After much legislative drama and procrastination, Congress has finally passed its long-promised, comprehensive pension reform legislation, the Pension Protection Act of 2006 (“PPA”). President Bush is expected to sign the legislation into law in the next few days. The new statute will dramatically change the funding landscape for defined benefit retirement plans. However, its reach extends well beyond just defined benefit plans. In fact, the PPA introduces new rules for defined contribution plans (including incentives for adopting automatic enrollment features), validates the legality of cash balance and other hybrid pension plans, imposes new disclosure and reporting requirements, and makes permanent the expiring EGTRRA retirement plan enhancements. In short, there is something here for everybody.
Given the length and complexity of the legislation, we have decided to report it to you in installments. In this first installment, we will broadly summarize what the legislation provides. If you are left itching for more after reading this first installment, don’t despair: in subsequent installments, we will discuss in greater detail how various aspects of the legislation will affect your plans.
New Funding Rules for Single Employer Plans
At the heart of the PPA are new funding rules for single employer plans. Hardly a month seems to go by when you don’t hear a new report of a bankruptcy in which a company has foisted its underfunded defined pension plan onto the Pension Benefit Guaranty Corporation (“PBGC”). In fact, many predict that a federal bailout of the PBGC may be required at some future date. In this tenuous environment, the PPA is Congress’s attempt to force employers to own up to their funding obligations while, at the same time, not scaring employers away from sponsoring defined benefit plans.
The PPA adopts a completely new methodology for measuring the funding level of a single employer plan. In some respects, this methodology is much simpler than the old methodology: a plan’s funding status is determined by comparing the present value of participants’ benefits to the value of plan assets. Each year, employers are responsible for funding the value of benefits that are earned during the year, plus a portion of any shortfall that exists if the value of plan liabilities exceeds the value of plan assets.
The new funding rules generally become effective for plan years beginning after 2007, and many of the rules are phased in over several years.
1. Interest rate for calculating plan liabilities—The modified yield curve approach
One of the cornerstones of pension funding reform is determining an appropriate interest rate by which to measure a pension plan’s current liability. Generally, a pension plan’s liabilities are expressed as the present value of participants’ accrued benefits. If the interest rate used in this present value calculation is too low, a pension plan’s liabilities are overstated. If the rate is set too high, a pension plan’s liabilities are understated. Historically, the Internal Revenue Code and the Employee Retirement Income Security Act of 1974 (“ERISA”) have used the rate on thirty-year Treasury bonds as the basis for calculating pension liabilities. In more recent years, a rate based on long-term investment-grade corporate bonds has been used.
With the PPA, Congress has adopted a “modified yield curve” approach. Under this approach, the interest rate for measuring pension liabilities will be based on the twenty-four-month average yield curve for the top three grades of corporate bonds. While currently a single interest rate is used for calculating a pension plan’s liabilities, the PPA will require employers to use different rates for different age participants, depending on when benefits are expected to be paid. Thus, a short-term corporate bond rate will be used for liabilities expected to be incurred in the next five years; a mid-term corporate rate will be used for measuring liabilities expected to be incurred in the next five to twenty years; and a long-term corporate rate will be used for measuring liabilities expected to be incurred thereafter. The underlying principle is that the interest rate used to value a liability should be consistent with when that liability is expected to be incurred. Generally, a lower interest rate will apply to liabilities that will be incurred in the near term, and a higher rate will be used to value the liabilities that will be incurred in the longer term.
Rather than adopting the approach described above, which segments the corporate bond yield curve into three interest rates (i.e., short-term, mid-term, and long-term), employers can elect to use interest rates throughout the corporate bond yield curve. If elected, the yield curve will be calculated without twenty-four-months’ averaging.
The modified yield curve approach will be phased in over three years starting in 2008. Until then, the interest rate methodology employed in 2004 and 2005 will be used (i.e., the interest rate used for measuring pension liabilities in 2006 and 2007 will be based on rates for long-term investment-grade corporate bonds).
2. Mortality assumptions
Mortality assumptions are an important factor, used in calculating a pension plan’s liabilities. Under the PPA, with certain exceptions, employers will be required to use a mortality table prescribed by the IRS. The IRS is required to update this table at least every ten years. Additionally, the IRS is directed to adopt a special mortality table for disabled participants.
3. Valuing plan assets
The PPA also changes the rules for valuing plan assets. Currently, the law allows employers to adopt a “smoothing” approach to value plan assets. Under this approach, rather than using the current fair market value of plan assets for purposes of calculating a plan’s funding obligations, employers can adopt a methodology that takes into account the value of plan assets over a five-year period, provided that such methodology does not result in a valuation that is less than 80 percent or more than 120 percent of the assets’ current fair market value. This allows the ups-and-downs of the market to be “smoothed.” The PPA permits employers to use, at most, a twenty-four-month average for calculating the value of plan assets, provided that the average does not result in a valuation that is less than 90 percent or more than 110 percent of the assets’ current fair market value. While the new approach will ensure that the value of a plan’s assets used for funding purposes more closely approximates the assets’ current fair market value, it will likely increase the volatility of funding calculations—a result that may not sit well with many employers.
4. Funding target
Generally, under current law the funding target for healthy plans is ninety percent of the plan’s current liability. The PPA increases the funding target to one hundred percent of the plan’s ongoing liabilities. The PPA’s goal is to force employers to fully fund their plans.
5. Minimum contributions/Amortization periods
Under the PPA, employers must make a minimum contribution each plan year in an amount sufficient to cover the value of benefits accrued during the year. Additionally, employers have to make a contribution if the value of a plan’s assets is less than the plan’s funding target. The amount of this supplemental contribution is calculated by amortizing the shortfall (i.e., the excess of the value of the plan’s liabilities over its assets) so that it is paid over seven years. No contribution is required if the value of a plan’s assets exceeds the plan’s target liability plus the value of benefits that have accrued during the plan year. For the most part, this methodology will require plans to fund plan charges more quickly than under current rules. For example, employers will have to pay for plan improvements over a shorter period of time than under current rules.
6. “At risk” plans/Limits on plan improvements
One controversial aspect of the new legislation is how to identify and respond to “at risk” plans. The PPA’s goal is to create rules to identify plans that are developing funding problems early on and to accelerate those plans’ funding responsibilities. The balancing act under these rules is to force employers to address plan funding issues sooner, but do so in a manner that does not place undue additional financial burdens on a company that may already be experiencing financial pressures. A plan will be deemed to be “at risk” if its “funding target attainment percentage” is less than eighty percent on an ongoing basis and less than seventy percent taking into account the more aggressive funding assumptions that are used for “at risk” plans. Generally, a plan’s “funding target attainment percentage” is calculated as the ratio of the value of a plan’s assets to the plan’s funding target. If a plan is “at risk,” it must step up its funding obligations.
Congress was also concerned about employers making plan improvements when a plan’s financial condition was precarious. To remedy this, the PPA prohibits plan sponsors from making certain plan improvements (e.g., increasing benefits, establishing new benefits, changing the rate of benefit accruals, and improving the plan’s vesting schedule) and places limits on lump-sum benefits if the plan’s adjusted funding target attainment percentage is less than eighty percent. If such percentage falls to less than sixty percent, plan benefits are automatically frozen and distributions are prohibited.
7. Other provisions affecting single employer defined benefit plans
The PPA includes a host of other provisions affecting single-employer defined benefit plans, including:
- adopting new limits on the maximum deductible contributions for defined benefit plans and relaxing the combined deductible limit for employers with defined benefit and defined contribution plans. This will allow employees to make larger contributions in profitable years, if they wish to do so.
- calculating distributions using interest rates based on the modified yield curve described above. This will be phased in over five years beginning in 2008. Generally, this is expected to reduce the value of distributions from the values that would be calculated under current law.
- applying special rules for certain industries (i.e., airlines) and certain types of multiple employer plans.
- creating new disclosure and reporting requirements, including a requirement that the plan provide an annual notice to participants that describes the plan’s funding status.
1. Heading off multiemployer plan funding issues
While the PPA does not dramatically change the current structure for determining a multiemployer plan’s funding status, the new law forces problem multiemployer plans into the spotlight so that the bargaining parties can take action to prevent the plans’ further financial deterioration. Under the PPA, if a multiemployer plan is funded below certain levels, the bargaining parties must implement a plan that would bring the plans out of the endangered or critical status. The legislation requires the plan’s actuary to provide an annual certification to determine whether the plan’s financial status is “endangered” or “critical.” If the actuary determines that the plan falls into one of these categories, the plan must provide notice of that status to the participants, beneficiaries, contributing employers, PBGC, secretary of the Treasury, and the secretary of labor.
Generally, a plan will be “endangered” if:
- its funding percentage for the plan year is less than eighty percent or
- the plan is projected to have an accumulated funding deficiency in the current or six succeeding plan years.
After a plan is certified as endangered, the plan sponsor is supposed to adopt a funding improvement plan to address the plan’s funding problems. The improvement plan must meet specified financial targets. The mechanism for implementing this strategy is to create a dialogue between the bargaining parties to determine the best approach for addressing the plan’s funding problems. This is facilitated by the plan trustees who are responsible for proposing improvement plans to the bargaining parties for addressing the plan’s funding issues. The strategies include suggestions for improving the plan’s funding by reducing future benefit accruals and increasing contributions.
A plan will be deemed to be in “critical” status if certain funding tests are not satisfied (e.g., the plan’s funding percentage is less than sixty-five percent, and the plan assets and projected contributions over the current and next six years are less than the benefits and administrative expenses projected to be payable in the current and next six years). A plan in critical status is required to adopt a rehabilitation plan that satisfies certain funding objectives. The plan trustees are required to offer suggestions to the bargaining parties for improving the plan’s funding by reducing future benefit accruals and increasing contributions. If the collective bargaining parties cannot agree on a rehabilitation plan, future benefit accruals must be reduced. Upon providing participants with advance notice, the plan sponsor can reduce certain ancillary benefits, rights and features (e.g., postretirement death benefits, disability benefits, early retirement benefits, and early retirement subsidies). Additionally, a surcharge is imposed on employers that contribute to a plan that is in critical status.
2. Other provisions affecting multiemployer plans
The PPA includes a number of other provisions affecting multiemployer plans, including the following:
- A partial withdrawal will be triggered if an employer ceases to have an obligation to contribute under one or more collective bargaining agreements, but the employer transfers such work to an entity owned or controlled by the employer.
- The PPA reduces the amortization periods applicable to certain costs under the minimum funding rules. For example, the period for amortizing past service liabilities and changes in actuarial assumptions will be reduced from thirty years to fifteen years.
- All members of a contributing employer’s controlled group are liable for making minimum contributions to multiemployer plans.
- Within thirty days of a written request, plan administrators must provide copies of actuarial reports, financial reports and amortization extensions filed with the IRS to any participant, beneficiary, employee organization, or employer that has an obligation to contribute to the plan.
- Within 180 days of a written request, plan administrators must provide each employer with an estimate of its withdrawal liability, including a detailed explanation of the calculation.
- Each year plan administrators must provide summary plan information to contributing employers and employee organizations.
PPA Blesses Hybrid Plans
The PPA affirms, prospectively, the legality of hybrid plans, such as cash balance and pension equity plans. Hybrid plans share characteristics of both defined contribution and defined benefit plans. Generally, they are like defined contribution plans, in that benefits are expressed as amounts (e.g., a hypothetical account for cash balance plans or a percentage of final average compensation for pension equity plans) but the funding rules of defined benefit plans apply (i.e., the employer, not the participant, bears the investment risk). Some participants have brought lawsuits against hybrid plans, arguing that the fundamental structure of hybrid plans violates federal laws. While most courts that have considered these arguments have rejected them, these lawsuits have created concerns for hybrid plan sponsors.
The PPA has addressed these concerns by adopting a uniform test that applies to all pension plans. Generally, a pension plan will not violate federal rules provided that the accrued benefit of an older participant is no less than the accrued benefit of a similarly situated younger participant. A younger participant will be treated as similarly situated to an older participant if the younger participant is identical in every respect other than age (e.g., has the same service, compensation, position, and work history). In applying this test, a participant’s accrued benefit may, under the terms of the plan, be expressed as an annuity payable at normal retirement age, the balance of a hypothetical account or the current value of the accumulated percentage of a participant’s final average compensation.
Therefore, for a cash balance plan that expresses a participant’s benefit as a hypothetical account balance that receives annual pay and interest credits, this test is applied by comparing a younger participant’s account balance to a similarly situated older participant’s balance. If the older participant’s hypothetical balance equals or exceeds the younger participant’s balance, the age discrimination rules are satisfied. Likewise, in a pension equity plan, where a participant’s benefit is expressed as the current value of an accumulated percentage of a participant’s final average compensation, this test is applied by comparing a younger and older participant’s current lump-sum benefit (i.e., the accumulated percentage multiplied by the final average compensation).
The statute provides that the hybrid plan changes made by the PPA should not create any inferences about the application of the age discrimination rules to hybrid plans before the provision’s effective date (i.e., June 29, 2005). As a result of Congress’s failure to address the issue in the past, the fate of hybrid plans for periods before June 29, 2005, will be left to the courts to resolve. In this regard, sponsors were recently helped by a federal court of appeals decision from the Seventh Circuit that concluded cash balance plans do not violate federal age discrimination laws (Cooper v. IBM, No. 05-3588 (7th Cir. August 7, 2006)).
The PPA also sets forth special rules that apply to hybrid plans. Under these rules:
- For hybrid plans that apply interest credits, the interest credits may not exceed a market rate of return (as set by the IRS). If this requirement is satisfied, plans can pay out a participant his/her hypothetical balance as a lump distribution without worrying about the so-called “whip-saw” effect (some courts have suggested that if the rate used for giving interest credits exceeds the interest rate used for calculating lump distributions, a plan may have to pay lump-sum benefits that exceed the hypothetical account balance).
- Benefits must be one hundred percent vested after three years of service (effective for years beginning after December 31, 2007).
- If a pension benefit is converted from a traditional formula to a hybrid formula, the participant’s benefit after the conversion must not be less than the sum of (i) the participant’s benefit immediately before the conversion under the prior formula plus (ii) the benefit the participant earns under the new formula for service after the date of the conversion. In the event a participant earns an early retirement subsidy under the prior formula, this subsidy must also be taken into account when applying this test. This provision is intended to prevent a participant from incurring any “wearaway” when a benefit is converted to the new formula (i.e., a period when the participant is not accruing any benefit.
- Plans may index accrued benefits by periodically adjusting a participant’s accrued benefit by means of a recognized investment index or methodology.
New Rules Affecting 401(k) Plans and Other Defined Contribution Plans
Though the bulk of the pension reform legislation pertains to defined benefit pension plans—and particularly pension funding issues—many of the reforms affect 401(k) plans and other defined contribution plans. If you have a defined contribution plan, here are a few of the most important changes to watch for.
1. Automatic enrollment
The PPA offers several incentives for plan sponsors to adopt automatic enrollment 401(k) plans. With automatic enrollment, participants who satisfy the plan’s eligibility requirements automatically begin making salary deferral contributions to the plan at a specified percentage (without the participant’s consent), unless the participant makes an affirmative election not to participate or to contribute a different percentage.
The PPA simplifies the administration of automatic enrollment features in several ways, including the following:
- It creates a new nondiscrimination testing safe harbor for automatic enrollment plans that provide a default salary deferral contribution of at least three percent that increases annually by one percent increments to at least six percent (but no more than ten percent). To qualify for the safe harbor, in addition to providing automatic enrollment, the plans must: (i) provide for an employer nonelective contribution of at least three percent of compensation or a matching contribution of one hundred percent of elective deferrals up to one percent of compensation, plus fifty percent of elective deferrals on the next five percent of compensation; (ii) one hundred percent vest the matching or employer contributions after two years of service; and (iii) satisfy certain notice requirements. This testing safe harbor is available even if the plan sponsor does not apply the auto enrollment feature to current employees who have already made an election of whether or not to participate in the plan. Plan sponsors who take advantage of this option do not have to perform the annual ADP/ACP tests, which can limit contributions for highly compensated employees. The new safe harbor can be implemented in plan years beginning after December 31, 2007.
- Some states have laws limiting an employer’s right to take deductions from an employee’s wages. The PPA includes a provision to preempt such state laws, thus eliminating this as a risk to adding automatic enrollment as a feature to a 401(k) plan.
- It allows employers to designate default investment options for automatic contributions without worrying about potential fiduciary liability, provided the default options comply with future Department of Labor regulations (expected soon). These fiduciary protections for default investment options are not limited to auto-enrollment, and they will be welcome news to plan fiduciaries who have to select a default investment option in a variety of contexts.
2. Faster vesting
Beginning in 2007, employer profit sharing and other nonelective contributions must vest under either a three-year cliff or six-year graduated vesting schedule—the same as employer matching contributions under current law.
3. Diversification of company stock
Defined contribution plans that hold publicly traded company stock are subject to expanded diversification requirements. All participants must be allowed to immediately diversify their employee contributions that are invested in publicly traded employer securities. Participants with at least three years of service must be allowed to diversify their employer contributions. For company stock acquired with employer contributions before 2007 (the effective date of these rules), the diversification requirement phases in over three years (except that no phase-in applies to employees age 55 or older with at least three years of service). These diversification requirements do not apply to an ESOP that does not hold employee or matching contributions and is a separate plan from all other qualified retirement plans of an employer.
4. Offering professional investment advice services to participants
The PPA relaxes ERISA’s fiduciary rules to remove obstacles for plan sponsors that want to offer professional investment advice services to plan participants with self-directed investment accounts. The new rules create a prohibited transaction exemption that permits fiduciary advisors to recommend their own funds beginning in 2007. Not surprisingly, certain restrictions apply that are intended to curb fiduciary self-dealing. The plan’s arrangement with the fiduciary advisor must require, among other things, that either (i) the fiduciary advisor’s fee (including commissions) will not vary depending on the investment choices made by the participants, or (ii) the fiduciary advisor must use an unbiased computer model that generates a recommended portfolio based on the historical performance of the investment options and the participant’s expected retirement age and other investment criteria.
If the plan’s arrangement with the fiduciary advisor satisfies the requirements of this exemption, the plan sponsor and other plan fiduciaries are relieved of any fiduciary responsibility to monitor the particular investment advice given to participants—although the plan fiduciaries must act prudently in retaining and monitoring the professional fiduciary advisor.
5. Roth 401(k) plans
The PPA permanently extends Roth 401(k) contributions and Roth 403(b) contributions. Now that Roth contributions are here to stay, plan sponsors may want to reconsider whether a Roth contribution feature would enhance the value of their 401(k) or 403(b) plans for their participants.
6. Contribution dollar-limits increased
The PPA permanently extends the annual dollar-limits on various contributions to 401(k) and 403(b) plans, including salary deferral contributions ($15,000) and catch-up contributions for participants age 50 and older ($5,000).
The PPA provides for a host of other provisions, including the following:
- The pension and IRA enhancements enacted under EGTRRA are made permanent (e.g., the availability of catch-up contributions, more flexible rollover rules, higher 415 limits, modified top-heavy rules, accelerated vesting for matching contributions, automatic rollovers of mandatory contributions).
- Congress was concerned that some companies might fund their nonqualified deferred compensation programs for executives when their qualified plans were significantly underfunded or being terminated by the PBGC. Therefore, the PPA imposes adverse tax consequences on certain executives (i) if an employer sponsors a single employer defined benefit pension plan that is “at risk” under the PPA’s new funding rules (the “at risk” rules become applicable in plan years beginning after 2007); (ii) if the employer is in bankruptcy; or (iii) six months before or after the date an employer’s defined benefit plan is terminated in an involuntary or distress termination. In such circumstances, if an employer sets aside or reserves assets to fund an executive nonqualified deferred compensation plan (even if such funding is only through a rabbi trust) that covers the employer’s CEO, the top four highest-paid officers (other than the CEO), any person subject to Section 16(a) of the Securities and Exchange Act of 1934, or a former employee who fell within one of the preceding categories when he/she terminated employment, significant adverse tax consequences are imposed on such individuals. This provision becomes effective for any such transfers or reservations of assets that occur after the president signs the PPA into law.
- New rules apply to employer-owned life insurance. Generally, unless certain requirements are satisfied, if an employer is the beneficiary of a life insurance policy it purchases on the life of its employees, the death benefit will be taxable to the extent it exceeds the premium paid on such policy. This tax result can be avoided if certain notice and consent requirements are satisfied and the insured was either (i) an employee during the twelve-month period before death or (ii) a director or highly compensated employee when the policy was issued.
- Pension plans may pay retirement benefits to employees who have attained age 62 even though the employee continues to be employed by the employer. This loosens the pension rule that currently prohibits plans from commencing retirement benefits to active employees before normal retirement age.