The Pension Protection Act of 2006: What Employers Should Be Doing Now

The Pension Protection Act of 2006 (the "PPA") contains 900-plus pages of changes in the law governing employee benefit plans. Some PPA provisions are retroactive, and some took effect immediately when the Act was signed on August 17th, but the majority of the changes will take effect at various dates in the future from now to 2010. This Benefits Alert focuses on the PPA changes for which employers may need to take prompt action or to begin planning this year to deal with changes that are taking effect in 2007.

(Note that in many cases, later effective dates apply to plans that are subject to collective bargaining, or to other special situations. In most cases, this Benefits Alert describes only the general effective dates.)

Defined Contribution Plans

• Vesting of employer contributions. Effective for contributions made for plan years beginning in 2007 or later, employer nonelective contributions (such as profit sharing contributions) must vest under the same rules that are already in effect for matching contributions – either a 3-year cliff vesting schedule, or a schedule that vests 20% per year beginning with the employee's second year of service and reaches 100% at 6 years of service. The current vesting schedule can continue to apply to contributions made for 2006 and earlier plan years, but some employers may want to apply the new faster schedule to all contributions to simplify plan administration. For ESOPs, the faster vesting rules don't apply until the ESOP loan is repaid.
  
• Right to diversify employer securities. Effective for plan years beginning during or after 2007 (2008 for certain ESOP securities), publicly-traded employers whose defined contribution plans hold employer stock (other than stand-alone ESOPS) are subject to two new diversification rules:
  
  
  • Participants must be allowed to diversify their 401(k) and other employee contributions out of employer stock as often as other investment election changes are allowed, but in all events at least quarterly. (This means that plans which allow daily investment elections must permit diversification of employer stock in such accounts immediately upon allocation.) This diversification requirement applies to existing amounts as well as new contributions.
  
  
  • Employees who have completed three years of service must be allowed to diversify matching and nonelective employer contributions out of employer stock. This rule is phased in over three years for existing amounts contributed in plan years before 2007, except for participants who reached age 55 before the 2006 plan year.



At least three other diversified investment options must be available to participants for these diversification elections.



Each participant in a plan subject to the new rules must receive a notice of the right to diversify at least 30 days before the first date the participant is eligible to diversify. For plan years beginning January 1, 2007, this means that notices may have to be provided by December 2, 2006. For a plan that allows immediate entry upon hire and immediate diversification rights, a notice included with the enrollment materials presumably will be sufficient, even if that is less than 30 days before the first right to diversify arises (but that will not be certain until guidance is issued by the IRS or Department of Labor). Failure to provide the notice can result in steep penalties of up to $100 a day per participant. The Secretary of the Treasury is directed to provide a model notice, but the deadline for that is February 13, 2007.



In general, a plan cannot impose restrictions on employer stock investment or diversification that are not imposed on other plan investments. While there is an exception for restrictions or conditions imposed by reason of the securities laws, it is not clear that the new rules will allow insider trading policies which affect plan transactions and which go beyond what is technically required by the securities laws.

• EGTRRA changes are made permanent. Some employers hesitated to amend their plans for certain provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001, because those provisions were to expire after 2010. The PPA eliminated the EGTRRA sunset, making EGTRRA permanent. Employers who have not already done so may now wish to consider amending their plans to allow Roth 401(k) contributions or catch-up contributions, or to increase the maximum deferral percentage allowed under the plan (up to 100% of the amount available after other withholdings).
  
• Automatic enrollment arrangements. In an automatic enrollment plan design, contributions are made from each participant's salary at a specified rate, unless the participant affirmatively elects to receive cash instead. Effective immediately, the PPA amends ERISA to preempt any state laws, such as state wage deduction or garnishment laws, that could have interfered with automatic enrollment arrangements.

To qualify for this ERISA protection, the plan must issue a notice to participants a reasonable period before the beginning of each plan year (in other words, by December of 2006 for a plan year beginning January 1, 2007). This notice must explain the employee's right to opt out of the automatic enrollment feature, and must explain how contributions under the arrangement will be invested if no investment election is made. Beginning in 2007, default investment of contributions under an automatic enrollment arrangement must be made in accordance with the default investment rules described below.



(Note that beginning in 2008, the PPA introduces a new "safe harbor" design that can be used by plans with automatic enrollment arrangements. Such plans will be exempt from both ADP/ACP nondiscrimination testing and the top heavy rules, and will be able to use a two-year vesting schedule for safe-harbor matching or nonelective employer contributions.)

• Default investment elections. For plan years beginning during or after 2007, the PPA extends fiduciary protection under ERISA Section 404(c) to default investments (investments that apply if the participant does not make an investment election). On September 27th, the Department of Labor published proposed regulations that will provide the rules a plan must follow to obtain this relief. Among other requirements, participants must receive a notice that explains the plan's default investment rules within a reasonable period of time before the beginning of each plan year (again, in 2006 for years beginning January 1, 2007, even though it is likely that final regulations will not be issued until later in 2007). Presumably, a plan using automatic enrollment would combine this default investment notice with the notice regarding the automatic enrollment arrangement. Note, however, that any plan using a default investment provision can take advantage of this fiduciary protection, even though it does not use automatic enrollment.

The proposed regulations define the types of "qualified default investment alternatives" that will be allowed (including balanced funds, life-cycle funds and managed portfolios), and impose numerous (and fairly burdensome) disclosure requirements. The proposal is already attracting many comments, and may well be changed in the final regulations.

• Investment advice. The PPA contains provisions effective January 1, 2007 that are designed to encourage plans to provide participants access to personalized investment advice for investing their plan accounts. A new prohibited transaction exemption will allow plan investment advisors to recommend their own funds to participants, provided that either (i) the advisor's fees and commissions do not vary depending on the investment option selected (it's unclear whether the advisor's firm's fees can vary), or (ii) the advisor uses a certified unbiased computer model to generate the recommendations (it's unclear whether this could ever work for a plan that permits a brokerage window). Certain safeguards apply, including requirements for disclosure notices and annual independent audits of the program. If the requirements are met, the plan sponsor does not have to monitor the advice given to participants, but must prudently select and monitor the investment advisor. Employers can expect to be hearing soon from their plan's providers about the investment advisory services that they intend to offer starting in 2007.
  
• Selection of an annuity provider. If a defined contribution plan allows participants to elect an annuity option by purchasing an annuity through an annuity provider, the selection of the annuity provider by the employer or another plan fiduciary is a fiduciary decision. Current Department of Labor guidance requires the fiduciary to select the safest available annuity in most circumstances. The PPA eliminates the "safest available annuity" standard, effective immediately (the Secretary of Labor is directed to issue regulations giving new guidance on annuity selection). Although this change could encourage some plans to consider adding annuity options, it does not eliminate the spousal consent requirements that come along with such options.

Defined Benefit Plans

• Funding changes. The PPA significantly changes the rules for funding defined benefit plans, requiring faster funding in most cases. These changes are generally not effective until 2008, but employers will want to begin working with their actuaries now to determine the specific impact on their plans and what plan changes may be necessary or desirable. If an employer decides to make changes effective in 2007 to anticipate the new funding rules, participant notices could be required as soon as November 15, 2006.
  
• Deduction limits.For plan years beginning in 2006 and 2007, an employer may deduct plan contributions that increase the plan's funding level up to 150% of current liability, instead of 100%. In addition, the combined plan deduction limit that applies to an employer who maintains both a defined contribution plan and a defined benefit plan has been modified beginning with 2006 so that an employer can contribute more to the plans and deduct the contributions.
  
• 415 Limits. Section 415 of the Internal Revenue Code limits a participant's annual benefit to the smaller of 100% of the participant's average compensation for his or her three consecutive highest years of compensation, or an indexed dollar limit ($175,000 for 2006). The PPA provides that there is no longer a requirement that an employee must be an active participant in each of the high three years. The PPA also changes the interest rate assumption required to be used for calculating the 415 limit on a lump sum form of distribution (or certain other optional forms, such as Social Security Leveling options). These changes apply retroactively to distributions made in plan years beginning in 2006, which could increase or decrease amounts already paid this year. The IRS will need to issue guidance (and possibly relief) on how to correct 2006 distributions that have already occurred.
  
• In-service distributions at age 62 or later. Defined benefit plans normally cannot pay benefits before the plan's normal retirement age or the participant's termination of employment. Starting in 2007, a defined benefit plan may pay benefits after the participant has reached age 62, even though he or she is still working and has not yet reached the plan's normal retirement age. This feature is entirely optional, and each employer will need to decide whether or not to add it. It is not clear whether the IRS will continue to work on its proposed "phased retirement" regulations (which allowed distributions during working retirement after age 59½, provided certain detailed and restrictive conditions are met) after this PPA change. Note also that the PPA provision does not prohibit an employer from using a normal retirement age that is less than age 62.
  
• Cash balance plans and other hybrid plan designs. The PPA contains a number of provisions that regulate what commonly have been called "hybrid" defined benefit plans, which includes cash balance plans and pension equity plans. Many of these provisions have retroactive effective dates.
  
  
• Age discrimination: A hybrid plan is deemed not to be age discriminatory commencing June 29, 2005 as long as each participant's accrued benefit determined as of any date would be equal to or greater than the accrued benefit of any similarly situated younger participant. In general, this rule eliminates exposure to claims (for periods after June 29, 2005) that a cash balance plan is age discriminatory simply because a younger participant has more time for the value of his/her account to grow before reaching the plan's normal retirement age. The PPA states that no inference is to be drawn from the new law regarding what the law regarding age discrimination was before June 29, 2005.
  
• Whipsaws: The PPA also addresses the "whipsaw" problem that affected some hybrid plans (where the amount payable as a lump sum could be higher than the plan's hypothetical account balance). Some cash balance plans accepted the whipsaw calculation as part of the plan design, while other plans avoided the whipsaw by relying on IRS Notice 96-8. Generally effective for plan years beginning in 2008 or later, a cash balance plan which has an interest crediting rate that is not greater than a "market rate of return," and which provides for 100% vesting after three years of service, will not be required to perform a whipsaw calculation. The PPA allows plans that were in effect before June 29, 2005 to elect to apply the PPA provisions earlier than 2008 (but the PPA provisions will not in any event provide whipsaw relief for any distributions made before August 17, 2006). Employers with plans that had whipsaw concerns in the past, or who are uncertain whether they can continue to rely on IRS Notice 96-8, may want to consider electing the early application of the PPA rules, despite the additional cost of applying a three-year vesting schedule early. (A hybrid plan being "cross-tested" with a defined contribution plan that has to move in 2007 to faster vesting of employer contributions which are being included in the testing may also need to consider adopting the three-year vesting schedule in 2007, rather than waiting until 2008.)
  
• The general definition of an "applicable defined benefit plan:" To be an "applicable defined benefit plan" for purposes of the new rules, a plan must comply with certain requirements, some of which relate to the form of the plan. Some cash balance plans that in the past would have been viewed as clearly being cash balance plans may fail (at least arguably) to satisfy the formalistic requirements. Most sponsors of such plans will want them to be "applicable cash balance plans" and consideration should be given to taking prompt action to best secure that status. Other plans with hybrid features had been intentionally designed to avoid rules that were emerging for cash balance plans prior to the PPA, and could now have problems unless they can be amended into "applicable defined benefit plans." Again, prompt action may be best.
  
• Other new requirements to be an "applicable defined benefit plan." The PPA also establishes several substantive requirements that a hybrid plan must satisfy to qualify as an "applicable defined benefit plan." In each case, for any plan established after June 29, 2005, the new rules apply commencing on the plan's initial effective date.
  
  
  • Minimum vesting. The plan must provide full vesting after three years of service.
    
  • Minimum interest crediting rate. The plan must provide that on a cumulative basis, each participant's account balance must not be less than the total pay/contribution credits that have been added to the account. A plan that could credit a negative rate in any one year (for example, based on an equity index) may fail this requirement (although there currently are not many of these plans).
    
  • Plan termination requirements. The plan must use a five-year average interest rate to determine benefits if it is terminated. This can significantly change the cost of this type of plan in the event of termination.


• Plan conversions: Plans that convert to a cash balance formula or another hybrid formula effective after June 29, 2005 cannot use a "wearaway" formula (where there can be a period of time that no benefits accrue until the hybrid formula "catches up" to the pre-conversion accrued benefit). Participants must be allowed to grow into any early retirement and retirement-type subsidies associated with the benefit accrued at the time of the conversion. Any plans that converted after June 29, 2005 and used a wearaway method may now need to modify their benefit formula.

For plans that still use traditional formulas, it should be noted that some groups had been urging Congress to adopt harsher rules for plan conversions than the PPA requires. Therefore, employers who have been considering cash balance plan conversions may feel more comfortable proceeding now in light of the PPA.

All Retirement Plans

• Benefit statements. New requirements for providing benefit statements go into effect for plan years beginning in 2007.
  
  • For defined contribution plans, benefit statements must be provided at least quarterly to participants and beneficiaries with accounts who can direct their investments, at least annually to participants and beneficiaries with accounts who cannot direct their investments, and upon request to other beneficiaries (presumably meaning alternate payees under QDROs), but not more than once per 12-month period.
    
  • For defined benefit plans, benefit statements must be provided at least once every three years to vested participants who are employees when the statement is required to be provided. Participants and beneficiaries may also receive defined benefit plan statements upon written request, but not more often than once per 12-month period. Alternatively, an annual notice can be provided that benefit statements are available upon request.
  
  

  The PPA prescribes specific information that must be included in the benefit statements for each type of plan. For defined contribution plans, this includes a statement regarding the diversification risk associated with holding more than 20% of a participant's account in a single security (such as employer stock). Even if your plans are already satisfying the timing requirements for benefit statements, those statements should be reviewed to make sure all of the required information is included. The Department of Labor is directed to issue model benefit statements, but the deadline for that is not until August 17, 2007.

• Distribution notices. The PPA directs the IRS to modify the regulations regarding the content of the notices that participants are given at the time they are eligible to receive a distribution from the plan. The notice must now include a description of the consequences of the participant failing to defer receipt of the distribution. Until the IRS publishes revised regulations, employers should make a reasonable attempt to comply with this requirement. Also, the period within which the distribution notice can be given to the participant is extended by the PPA from 90 days to 180 days prior to the annuity starting date. These changes are both effective for plan years beginning in 2007. For a calendar year plan, this means that the new requirements are effective now for notices being provided with respect to distributions that will occur or pensions that will commence on or after January 1, 2007.

Revisions to the distribution materials may also be necessary for the following changes beginning in 2007: (a) benefits of non-spouse beneficiaries may be rolled over in a direct transfer to an "inherited IRA" as described further below, (b) distributions of after tax contributions may be rolled into a 403(b) plan or a defined benefit plan, if they are accepted and separately accounted for by the transferee plan, and (c) early distributions of elective deferrals for reservists called up for active duty between September 11, 2001 and December 31, 2007 for a period greater than 179 days are no longer subject to the 10% early distribution tax, and may be recontributed to an IRA within two years after the active duty service ends (or after the PPA was enacted, if later).

• Rollovers by Non-Spouse Beneficiaries. Starting January 1, 2007, the benefits of non-spouse beneficiaries can be transferred in a direct rollover to an "inherited IRA." (Note: Distribution to a non-spouse beneficiary followed by a rollover to an IRA by the beneficiary is still not allowed.) Once in the IRA, distributions will have to be made in compliance with the minimum distribution rules that apply following the death of a participant. In general, the IRA balance will have to be distributed in installments over the life or life expectancy of the beneficiary commencing in the year after the participant's death, or the IRA will have to be distributed in full within five years. While these distribution rules are generally more restrictive than what is allowed for participants and spouse beneficiaries, the additional period of tax deferral may still be a significant benefit to a non-spouse beneficiary. It is not yet clear whether a plan will be required to permit such rollovers.

Nonqualified Plans

• Funding Provisions. Effective immediately, any deferrals in nonqualified arrangements subject to Internal Revenue Code Section 409A will be immediately taxed to the participant, and the 409A 20% penalty tax and interest will apply, if any asset is transferred or set aside in a trust for the benefit of a "covered employee" while (a) the employer's defined benefit plan is considered at-risk (for plan years beginning in 2008 or later), (b) the plan sponsor is in bankruptcy, or (c) during the 6-month period on either side of the termination of an underfunded pension plan. This provision applies to all nonqualified plans, even plans that are "grandfathered" for 409A purposes. Employers should review their plans and any rabbi trusts and revise them if necessary to ensure that funding prohibited by this new provision cannot occur.

Amendment Deadlines

Many of the PPA changes will eventually require plan amendments. PPA required changes will not have to be adopted until the last day of the plan year beginning in 2009 (2011 for government plans). However, plans must comply in practice with the required changes in the meantime. For other PPA changes that are optional, the IRS may require that amendments be adopted by the end of the year in which the change is implemented by the plan.

Other Amendments Required This Year

Don't forget that many plans will have to be amended for other non-PPA changes by the end of the 2006 plan year (by December 31st for calendar year plans). For example, 401(k) plans must be amended for the final 401(k)/401(m) regulations, to add the Roth 401(k) rules if they were implemented in 2006, and for any other optional provisions that have been implemented during 2006. Although the PPA eliminates the "gap period income" requirement for refunds of excess deferrals beginning in 2008, 401(k) plans may still need to be amended this year to add the rules that they will use during 2006 and 2007.