President Bush recently signed into law the Pension Protection Act of 2006 (“Pension Act”), which is being haled as the most comprehensive pension reform legislation in the last 30 years. It contains significant changes for defined benefit plan funding, annuity options, lump sum calculations and disclosure requirements, as well as defined contribution plan vesting, enrollment, investment and portability rules. Other provisions of the Pension Act include requirements for cash balance plans, and permanence for some changes under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA).
Generally, plans must comply with the legislative changes as of the respective effective dates indicated below, and plan amendments may be adopted on or before the end of the 2009 plan year (2011 for government plans). Due to the expansive scope of the Pension Act, this Legislative Alert highlights only key provisions of the Pension Act impacting employee benefit plans. It should be noted that there are additional provisions of the Pension Act that may impact benefit plans of employers that are not covered in this Benefits Update.
Defined Benefit Plan Changes
The provisions of the Pension Act completely replace the rules governing funding for single employer defined benefit plans with new standards that are tied to a plan’s funded status. In the case of underfunded plans, the new requirements increase the employer’s funding obligation.
New minimum funding requirements after December 2007. For 2006 and 2007, the current rules continue to apply. Starting in 2008, the new minimum funding requirement will apply, and employers must make contributions necessary to fund all benefits that accrue in the current year, including increases in previously accrued benefits based on current compensation, plus an amount to eliminate shortfalls. Any shortfalls must be amortized over seven years.
Contribution requirements are accelerated for at risk plans. A plan is considered “at risk” if the value of the plan’s assets for the preceding year was less than 80% funded using standard assumptions, or less than 70% funded using worst case assumptions - - that participants will take the most expensive benefits at the earliest possible age. Additionally, when at risk, employers may not use credit balances or new prefunding balances, and a loading factor applies to plans that have been at risk for two out of the last four years. The 80% test will be phased in between 2008 and 2011.
No executive deferred compensation plan contributions when at risk. Under Code Section 409A, adverse tax consequences would result if amounts are set aside for the executive deferred compensation plan when the employer’s defined benefit plan is in at risk status (less than 80% funded), if the employer is in bankruptcy, or during the 12-month period beginning six months before the termination of an underfunded plan.
Recently enacted PBGC premiums remain. The $30 flat rate per participant premium set by Congress in 2005 is unchanged. The variable rate premium of .9% of the unfunded vested benefits is changed under the Pension Act, with a new rate being phased in beginning in 2008. For employers who sought Pension Benefit Guaranty Corporation (PBGC) coverage for pension liabilities and then emerged from bankruptcy, the Pension Act makes permanent the termination premium (previously enacted on a temporary basis) of $1,250 per participant for up to three years.
New disclosure requirements for plan sponsors. Employers are required to provide additional information regarding funding and the attainment percentage in the Form 5500 filed for the defined benefit plan. This information is to be displayed on a website maintained by the Secretary of Labor, and on any intranet website maintained by the employer. In addition, for plan years beginning after 2006, benefit statements are to be provided to participants at least once every three years, or they are to receive an annual notice outlining how a participant may obtain a statement. Changes made to benefit payment options. A few provisions were included that will change how benefit payments are calculated and when they are paid to participants.
- Plan sponsors facing the challenge of an aging work force will be glad to know that, effective in 2007, a pension plan will not be deemed to violate the qualification requirements when the plan allows for an in-service distribution to an employee who has attained age 62.
- If not in place already, in 2008, defined benefit and money purchase pension plans must offer a joint and survivor annuity, with a 75% survivor annuity, as well as an optional benefit of at least a 50% survivor annuity.
- When converting annuity benefits to lump sum payments, plans must use segmented interest rates based on the expected payment dates. This change is effective in 2008, and the conversion rates will be phased in from 2008 to 2012.
Support for Cash Balance Plans The Pension Act establishes requirements for hybrid plans. The Pension Act addresses what constitutes a legitimate hybrid retirement plan and resolves the three major controversies associated with these types of plans. Provided that specified standards are met regarding (i) the plan’s vesting schedules and interest crediting rates, (ii) prohibited wear away of previously accrued benefits, and (iii) calculation of hypothetical balances for lump sum distribution purposes, the hybrid plans are protected against age discrimination challenges under the Internal Revenue Code, Employee Retirement Income Security Act (ERISA), and the Age Discrimination in Employment Act. These protections apply prospectively effective on or after June 29, 2005.
Note: On August 7, 2006, in a highly anticipated ruling, the Seventh Circuit Court of Appeals in Cooper, et al. vs. IBM Personal Pension Plan and IBM Corporation, No. 05-3588 (7th Cir. 2006) held that the IBM cash balance plan was not age discriminatory under ERISA, overturning a lower court decision that held that the plan was age discriminatory. Since the Pension Act only applies prospectively, this recent decision by the Seventh Circuit is significant since it is the first Court of Appeals to rule on the issue.
Defined Contribution Plan Changes
There are a number of major changes under the Pension Act impacting defined contribution plans, such as 401(k) plans and profit sharing plans. The changes are designed to increase participation rates, allow participants to save more for retirement, and arm participants with investment knowledge. Faster vesting and improved portability is expected to increase the likelihood that plan balances are able to move with employees who change employers.
Automatic enrollment may provide plan safe harbor. Effective in 2008, plans may avoid complicated 401(k) nondiscrimination testing and top heavy requirements by implementing automatic enrollment. The provision requires notice and opportunity for employees to opt out of the plan within the first three months. To qualify for the safe harbor, the plan must be amended to provide for employee deferrals at 3%, with annual increases of 1%, so that deferrals reach 6% by the fourth year (with a maximum of 10%). The employer must make a 3% nonelective contribution, or matching contribution of 100% on the first 1% deferred, plus 50% on employee deferrals between 1% and 6%. Employer contributions must be fully vested after two years.
Note: The Pension Act confirms that, effective as of the date of enactment, ERISA preempts any state wage withholding laws that would otherwise hinder implementing automatic enrollment. Participants are required to receive an annual notice regarding their rights under the plan’s automatic enrollment provision.
Portability of plan balances is improved. For distributions after 2006, benefits received by a non-spouse beneficiary may be transferred to an individual retirement arrangement (IRA), rather than being paid in cash. The IRA is then treated as an inherited IRA and any distributions are made in accordance with rules for inherited IRAs. In addition, effective in 2008, and limited to individuals who are eligible to convert a traditional IRA to a Roth IRA, rollovers may be made directly from qualified plans into Roth IRAs (subject to applicable taxes for the Roth IRA conversion).
EGTRRA enhancements become permanent. The Pension Act makes permanent many of the provisions of EGTRRA, which were scheduled to sunset in the year 2010. These enhancements include the provisions for designated Roth 401(k) deferrals, catch-up contributions for employees age 50 or older, and increases in the annual compensation and contribution limits under the Internal Revenue Code.
Faster vesting expanded to nonelective contributions. Similar to the requirement for faster vesting on employer matching contributions required under EGTRRA, plans must shorten their vesting schedules for all employer nonelective contributions to either a three year cliff or six year graded vesting schedule, effective in 2007.
Investment advice rules clarified. The Pension Act provides protection for employers offering qualified investment advice programs, if under the program the fees received by the fiduciary adviser do not vary based on the investment options selected, or the advice is based on computer models designed by an independent third party. The provision is effective in 2007 and requires both that certain disclosures be made to participants and that an independent fiduciary approve the advisory arrangement.
Transfers to retiree medical accounts. Upon enactment, employers are permitted to transfer excess pension assets to retiree medical accounts to fund the expected cost of retiree medical benefits for current and future years. Qualified future transfers may be made if the transfers are made for at least two consecutive years and to the extent the plan assets exceed the greater of (i) accrued liability, or (ii) 120% of current liability during the transfer period. The provision is scheduled to sunset in 2014.
Planning Note Employers should become familiar with the new law and assess how the Pension Act changes will impact their health care, compensation and other employee benefit programs.