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Pension Protection Act of 2006

 

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  Pension Protection Act
  of 2006

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On August 4th, Congress passed the Pension Protection Act of 2006 ("PPA"), a package of sweeping reforms for employer-sponsored retirement plans. Many provisions of PPA do not take effect until 2008, but some will become effective as early as January 1, 2007.

PPA's primary provisions:

The PPA is over 900 pages so this analysis is merely a very broad overview, but it will have a profound impact on retirement plan sponsors.  Most sponsors of single-employer plans will need to accelerate plan contributions, many by a very significant amount.  It is considered the single largest change to retirement plan laws in almost 30 years.


Defined Benefit Plan Funding Obligations

PPA sets up a new scheme for measuring the minimum required contributions for single employer defined benefit pension plans beginning with 2008 plan years (multi-employer plans are subject to slightly different rules). Minimum funding is defined as the present value of benefits accrued during the current year, plus the amortized amount of any funding shortfall. There is a transition rule in the case of small funding shortfalls.

An annual funding notice is now required to be furnished to all defined benefit plan participants within 120 days after the end of each plan year and must provide information about the plan’s funded status, asset allocation and related issues. The DOL is expected to develop a model notice within the next year.

PPA changes the calculation of both assets and liabilities for purposes of determining whether a plan is fully funded. You may still "smooth" asset values, but only over a 24-month period which essentially creates a reduction in the smoothing period from five years to three. The resulting asset value must then fall within 90% to 110% of the fair market value of the assets.

The calculation of plan liabilities is also impacted.  PPA directs the Treasury Department to prescribe the mortality table to be used in calculating plan liabilities and liabilities will also be subject to a new methodology based on a three-segment yield curve based on a 24 month average of the yield on investment grade corporate bonds.

Underfunded Plans - Beginning in 2008, plans that are not 100% funded will have to amortize any shortfall over seven years. If the plan is not subject to the Deficit Reduction Contribution rules in 2007, the 100% funding target is phased in, starting with a 92% target in 2008, moving to 94% in 2009, 96% in 2010, and ending at 100% in 2011.

Underfunded plans are now also subject to restrictions concerning plan amendments that increase benefits or accruals, or accelerate payment of benefits.  PPA also changes the assumptions used for calculating lump sum distributions from defined benefit plans and restricts the ability to set aside amounts to pay nonqualified deferred compensation.

At Risk Plans - For "at risk" plans with funding percentages in the preceding year less than 80 percent using normal assumptions and below 70 percent using at risk assumptions, enhanced funding obligations are being imposed with increased contributions phased in over a five year period.

PPA will increase the required contributions for such plans by applying an at risk assumption that participants who may elect to commence a benefit within the next 10 years will actually retire and elect the form of benefit with the highest present value.  

Plans that were considered to be at-risk in the current plan year plus two out of the last four years must also include an additional load charge of 4% of the plan’s funding target plus $700 per plan participant.  Plans with fewer than 501 participants are not subject to the at-risk rules.

Multi-employer Plans - The minimum funding standards for multiemployer plans include a reduced amortization period for liabilities resulting from plan amendments that increase benefits. For multiemployer plans that are severely underfunded (generally less than 80 percent), PPA will require them to adopt programs for improving funding over a 10 to 15 year period.

The Act also creates a new annual funding notice requirement for all defined benefit plans. The notice must be furnished to participants within 120 days after the end of each plan year and must provide information about the plan’s funded status, asset allocation and related issues. The DOL will develop a model notice within the next year.

Deduction Limitations

PPA increases the deduction limits for single-employer plans to 150% of current liability for 2006 and 2007. For subsequent years, plans are permitted to deduct an additional 50% of their funding target for a year.  Plans may also choose to deduct their at-risk liability even if they are not in an at-risk status.

Employers who maintain both a defined benefit and defined contribution plan also have had their deduction limits eased.  Single-employer defined benefit plans that pay PBGC (Pension Benefit Guaranty Corporation) premiums will not be subject to the overall limit after 2007. 

The limit will apply to contributions to a defined contribution plan only to the extent that the contributions exceed 6% of compensation for years after 2005.  The excise tax on nondeductible contributions will not be applied to matching contributions to a defined contribution plan that are nondeductible solely because of the overall limit.

EGTRRA Provisions Made Permanent

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) included a number of temporary provisions that were favorable to plan sponsors and plan participants but it included a sunset provision that would have caused these retirement plan provisions to expire after 2006 and 2010.

Retirement Plans - EGTRRA increased the limits on elective deferrals to 401(k) and other plans, allowed catch-up contributions for workers age 50 and over, authorized Roth 401(k) contributions, repealed the “same desk” rule, and simplified the top-heavy plan provisions through 2010 and PPA makes all of these changes permanent.

Saver’s Credit - The nonrefundable tax credit up to $2,000 that matched the savings of low-income workers contributing to traditional or Roth IRAs or making elective deferrals to qualified retirement plans has been made permanent.  PPA also indexes the adjusted gross income limits beginning in 2007 and allows a taxpayer to direct the IRS after 2006 to deposit any tax refund attributable to the saver’s credit into a retirement plan.

Encouraging Enrollment In Defined Contribution Plans

PPA has made numerous changes in regard to enrollment and vesting in defined contribution plans in order to encourage more and higher participation.  ERISA has been amended to preempt state wage withholding laws that might otherwise interfere with the approach of requiring employees to elect out of participating in a plan.

Vesting - Vesting rules for non-elective employer contributions to defined contribution plans are now subject to the same shorter vesting schedules (a three-year cliff or six-year graduated vesting) that were implemented for employee matching contributions under EGTRRA.  Beginning for 2007 plan years, PPA has extended these shorter vesting schedules to all employer non-elective contributions such as profit sharing contributions.

Plan Design Safe Harbors. - Employers can now avoid ADP and ACP nondiscrimination testing with the adoption of new safe harbor automatic enrollment designs which require the following minimum contributions:

  • Employees automatically defer 3% of pay initially as elective contributions and increase them annually in 1% increments until 6% of pay is reached.  The deferral could also start out at a higher rate as long as it reaches the 6% minimum rate on schedule and does not exceed 10%.
  • The employer must match 100% of the first 1% of pay contributed by the employee, plus 50% of the next 5% of pay or make a 3% of pay non-elective contribution for all eligible employees.  Deferrals in excess of 6% may not be matched.
  • The employer’s matching or non-elective contributions must be 100% vested after two years of service. They are still subject to the withdrawal restrictions applicable to elective deferrals under present law and cannot be withdrawn for hardships.
  • 401(k) plans must allow employees to change or elect out of the automatic deferrals and must comply with safe harbor notice requirements. Employers can implement automatic enrollment without applying it to existing employees who have either elected to participate in the plan or elected not to participate in the plan.

90 Day Withdrawal Period - Employees can now be allowed to withdraw their elective contributions within 90 days of their first contribution to a 401(k) plan with automatic enrollment . When this withdrawal occurs, the withdrawal will be taxed in the year of distribution, no early distribution tax will be imposed, and the withdrawal will not be treated as violating other restrictions imposed on distributions nor counted in ADP tests.

Investment Advice - PPA amends ERISA’s fiduciary rules to encourage employers to provide investment advice to 401(k) plan participants.  The term “fiduciary advisers” is defined and the role of plan sponsors that select and monitor them is clarified.  Potential conflicts of interest have been addressed with two new prohibited transaction exemptions in the area of commissions and investment compensation.

Plan sponsors still have fiduciary responsibility for the prudent selection and monitoring of a fiduciary adviser, but a plan sponsor has no duty to monitor the specific investment advice given by a fiduciary adviser to a particular plan participant.

Employer Stock - For employer non-elective or matching contributions, defined contribution plans must allow participants to diversify out of publicly traded employer stock with at least three diversified investment options after three years of vesting service and no waiting period requirement. Barring unusual circumstances, participants must be given the opportunity to make employer stock investment changes on the same basis as they can make other investment changes.  The diversification requirement applies only to plans with publicly-traded employer stock and do not apply to stand-alone ESOPs without elective, employee, or matching contributions.

Clarification of Cash Balance Plan Status

The PPA clarifies the status of cash balance plans but actual investment returns are not individually allocated.  A cash balance plan is a defined benefit pension plan which allows participants to have hypothetical individual accounts.  Cash balance plans have historically been the target of lawsuits alleging age discrimination from older employees and an IRS moratorium on issuing determination letters for cash balance plans left them in a controversial and indeterminate state.

Effective for cash balance plan conversions on or after June 29, 2005, the PPA provides the following:

  • No inference of age discrimination arises for benefits of equal present value regardless of the participants’ ages
  • Requires the adoption of a three-year cliff vesting schedule
  • Imposes interest crediting limitations
  • Restricts the use of "wearaway" in plan conversions (a rule under which participants with large pre-conversion benefits are suspended from accruing new benefits for a period after the conversion).

It is anticipated that the IRS will begin to review unresolved determination letter requests in the near future.

The PPA contains hundreds of provisions affecting specific industries and interests which are beyond the scope of this analysis. Please contact our office to discuss the implications of the PPA for your retirement plans.

 

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