On August 17, 2006, President Bush signed into law the Pension Protection Act of 2006 (the "PPA"). The PPA makes fundamental changes to the Internal Revenue Code (the "Code"), the Employee Retirement Income Security Act of 1974 ("ERISA"), and numerous other laws that impact plan sponsors. The most notable changes are an overhaul of defined benefit plan funding, the permanence of previous tax cuts and new automatic enrollment provisions. In addition, the PPA makes changes with respect to retirement plan fiduciary requirements, health plans, investment limitations, donations to exempt organizations, and individual retirement accounts.
The Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") substantially increased contribution and accrual limitations under qualified retirement plans. These increases were to be automatically repealed in 2011, absent further legislation. The PPA makes a majority of these provisions permanent. The most important changes that have become permanent are the increased limit on elective deferrals and contributions to 401(k) and other retirement plans, the existence of catch-up contributions for individuals age 50 or over, the existence of Roth 401(k) contributions, and the more liberal rules regarding rollovers. Most plan sponsors will welcome the certainty of this permanent extension.
401(k) and Defined Contribution Plan Changes
Automatic Enrollment. The PPA is designed to encourage employers to provide for automatic enrollment in their 401(k) plans. These changes include:
- A new safe harbor option that specifically allows automatic enrollment arrangements (in addition to the existing safe harbors), which eliminates numerous testing requirements.
- Fiduciary relief for default investments.
- No adverse tax consequences if automatic enrollees withdraw their deferrals within 90 days of participation.
- Protection from the top-heavy rules for plans that meet the automatic enrollment safe harbor.
- Preemption of state wage laws that could otherwise impact the use of automatic enrollment.
Effective for plan years beginning after December 31, 2007.
Faster Vesting. The PPA requires that employer contributions vest on an accelerated schedule. Vesting of employer contributions must occur no slower than on a three-year cliff vesting schedule or on a six-year graded vesting schedule (20% per year starting after the second year). Effective for contributions for plan years beginning after December 31, 2006.
Investment Advice. The PPA permits fiduciaries to be paid to provide investment advice to plan participants. Although certain requirements apply, this change will encourage employers to furnish investment information to plan participants. Effective for advice provided after December 31, 2006.
Diversification. Plans that hold employer stock must allow participants to diversify their investments away from employer securities. For employee contributions, diversification must be available at any time. For employer contributions, diversification must be available to those with three or more years of service. New diversification notices are also required. These rules do not apply to employee stock ownership plans ("ESOPs"). Effective for plan years beginning after December 31, 2006, but phased in over three years.
Combined Defined Benefit/401(k) Plans for Small Employers. The PPA allows companies with fewer than 500 employees to create combined defined benefit and automatic enrollment 401(k) plans using a single trust and filing a single Form 5500. Effective for plan years beginning after December 31, 2009.
Defined Benefit Plan Changes
Funding Changes. The PPA almost completely replaces the old rules for funding defined benefit plans. In many cases, this will require employers to accelerate their defined benefit plan funding schedule. For example, the new funding target is 100% instead of 90%. The new rules change the filing requirements, Pension Benefit Guarantee Corporation (“PBGC”) premiums and deduction limits. Generally effective for plan years beginning after December 31, 2007, but employers must begin planning now.
Increase in Deduction Limits. In anticipation of the funding rules described above, the PPA has increased the deduction limit to 150% of current liability for 2006 and 2007. After that, plans will be able to deduct an additional 50% of their funding target for the year.
Cash Balance Plans. The PPA protects cash balance plans from age discrimination claims and provides specific rules for the conversion of traditional defined benefit plans to cash balance plans. Some of these provisions are retroactively effective (to June 29, 2005) and others are effective as of the enactment of the PPA. This primarily provides prospective protection for employers who have maintained such plans. However, on August 7, 2006, the Seventh Circuit Court of Appeals released an employer-friendly decision in Cooper, et al. v. IBM Personal Pension Plan, ____ F. 3d ____ (7th Cir., 2006). Employers with cash balance and other hybrid defined benefit plans should carefully examine both the PPA and the Seventh Circuit's recent decision.
"At Risk" Plans. Under the PPA, defined benefit plans that are not adequately funded will be considered "at risk." Such plans will be subject to increased funding and reporting requirements. Plans with fewer than 501 participants are not subject to these rules. Generally effective for plan years beginning after December 31, 2007, but employers must begin planning now.
Lump Sum Distributions. New interest rate assumptions will be required for calculating lump sum distributions. Although not certain, it is likely that this change will cause a decrease in the amount paid out upon a lump sum distribution. In addition, the required mortality tables used for valuing lump sum distributions will change. New interest rate will be phased in over five years beginning with plan years beginning after December 31, 2007.
Phased Retirement. Under the PPA, defined benefit plans can provide for in-service distributions beginning as early as age 62. Effective for distributions made in plan years beginning in 2007 or later.
Multiemployer Plan Changes. The PPA makes significant changes specific to multiemployer plans. These include changes to such a plan's funding rules, especially for underfunded plans. The PPA also modifies the withdrawal liability rules. The changes are not as sweeping as the single employer defined benefit plan changes, but they are serious and fundamental. Most of the changes specific to multiemployer plans are effective after December 31, 2007.
Retiree Health Funding. The PPA allows certain pension plan assets (including those of a multiemployer plan) to transfer to a health benefits account, to fund retiree medical benefits.
Quarterly Statements. Employers must provide quarterly statements to defined contribution plan participants and beneficiaries who have the right to direct investments, and annual statements to those who do not. An active, vested participant in a defined benefit plan must receive either (1) a benefit statement once every three years, or (2) an annual notice describing the availability of a benefit statement and the manner in which the participant can obtain a benefit statement. Generally effective for plan years beginning after December 31, 2006 (a delayed effective date applies to a collectively bargained plan).
Funding Notice. PBGC insured plans must distribute annual funding notices to participants no later than 120 days after the end of the plan year. Effective for plan years beginning after December 31, 2007.
Form 5500 Expansion and Disclosure. The PPA requires additional information to be provided on Form 5500. The PPA also requires that employers make Form 5500 information available on the employer's Intranet site, if any. Effective for plan years beginning after December 31, 2007.
Multiemployer Information. In response to written requests, multiemployer plan administrators will be required to provide contributing sponsors, within 180 days of the request, estimates of their withdrawal liability and explanations of how the estimate was determined. Contributing sponsors, participants and labor organizations will be entitled to ask for actuarial reports, financial reports and funding extension requests. These need to be delivered within 30 days of the request in a form (e.g., electronic or paper) reasonably accessible to those individuals. These changes apply to plan years beginning after December 31, 2007.
Other Important Provisions of the PPA
Company Owned Life Insurance. The PPA requires the taxation of life insurance proceeds received by a company on policies maintained by the company on the lives of its employees. This rule is subject to certain exceptions. Effective for contracts issued or materially changed after the effective date of the PPA.
Deferred Compensation. The PPA provides for additional limitations under Code Section 409A for funding executive deferred compensation if the company's defined benefit plan is "at risk," anytime within 6 months before or after a defined benefit plan termination, or whenever the company is a bankruptcy debtor. Effective as of the effective date of the PPA.
Exempt Organizations. The PPA has made numerous changes and additions to the rules governing donations to exempt organizations. In general, these rules place additional compliance burdens on tax exempt organizations and donors.
The PPA represents the most sweeping change to the retirement system in over 20 years. Employers are urged to begin planning for the impact of these changes immediately.
IRS regulations require us to advise you that, unless otherwise specifically noted, any federal tax advice in this communication (including any attachments, enclosures, or other accompanying materials) was not intended or written to be used, and it cannot be used, by any taxpayer for the purpose of avoiding penalties; furthermore, this communication was not intended or written to support the promotion or marketing of any of the transactions or matters it addresses.
For more information, please contact John L. Barlament at 414.225.2793, or JLBarlament@michaelbest.com.