that a prohibited transaction involving the acquisition, holding or disposition of a security will not be considered to be a prohibited transaction if the transaction is reversed and any harm to the plan is corrected within 14 days after the error is or should have been discovered. This exemption is not available for transactions between a plan and the plan sponsor with regard to employer securities or employer real property.
Increased ERISA Penalties
ERISA penalties for interference with ERISA rights are increased from a fine of $10,000 to a fine of $100,000, and from one year in prison to three years in prison.
Increase in ERISA Bonding Requirements
The ERISA fiduciary bonding requirement is increased from $500,000 to $1 million for plans with employer securities for plan years after 2007.
New Defined Benefit Plan/401(k) Combination
Effective in 2010, employers with 500 participants or less may create a combined 401(k)/defined benefit plan that will be subject to simplified compliance requirements (e.g., a single trust and one Form 5500). The 401(k) component must include automatic enrollment and satisfy minimum matching and vesting rules, and the defined benefit plan component must satisfy minimum accrual and vesting requirements.
Finding Missing Participants
The Act provides that, after issuance of final regulations, the PBGC’s missing participant program may be used by terminated defined contribution plans to find lost participants. The administrator of a terminated plan can transfer funds of a “missing participant” to the PBGC as trustee until the PBGC locates the missing participant.
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