Employee Benefits & Executive Compensation Benefits Alert – Fall 2006
Highlights of the Pension Protection Act of 2006
The most sweeping pension reform bill to emerge from Washington in recent years, the Pension Protection Act of 2006 (the ‘Act’), passed both houses of Congress in July. President Bush signed the Act into law on August 17, 2006. The Act contains a number of significant changes affecting defined benefit plans and defined contribution plans alike, including 401(k) profit sharing plans and Employee Stock Ownership Plans (‘ESOPs’).
This K&C Benefits Alert highlights the important provisions of the Act:
- Accelerated Funding for Defined Benefit Plans. The main thrust of the Act is to shore up funding of defined benefit (DB) pension plans, to reduce the number of insolvent plans turned over to the Pension Benefit Guaranty Corporation for federal bail out. Current law DB funding rules are repealed for plan years beginning in 2008, and replaced with a complex set of rules designed to achieve full funding of the current value of accrued benefits. The requirement to fund at 100% of plan liabilities is phased in over the 7 year period from 2008 to 2015. New market determined interest rate assumptions are imposed, as are restrictions on an employer’s ability to improve plan benefits, pay benefits, or fund nonqualified deferred compensation at a time when its DB plan is underfunded. The new funding rules will undoubtedly result in a dramatic increase in the short term costs of DB plans.
- Accelerated Vesting Schedules for Defined Contribution Plans. Effective for plan years beginning after December 31, 2006, all benefits provided under a defined contribution plan (including an ESOP) must vest on either a 3 year cliff or 2 to 6 year graded vesting schedule. Previously, employer contributions other than matching contributions were permitted to vest according to a 5 year cliff or 3 to 7 year graded vesting schedule. These vesting schedules will not apply to leveraged ESOPs with loans outstanding on September 26, 2005, until the earlier of the date the loan is scheduled to be fully repaid or is fully repaid.
- Automatic 401(k) Enrollment. The Act effectively clears the way for employers to use automatic enrollment provisions in their 401(k) plans. Previously, wage-withholding laws may have prohibited automatic 401(k) enrollment in some states. The Act clarifies that ERISA preempts all state laws to the extent that they impact 401(k) automatic enrollment provisions, provided that the default investments chosen by the plan fiduciaries satisfy certain requirements. The Act also creates a new automatic enrollment 401(k) safe harbor plan design for plan years beginning after December 31, 2007.
- Default Investment Rules. Protection of plan fiduciaries from liability for losses has been expanded to include default investment options for automatic enrollment plans provided that such investments include a mix of asset classes consistent with capital preservation or long-term capital appreciation and satisfy certain notice requirements. In addition, fiduciaries will receive protection from liability from losses during a blackout period if the investments are mapped to new investment options with risk and return characteristics similar to the options being replaced. The plan administrator must provide notice of these changes at least 30 days and not more than 60 days in advance of the change and give participants an opportunity to decide whether to choose alternative investments options.
- Investment Advice. Investment advisers will be allowed to provide fund-specific investment advice under a new prohibited transaction exemption. This exemption affects participants in 401(k) plans and other individually directed account plans. Prior to this exemption, investment advisers were limited to providing advice about broad allocation strategies and were prohibited from advising participants about investment in particular funds. Expect institutional service providers to begin rolling out this potentially valuable service in 2007.
- Diversification Requirement for Plans Holding Publicly Traded Employer Stock. Certain defined contribution plans that hold employer stock of publicly traded companies must permit employees with at least three years of service to diversify up to 100% of their holdings of employer stock starting in 2007. This new requirement does not apply to stand-alone ESOPs, but it does apply to public company KSOPs and 401(k) or profit sharing plans in which employer contributions are made in the form of employer stock. Transitional rules will help spread out the diversification requests through the end of 2008.
- Cash Balance Plans. Cash balance plans have previously come under attack as violative of applicable age discrimination laws. Effective June 29, 2005, the Act provides that a cash balance plan will not violate the prohibition on age discrimination so long as the plan satisfies two requirements: each participant’s accrued benefit on any date must not be less than that of any similarly situated, younger participant; and participants must become fully vested after three years of service. Compliance with these new cash balance rules will not provide any protection against claims for periods prior to the effective date.
- Non-Spousal Rollovers. Effective for distributions after December 31, 2006, a direct trustee-to-trustee transfer may be made from the eligible retirement plan of a deceased employee to an individual retirement plan that has been established for the purpose of receiving such a distribution on behalf of a non-spouse designated beneficiary. The transfer will be treated as an eligible rollover distribution to the IRA. A trust maintained for designated beneficiaries will be treated in the same manner. This change provides welcome relief for non-spousal beneficiaries and opens up for them the possibility of extended payouts.
- Pension Benefit Statements. Individual account plans will be required to provide pension benefit statements quarterly to participants who have the right to direct the investment in their account. Participants in other individual account plans will receive pension benefit statements annually. Defined benefit plans must provide benefit statements to actively employed vested participants at least once every three years. The Act now specifies the contents of such statements. These changes are effective for plan years beginning after December 31, 2006.
- Bonding Requirements. The bonding requirement for plans holding employer securities will increase to a maximum of $1,000,000 from $500,000 effective for plan years beginning after December 31, 2007. Plans that add or remove employer securities from investments will need to adjust their bonds accordingly.
- EGTRRA Changes Made Permanent. Pension and IRA provisions in the Economic Growth and Tax Relief Act of 2001 (EGTRRA) that were previously scheduled for automatic repeal have been made permanent. EGTRRA provisions that are affected include the higher benefit-related limits, catch-up contributions, expansion of hardship distribution and rollover availability, and Roth 401(k) plans. The inflation-adjusted limits under EGTRRA are set at the following dollar amounts for 2006:
Limitation Amount Annual Compensation $220,000 Elective Deferrals under 401(k) and 457(e)(15) $15,000 Catch-up Contributions $5,000 Annual Defined Benefit $175,000 Defined Contribution Annual Addition $44,000
- Deadline for Plan Amendments. Plans must be amended to conform to the requirements of the Act by the end of the first plan year beginning on or after January 1, 2009.
If you would like to discuss how these changes will impact your company’s specific benefit plans, please contact one of the members of our Employee Benefits team.
The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances.
The contents of this publication are intended for general information only and should not be construed as legal advice or a legal opinion on specific facts and circumstances. Copyright 2023.