On August 17, the President signed the Pension Protection Act of 2006. PPA contains a number of provisions affecting retirement plans, some that create new burdens for employers and some that create new opportunities.
PPA is over 900 pages long, and will be the subject of new regulations over the next several months that will explain and expand on its many provisions. The following overview of some of the primary provisions of PPA should provide a good starting point for employers, all of whom should review these changes in detail to determine how they impact their individual situations.
I. PROVISIONS AFFECTING DEFINED CONTRIBUTION PLANS
A. Required DC Plan Provisions
1. Liberalized Vesting Rule. All DC plan employer contributions for plan years beginning after 2006 will need to become vested under a vesting schedule that is at least as favorable as either the three year cliff or two-to-six year graduated vesting schedule currently applicable only to matching contributions. (As they did when this vesting requirement previously was imposed only on matching contributions, many employers likely will apply the new vesting rule to participants' entire DC plan accounts (rather than just to post-2006 contributions) in order to avoid bifurcated recordkeeping.)
2. Employer Stock Diversification Rules. For plan years beginning after 2006, in cases in which the employer is a public company or part of a controlled group (using a 50 percent test rather than the otherwise applicable 80 percent test) that has publicly traded stock, DC plans (other than certain ESOPs and single participant plans) with investments in employer stock must offer new account investment diversification opportunities and must provide new participant notices. (These new rules provide different diversification rules for participant contribution accounts and employer contribution accounts.) Employers with employer stock in their plans should review the details of these new rules carefully and as soon as possible.
3. Newly Required Account Statements. For the first time, for plan years beginning after 2006, DC plans must, as a matter of law, provide account statements to their participants and beneficiaries. These statements must be provided at least quarterly to participants (and beneficiaries) with participant-directed accounts, at least annually to participants (and beneficiaries) who do not direct the investments of their accounts, and on request to any other beneficiaries. These statements must contain information on the total account balance, its vesting status, its projected vesting date, and, in the case of participant-directed accounts, any limitations or restrictions on the participant's ability to direct investments of the account. These statements also must contain certain other language specified in the statute. Employers with calendar year DC plans with participant-directed accounts will need to comply with these new requirements following the first quarter of 2007 and therefore should review the details of these rules soon.
4. Corrective 401(k) Plan Distributions. Currently, contributions that must be returned to HCEs from 401(k) plans to satisfy the ADP and ACP tests (1) must be returned within two and one-half months after the end of the plan year or the employer must pay a 10 percent excise tax, (2) must include earnings from the end of the plan year to the date of distribution ("gap period earnings"), and (3) if returned within two and one-half months after the end of the plan year, must be included in the employee's income in the year deferred. In a very welcome change, PPA provides that, for years beginning after 2007, these corrective 401(k) plan distributions (1) must be returned within six months after the end of the plan year (if the plan is an "eligible automatic contribution arrangement", discussed below) to avoid the 10 percent excise tax, (2) will be included in the employee's income only in the year of distribution, and (3) will not include gap period earnings on the returned amounts.
B. Optional DC Plan Provisions
1. "Eligible Automatic Contribution Arrangements" for 401(k), 403(b) and Governmental 457(b) Plans. PPA creates a new set of "EACA" rules for these plans, effective for plan years beginning after 2007, that authorizes the "automatic enrollment" of all participants (except those participants who make an affirmative election to participate at another rate or not at all) in the salary reduction feature of the plan at a uniform deferral rate. In order to utilize this new, statutory automatic enrollment rule, employers must:
a. Amend their plans to include the rule, and, if desired, to include a special rule giving affected participants 90 days from the date of the first automatic deferral to opt-out and elect a taxable withdrawal, without early distribution penalties, of their automatic deferrals (plus earnings).
b. Provide a detailed notice that meets specified requirements prior to the beginning of each plan year.
c. Permit participants to opt-out of the automatic enrollment during a "reasonable time" after the provision of the annual notice.
d. Invest automatic enrollment deferrals in a required default investment (per to-be-issued DOL regulations) if the participant does not affirmatively select an investment.
PPA also amends ERISA's preemption provision – effective August 17, 2006 – to provide that any State laws that directly or indirectly attempt to prohibit EACA automatic enrollments are preempted by ERISA. (This change to the ERISA preemption rules eliminates a concern that historically has kept many of our clients from establishing automatic enrollment features in their plans.)
Another PPA rule provides that plans with EACA features have six months after the end of the year to effect any required return of excess deferrals or contributions under the ADP and/or ACP test, rather than the generally applicable two and one half months.
2. "Qualified Automatic Contribution Arrangements" for 401(k), 403(b) and Governmental 457(b) Plans. PPA also creates a new set of "QACA" rules for these plans, effective for plan years beginning after 2007, that not only authorizes automatic enrollments but that also provides new, relaxed safe harbor relief from the ACP and ADP and top heavy testing rules. (The former 401(k) safe harbor rules have not been changed and are still available alongside the new QACA rules.) In order to enjoy the benefits of the QACA rules, employers must:
a. Meet all of the requirements of the EACA rules discussed above.
b. Automatically enroll specified participants at 3 percent (or more) of compensation for their first full year of participation, 4 percent (or more) for their second year of participation, 5 percent (or more) for their third year of participation and six percent (or more) thereafter.
c. Limit automatic deferrals to no more than 10 percent of compensation.
d. Make an employer contribution to all non-HCEs that is either: (i) a non-matching contribution equal to 3 percent of compensation; or (ii) a matching contribution equal to 100 percent of the first 1 percent of compensation deferred and 50 percent of the next 5 percent of compensation deferred (i.e., a maximum match of 3.5 percent of compensation). These required employer contribution accounts must be subject to the same withdrawal restrictions as under the current 401(k) safe harbor rules for salary reduction contributions. (This new required safe harbor match is less than the current 401(k) safe harbor required match which results in a maximum match of 4 percent of compensation.)
e. Use a vesting schedule for the required employer contributions that is at least as favorable as a two year cliff vesting schedule. (This required QACA safe harbor vesting schedule is different from the current 401(k) safe harbor full and immediate vesting requirement.)
3. Default Investment Options. PPA adds ERISA Section 404(c)(5) which provides specific default investment rules (per to-be-issued DOL regulations) for participant-directed plans. If employers follow these rules, they will enjoy the same level of ERISA Section 404(c) protection for amounts defaulted into the plan's default investment as they do for amounts invested according to affirmative employee elections. These rules will require a specified notice prior to the beginning of each plan year and will require that participants have a "reasonable time" after the notice to make an affirmative investment election in order to avoid having their account default into the default investment.
This is a very welcome change to employers, who previously were required to default participant accounts only into investment selections that met the ERISA prudence and diversification requirements as applied to the defaulting participant's particular facts and circumstances. Employers with participant directed plans should take the steps necessary to ensure compliance with this welcome rule, which becomes effective in plan years beginning after 2006, and employers that have selected certain default investments over others due to the residual fiduciary liability that PPA now eliminates should revisit their plan default investment structure.
4. Mapping of Investments. "Mapping" is a process typically employed by a participant-directed DC plan whereby the employer or other fiduciary replaces an investment option with one of the same type but with a different investment advisor (e.g., an equity growth fund managed by advisor X for equity growth fund managed by advisor Y). Sometimes this is done with the plan's entire investment platform (e.g., when the plan is switching investment vendors) and sometimes this is done just with discrete funds (e.g., when a fund is underperforming). PPA amends ERISA Section 404(c) (i.e., the safe harbor from fiduciary liability offered to plans that permit participants to direct investments pursuant to detailed rules) to provide that the "mapping" of investments of participants' accounts from a current investment or menu to a new one will be deemed to comply with Section 404(c) if certain guidelines are met (e.g., the mapping must be a default that occurs only if the participant fails to give affirmative directions, written notice of the proposed mapping must be given to participants in the period from 60 to 30 days prior to the mapping, the old and new options must have similar risk and return characteristics, etc.). These new rules, if used, will provide additional protection to plan fiduciaries when a plan undergoes a change in the investment options available to plan participants.
These changes are effective for plan years beginning after 2006, but require DOL regulations for full implementation. Fortunately, the regulations are expected before year-end. Employers considering mapping transactions should monitor developments carefully.
5. Investment Advice Rules. PPA contains a comprehensive and detailed set of rules encouraging employers to engage professionals to provide investment advice to participants in their participant-directed plans. Although some DOL guidance previously existed on this issue, many employers felt it was inadequate to protect them and therefore avoided providing investment advice opportunities to their plan participants. Employers who carefully follow the new PPA investment advice rules should feel comfortable making investment advice available to their participants.
In addition, entities permitted to provide investment advice under these rules -- i.e., registered investment advisors, banks and insurance companies -- should review these rules to ensure that the services they offer and their service contracts satisfy the various requirements of the rules.
6. "Combined DB/DC Plan". In yet another futuristic benefit plan "experiment" by Congress, PPA invents the concept of the "small employer combined DB/DC plan". This provision, effective in 2010, permits employers with up to five hundred employees to maintain a single plan containing defined benefit and defined contribution features, so long as it meets specified design criteria. As 2010 approaches, if this concept has not been repealed, we will revisit it for those of our clients who might be interested.
7. PBGC Missing Participant Program Expanded. PPA extends the PBGC's missing participants program (currently available only to terminated DB plans) to terminated
DC plans. Under this very welcome change, terminated DC plans will have the option to give the account balances of missing participants (after reasonable efforts have been made to find the missing participants) to the PBGC to complete the termination of the plan.
II. PROVISIONS AFFECTING VARIOUS TYPES OF PLANS
1. EGTRRA Permanence. PPA repealed the sunset rules that would have caused certain provisions of EGTRRA 2001 to expire in 2007 and 2011 (e.g., the Savers' Credit, the EGTRRA rules concerning increased deferral and contribution limits, the Roth (k) and Roth 403(b) rules, the automatic rollover rules, etc.). This is a very welcome change because it avoids the potential for last minute piecemeal extensions of tax relief for which Congress is well known and avoids massive rewrites of benefit plans in 2010 to remove all the provisions that were added after 2001.
In addition, many employers have been hesitant to add Roth provisions to their 401(k) or 403(b) plans because of the perhaps temporary existence of the Roth concept. These employers now might wish to revisit the Roth concept.
2. Permissive Military Personnel Distribution Option. PPA permits, but does not require, 401(k) plans, 403(b) plans and IRAs to allow military reservists called up for more than 179 days of active duty between 9/12/01 and 12/31/07 to make penalty-free, taxable withdrawals from their elective deferral accounts while on active duty, without restrictions, which then can be re-contributed to an IRA (but not to a 401(k) or 403(b) plan), so long as the re-contribution is made within two years after the end of the active duty. This rule is effective for distributions after September 11, 2001, which should allow affected military personnel to file for refunds of any 10 percent penalty they already may have paid on these distributions.
3. New Rollover Opportunities for After-Tax Contributions. Currently, a distribution of after-tax contributions may be rolled directly to a qualified DC plan or to an IRA, but not to a 403(b) plan or to a qualified DB plan. PPA permits distributions of after-tax contributions after 2006 to be rolled to a 403(b) plan or to a DB plan. (Plans are still not required to accept rollovers, however.) Because the plan accepting a rollover of after-tax contributions must meet additional recordkeeping requirements, we recommend that you explore the administrative ramifications of this approach before amending your plan to accept these rollovers.
4. Non-Spouse Beneficiary Rollovers. PPA permits non-spouse designated death benefit beneficiaries receiving eligible rollover distributions from a qualified plan, a 403(b) plan or a governmental 457(b) plan to make direct rollovers to IRAs. The IRA accepting the direct rollover must be set up solely to receive the death benefit, will be subject to the minimum required distribution rules applicable to beneficiaries, and cannot accept additional contributions or permit rollovers of distributions from the IRA. The death benefit distribution to the non-spouse beneficiary will not be subject to the 20 percent mandatory withholding rules even though a rollover option is now available. This provision is effective for distributions after 2006.
5. Rollovers to Roth IRAs. PPA permits rollovers from qualified plans, 403(b) plans and governmental 457(b) plans directly to Roth IRAs, beginning in 2008. These rollovers will result in immediate taxation of the distribution, but will eliminate taxation on future earnings within the Roth IRA (if the earnings are withdrawn in a qualifying distribution). For 2008 and 2009, these rollovers will not be available to any individual whose adjusted gross income exceeds $100,000 or to any married individual who files a separate tax return. For years after 2009, these rollovers will be available regardless of AGI and filing status, because the current restriction is eliminated (for 2010 and later) by the Tax Increase Prevention and Reconciliation Act (which was enacted May 17, 2006).
6. Hardship Distribution Rule Changes. Current law allows hardship withdrawals from 401(k) and 403(b) plans, and unforeseeable emergency withdrawals from 457(b) and non-qualified deferred compensation plans, for qualifying expenses of the participant, the participant's opposite sex spouse, and the participant's dependents. PPA expands these withdrawal rules to cover eligible expenses incurred by any designated beneficiary, effective upon the issuance of IRS regulations.
7. Qualified Domestic Relations Order Changes. PPA requires the DOL to issue regulations before September 2007 that clarify that QDROs should be honored by plans, regardless of when they are issued and even if the QDRO is a modification of a prior court order.
8. Bonding Rule Changes. Effective for plan years beginning after 2007, ERISA's bonding rules have been changed to increase the maximum bond from $500,000 to $1M for plans with employer securities. Plans with employer securities should contact their fidelity bond carriers before 2008 to ensure that their plan's bond amount complies with this new rule.
9. Liberalization of IRS Amnesty Program. PPA directs the IRS to update its EPCRS program (i.e., the comprehensive IRS program pursuant to which plan sponsors can correct plan qualification defects in order to preserve the plan's tax-qualified status) to permit the IRS to waive income and excise taxes in cases of inadvertent and small errors, to extend the periods employers have to correct certain plan defects, to make the EPCRS program for insignificant operational failures available even to employers under examination, to ensure that the tax or penalty proposed by the IRS bears a reasonable relationship to the error in question, and so on.
These changes to the EPCRS should encourage more employers to work with their ERISA counsel and actuaries/administrators to conduct periodic self-audits of their plans, with the goal of utilizing this cost-effective method of correcting inadvertent plan defects that invariably arise even with the most carefully operated plans.
10. Age 62 In-Service Distributions from Pension Plans. Effective beginning in 2007, PPA permits (but does not require) money purchase pension plans and DB plans to allow participants to elect in-service distributions beginning at age 62, even if the plan's normal retirement age is later than age 62. This long-awaited response to demographic developments will be desired by many employers that have older employees wishing to trend down their hours but not terminate employment altogether (and who under pre-PPA law generally were not able to commence pension distributions until a full employment termination).
11. Expansion of Notice Period. PPA permits plans to provide the various tax and distribution notices required by Code sections 402(f), 401(a)(11) and 417 up to 180 (as opposed to the prior 90) days before the distribution.
12. Prohibited Transaction Exemptions for Service Providers. The PPA liberalized certain of the prohibited transaction rules to make it easier for non-fiduciary service providers to serve plans and receive compensation for their services without triggering excise taxes.
13. Plan Asset Prohibited Transaction Rules. The PPA reduced the types of plan investors that an investment fund must count (generally eliminating foreign plans and governmental plans) when determining whether the investment fund's assets are "plan assets" under ERISA, enabling these funds to expand their investor base.
14. Hedge Fund Rules. The ERISA plan asset rules have been amended in a manner that will have the effect of permitting hedge funds and other nonregulated investment vehicles to accept ERISA plan assets funds.
III. PROVISIONS AFFECTING DEFINED BENEFIT PLANS
1. DB Plan Funding Rules. PPA's most widely-reported provisions create new funding rules for DB plans. Although proponents of the legislation claim that these rules will "strengthen" the nation's DB plan system, some commentators fear that the new rules – because of their additional burdens on employers –will endanger these plans. In very general terms, these new rules (i) require underfunded pension plans to become fully funded within seven years (beginning 2008); (ii) impose new mortality and interest assumptions to be used in determining the plan's liabilities and participant benefits (e.g., lump sums); (iii) with exceptions for small plans and collectively bargained plans, impose onerous funding and benefit restrictions on plans that qualify as "at risk" plans (generally, below 65 percent funded in 2008, below 70 percent funded in 2009, below 75 percent funded in 2010 and below 80 percent funded in 2011 and future years).
In addition, beginning in 2008, DB plan sponsors will need to deliver to participants and to the PBGC a new annual disclosure regarding the plan's funded status and related matters. This disclosure will replace the current, and not particularly illuminating, summary annual report participant disclosure requirement as it applies to DB plans.
Employer-sponsors of DB plans should consult carefully with ERISA counsel and their actuaries about the impact of these new funding rules on their plans and the opportunities available before the effective date of these new rules.
2. PBGC Changes. PPA increases PBGC variable premium rates for underfunded plans and makes other technical changes to the PBGC insurance program for DB plans.
3. "Hybrid Plan" (e.g., Cash Balance and Pension Equity Plans) Rules. PPA "clarifies" (prospectively only) the law governing so-called "hybrid plans". (Cash balance plans are DB plans that establish participants' accrued benefits as hypothetical current account balances (in contrast to a traditional DB plan, where the accrued benefit is, often confusingly, expressed as an annuity commencing at the plan's retirement age).) PPA provides clear rules in three areas affecting these plans: (i) whether these plans give rise to age discrimination; (ii) how to compute lump sum benefit payments from these plans; and (iii) how to convert traditional DB plans to these plans.
Plan sponsors of hybrid plans should consult with ERISA counsel to ensure that the plans comply with these new rules and to discuss the way these new rules impact prior actions. In addition, although these new rules clarify several historically murky issues affecting hybrid plans, employers should consider many important issues (too lengthy and fact-specific to delineate here) before establishing a hybrid plan or converting their traditional DB plans to hybrid plans.
4. Retiree Health Benefits. Effective August 17, 2006, PPA expands the ability to transfer surplus DB plan assets to fund retiree health benefits. Employers with overfunded DB plans who provide retiree health benefits should consult with ERISA counsel and their actuaries to determine if they should take advantage of the opportunities provided by the new rules.
IV. PROVISIONS AFFECTING NONQUALIFIED PLANS
1. As part of the DB funding rules discussed above (and as yet another response to Enron), PPA provides that any assets set aside (such as in a "rabbi trust") or restricted to the payment of benefits for "covered employees" under a nonqualified plan will be subject to the very onerous tax penalties of Code Section 409A (i.e., immediate ordinary income tax, a 20 percent penalty tax, and interest penalties) if the assets are set aside or restricted: (a) while a DB plan sponsored by the employer (or by a member of the employer's controlled group) is in "at-risk status" under the new funding rules; (b) while the DB plan's employer-sponsor is in bankruptcy; or (c) during the twelve month period beginning six months prior to a distress termination date of a DB plan sponsored by the employer (or by a member of the employer's controlled group).
A "covered employee" for purposes of these new restrictions is any employee of a publicly-traded company who is (or was at termination of employment): (a) the CEO, or acting CEO; (b) required to be listed in a proxy statement's compensation disclosure statement; or (c) an "insider" subject to the insider trading rules under the Securities Exchange Act of 1934. (Some commentators have interpreted the language of these new restrictions to apply to the CEO, or acting CEO, of companies that are not publicly-traded, an issue that will need some clarification.)
Employers that sponsor (or whose controlled group members sponsor) nonqualified plans and DB plans will need to be very mindful of this new rule and will need to put in place procedures to "shut-off" nonqualified plan "covered employee" deferrals or contributions to a "rabbi trust" or similar arrangement should one of the three situations occur.
2. PPA changes the tax treatment for the death benefit proceeds paid to an employer under a corporate owned life insurance policy issued on the life of an employee. Under this change, the death benefit proceeds paid to the employer that are in excess of the premiums paid by the employer will be included in the employer's taxable income, unless the insured (1) was an employee any time within twelve months of death, or was a director or HCE at the time the policy was issued, (2) receives notice of the contract before it is issued, and (3) provides written consent to being designated as an insured under the contract. This change applies to COLI contracts issued after August 17, 2006.
We encourage our clients to contact us soon to talk through how PPA affects their plans, and to create a detailed "game plan" and timeline for dealing with its requirements and considering its planning opportunities.
