The Pension Protection Act of 2006 (the "Act"), which was signed into law by President Bush on August 17, 2006, represents the most comprehensive revision to the laws governing retirement plans since the enactment of the Employee Retirement Income Security Act of 1974 ("ERISA"). The Act follows tepid stock market performance, low interest rates, and increasingly unfavorable participant demographics, the combination of which has contributed to the deterioration of the funding of many defined benefit pension plans and, in extreme cases, plan termination where a plan sponsor was unable to meet its funding obligation. As a result, many of the Act’s provisions are aimed at defined benefit pension plans. However, the Act also makes changes to the rules governing 401(k) and other defined contribution plans, nonqualified deferred compensation plans, individual retirement accounts ("IRAs"), and health and welfare benefits. This Alert provides an overview of many of the Act’s provisions but focuses on those that are likely to be of greatest interest to Cooley clients.
Defined Benefit Pension Plan Funding Rules. The Act revamps the rules that govern a defined benefit pension plan sponsor’s funding obligations by:
- requiring contributions to an underfunded plan that are sufficient to fully fund the plan within seven years,
- requiring minimum contributions be made each quarter for certain underfunded defined benefit pension plans,
- mandating use of an interest rate based on a modified yield curve of investment-grade corporate bonds to determine the present value of a defined benefit pension plan’s liabilities,
- restricting use of a defined benefit pension plan’s credit balances (which arise from contributions in excess of a prior year’s minimum required amount),
- requiring larger contributions if a defined benefit pension plan is "at-risk,"1
- limiting benefit increases and acceleration of payments by underfunded plans, and
- increasing the limit on deductible contributions to 150% of a defined benefit pension plan’s current liability.
These changes are generally effective beginning in 2008.
Automatic Enrollment Arrangements in 401(k) and 403(b) Plans. The Act specifically addresses automatic enrollment arrangements for 401(k) and 403(b) plans whereby an employee is automatically enrolled in a plan and deemed to have elected to defer a specified percentage of compensation into a plan. Building on prior IRS authorization of this technique, the Act provides that a 401(k) plan (or 403(b) plan) with an automatic enrollment arrangement that meets certain requirements (a "qualified automatic enrollment feature") is treated as automatically satisfying the ADP and ACP nondiscrimination tests and is exempt from the top-heavy rules.
The four basic requirements are as follows:
- Unless a newly eligible plan participant opts out, automatic elective contributions made on the participant’s behalf must equal at least 3% of the participant’s compensation for the first plan year in which the deemed election applies to the participant, 4% for the second plan year, 5% for the third plan year, and 6% for any plan year thereafter, but in no case may exceed 10% of compensation.
- Participants must be given the opportunity to make an affirmative election to cease elective contributions at the "automatic" level or to have a different level of contributions made.
- The employer must either (1) satisfy a matching contribution requirement2 or (2) make a nonelective contribution of at least 3% of compensation for each non-highly compensated employee eligible to participate in the automatic enrollment arrangement, and the participant must fully vest in the employer contributions after 2 years of service. If matching contributions are made, the plan is deemed to satisfy the ACP test if (1) matching contributions are not provided with respect to elective contributions in excess of 6% of compensation, (2) the rate of matching contributions does not increase as the rate of an employee’s elective contributions increases, and (3) the rate of matching contributions with respect to any rate of elective contributions of a highly compensated employee is not greater than the rate of matching contributions with respect to the same rate of elective contributions for a non-highly compensated employee.
- Each participant subject to the automatic enrollment arrangement must receive a notice explaining his or her right to elect to cease automatic elective contributions or to have a different level of contributions and the manner in which the elective contributions will be invested absent the participant’s investment direction. The employee must be allowed a reasonable period of time after receipt of the notice and before the first automatic elective contribution is made to make such an affirmative election.
The provision is effective for plan years beginning after December 31, 2007.
Preemption of State Law for Automatic Enrollment Arrangements. One previously unresolved issue was whether the use of an automatic enrollment arrangement would violate state wage laws (such as minimum wage laws and laws regulating payroll withholding). The Act resolves the issue by preempting any state law that directly or indirectly prohibits or restricts the inclusion (or operation) of an "automatic contribution arrangement"3 (a term broadly defined to include automatic enrollment arrangements in addition to those meeting the requirements of a qualified automatic enrollment feature). This provision became effective on August 17, 2006.
Investment of Assets Absent Participant Election. The Act provides that, for purposes of ERISA Section 404(c),4 a participant is treated as exercising control with respect to assets in the participant’s account if such assets are invested in a "default investment" in accordance with forthcoming Department of Labor ("DOL") regulations until such time as the participant actually exercises control by making an affirmative investment election. Default investments are often utilized in situations where a participant in a plan providing participant-directed investments fails to provide any such direction for plan contributions made on the participant’s behalf. The prevalence of default investments is certain to increase given the Act’s future safe harbor treatment of plans with qualified automatic enrollment features.
The Act specifies that the DOL regulations be issued within six months following the Act’s enactment and that they provide guidance on designating certain investments as default investments, as well as the appropriate mix of asset classes considered to be consistent with long-term capital appreciation or long-term capital preservation (or a blend of both). This should provide support for existing default investment practices that make use of lifecycle and target retirement date funds rather than money market and stable value funds.
Before a participant’s account is first invested in a default investment, notice must be provided so that the participant has a reasonable period of time to actually make an affirmative investment election before the default investment is made. The notice must contain an explanation of the participant’s right to specifically direct investment of the assets in the account and the manner in which contributions will be invested absent any participant investment direction.
This provision is effective for plan years beginning after December 31, 2006.
Mapping of Investments. The Act also provides that, in connection with a "qualified change in investment options"5 under a plan providing participant-directed investments, a participant is considered to have exercised control (for ERISA Section 404(c) purposes) over the assets in his or her account during the change in options if the participant exercised control over such assets before a change, provided that the following three requirements are met:
- The participant must receive a written notice between 30 and 60 days before the change in investment options that compares the existing and new investment options and explains how, unless the participant affirmatively chooses other investment options, his or her account will be invested in new options with investment characteristics similar to those of the existing options.
- The participant must not actually have provided affirmative investment instructions even though the participant had an opportunity to do so.
- The investment of the participant’s account immediately before the change must be the result of the participant’s exercise of control over the assets in his or her account.
If these requirements are satisfied, a plan fiduciary is protected from liability under ERISA Section 404(c) with respect to the mapping of a participant’s account from one set of investment options to another.
This provision is effective for plan years beginning after December 31, 2007.
Right to Diversify Out of Company Stock. Currently, sponsors of certain types of defined contribution plans are permitted to either contribute in the form of company stock or require that plan contributions be invested in company stock and are only required to allow diversification out of company stock under limited circumstances. The Act greatly expands those circumstances for plans that hold publicly-traded employer securities (i.e., securities issued by the employer or a member of the employer’s controlled group of corporations that are readily tradable on an established securities market). Those plans, as a condition of qualification under the Code, must allow participants to immediately diversify their employee contributions and elective deferrals out of company stock and to diversify their employer contributions after three years of service. The plan must notify participants of their right to diversify and the importance of investment diversification. As an alternative to company stock, the plan must also offer participants a choice among three investment options with different risk and return characteristics.
This qualification requirement does not apply to a plan that invests in company securities that are not publicly traded6 or that is qualified as an employee stock ownership plan (unless the employee stock ownership plan accepts elective deferrals, employee after-tax contributions or employer matching contributions).
This provision is effective for plan years beginning after December 31, 2007 with a three-year phase-in transition period for diversifying employer contributions already invested in company stock prior to the provision’s effective date.
Investment Advice. The Act creates a statutory exemption from the prohibited transaction rules under ERISA and the Code7 so that a plan fiduciary (an "advice fiduciary") may provide investment advice to plan participants and beneficiaries who direct the investment of their accounts and to IRA beneficiaries if an "eligible investment advice arrangement" is utilized.
An "eligible investment advice arrangement" is one that either (1) provides that any fees received by the advice fiduciary for investment advice or with respect to an investment transaction involving plan assets do not vary among investment options selected or (2) utilizes a computer model meeting specified requirements including incorporation of relevant information about the participant (for instance, the participant’s age and risk tolerance) and operates in a manner that does not favor investments offered by the advice fiduciary. Certification by an independent investment expert that the computer model meets all such requirements is mandated prior to its use.
An eligible investment advice arrangement must also satisfy all of the following requirements:
- Use of the arrangement must be authorized by a plan fiduciary other than the advice fiduciary.
- Information on the arrangement must be provided to participants before any advice is given and annually thereafter, and such information must include a description of the fees, rates of return, roles of parties involved and an acknowledgment of the investment adviser’s status as a fiduciary.
- Investment transactions must occur only at the direction of a participant.
- Compensation received by the advice fiduciary must be "reasonable."
- An independent audit of the arrangement must be conducted annually to ensure compliance with these requirements (and evidence of such compliance must be retained for six years).
The Act expressly provides that, while the plan sponsor has no duty to monitor the specific advice provided by the advice fiduciary, nothing in the exemption relieves a plan sponsor from responsibility for the prudent selection and monitoring of the advice fiduciary.
This provision of the Act is effective for investment advice provided after December 31, 2006.
Faster Vesting in Employer Nonelective Contributions. The Code and ERISA currently require that, with respect to employer nonelective contributions to a defined contribution plan, plan participants either fully vest after five years or vest 20% per year beginning after two years of service. The Act requires that vesting in such contributions occur more quickly. A defined contribution plan must provide that a participant either fully vest in such contributions after three years of service or vest 20% per year beginning after one year of service.
This provision applies to contributions made for plan years beginning after December 31, 2006, with a possibly later date for plans subject to collective bargaining.
Hardship Rules. A 401(k) plan and a 403(b) plan may permit distribution on account of "hardship," which, prior to the Act, was defined as an immediate and heavy financial need of the participant, the participant’s spouse or dependent that could only be satisfied by a plan distribution. The Act directs the Secretary of the Treasury to revise the 401(k) and 403(b) hardship rules to permit a distribution on account of an event that occurs with respect to a designated beneficiary of a participant if such event would constitute a hardship if it occurred with respect to the participant, the participant’s spouse or dependent. For example, distributions on account of the hardship of a parent, domestic partner or grandchild (if designated as a beneficiary under the plan) would be permitted.
The Act directs that the Secretary of the Treasury modify the hardship distribution rules within 180 days following August 17, 2006.
Increase in Maximum Bond Amount. ERISA currently requires every plan fiduciary and every person who handles plan assets to be bonded. The amount of such bond is 10% of the plan assets handled each year, with a maximum bond amount of $500,000. The Act increases the maximum bond amount to $1,000,000 for a plan that holds employer securities. For purposes of this provision, a plan is not considered to hold employer securities if the only securities held by the plan are part of a broadly diversified fund of assets, such as a mutual or index fund.
This provision is effective for plan years beginning after December 31, 2007.
Nonqualified deferred compensation plans
The Act amends Section 409A of the Code, which governs the operation of nonqualified deferred compensation plans and the taxation of amounts deferred under such plans. Section 409A provides that funds that are either set aside in a foreign trust or become restricted for payment of nonqualified plan benefits upon a decline in the plan sponsor’s financial condition are treated as transferred in connection with the performance of services (i.e., constitute taxable compensation, regardless of whether such assets are subject to the claims of the employer’s general creditors).
Consistent with its major focus on the funding of defined benefit pension plans, the Act provides that if (1) assets are set aside in (or transferred to) a trust during any "restricted period"8 for purposes of paying deferred compensation to an "applicable covered employee"9 or (2) a nonqualified deferred compensation plan provides that assets will become restricted (or do become restricted) to provide benefits under the plan in connection with a restricted period, such assets are also treated as transferred in connection with the performance of services and are taxable to the applicable covered employee. Any subsequent increases or earnings on the transferred amount(s) are treated as additional transfers. As a further consequence, the applicable covered employee is subject to interest at the underpayment rate plus one percentage point on the underpayment of tax that would have occurred had the amounts been included in income when first deferred or, if later, the first taxable year the amounts were not subject to substantial risk of forfeiture, plus an additional 20% penalty tax.
If an employer directly or indirectly provides the applicable covered employee with a "gross-up" payment to cover income taxes on compensation included in income under this provision, such payment is also taxable to the employee, interest is imposed on such payment as if part of the deferred compensation to which it relates and a 20% penalty tax also applies. The employer is denied a tax deduction for the gross-up payment.
This provision is effective for transfers or reservations of assets after August 17, 2006.
Rollovers by Nonspouse Beneficiary Permitted. The Act changes the rollover rules to now permit a nonspouse beneficiary to roll over an inherited retirement account or benefit from an employer plan to an IRA in the name of the nonspouse beneficiary. For example, rollovers could be made by domestic partners named as beneficiaries. The Act does not change the requirement that minimum distributions must then be made to the beneficiary. This provision applies to employer plan distributions after December 31, 2006 (regardless of the participant’s date of death).
Tax-Free IRA Distributions to Charities. Prior to the Act, an individual who wished to donate IRA proceeds to a charity was required to include the proceeds in gross income from which a tax deduction was allowed for all or a portion of the donation. Because of the limitations on full deductibility of charitable contributions, such an individual often was not allowed a deduction for the full amount of the IRA proceeds donated to the charity, meaning that the individual paid tax on some portion of the proceeds even if the entire amount were donated. The Act now provides a federal income tax exclusion from gross income for otherwise taxable IRA proceeds donated to certain charitable organizations.10 Under the Act, an individual who has attained age 70½ may make tax-free IRA distributions of up to $100,000 annually directly from an IRA to a charitable organization. This provision is effective for distributions made in 2006 and continues to apply to distributions made through December 31, 2007. State tax treatment for a charitable donation of IRA proceeds is not changed by the Act.
Direct Deposit of Tax Refund into an IRA. The Act authorizes the deposit of all or a portion of an individual’s federal income tax refund directly into an IRA (provided that the individual otherwise qualifies to make an IRA contribution) and directs the IRS to develop a form to allow an individual to make such a deposit. This provision is effective January 1, 2007 and applies to 2006 tax year refunds to be paid in 2007.
Conversion of Employer Plan Account into Roth IRA. The Act permits an individual to convert an employer plan account directly into a Roth IRA, rather than first rolling the plan account into a traditional IRA and then converting that IRA into a Roth IRA, as was previously required. Conversion is permitted only if an individual’s adjusted gross income is less than $100,000. This provision is effective for employer plan distributions beginning January 1, 2008.
Health and welfare benefits/plans
Qualified Long-Term Care Rider on a Deferred Annuity or Life Insurance Contract. Taxation of earnings and gains on amounts invested in a deferred annuity contract does not occur until payments from the contract commence. If payments are made in the form of an annuity, an "exclusion ratio" is applied to determine the taxable amount of each payment. The Act now provides that, where long-term care insurance is provided by a rider to an annuity or life insurance contract, any charge against the cash value of the annuity contract or the cash surrender value of the life insurance contract made as a payment for the long-term care insurance is not includable in income.
This provision is effective for annuity and life insurance contracts issued after December 31, 1996, but only with respect to taxable years beginning after December 31, 2009.
Company-Owned Life Insurance. The Act provides that, with some exceptions, an employer is taxed on the portion of the death benefits received under a company-owned life insurance ("COLI") contract that is in excess of premiums paid. The employer will not be taxed on the excess benefit if the insured employee is (1) either an employee at any time during the 12 months prior to his or her death or is a director or other highly-compensated employee when the policy is issued, (2) notified before the COLI contract is issued, and (3) provides written consent to being insured under the COLI contract. The employer will also not be taxed on the excess benefit to the extent that the death benefit is paid to the insured’s heirs or to a beneficiary designated by the insured, provided that the notice and consent requirements are met.
This provision is effective for COLI contracts issued after August 17, 2006.
EGTRRA Provisions Made Permanent. The Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") made a number of changes to the federal tax laws governing qualified retirement plans and IRAs. These changes included an increase in plan and IRA contribution limits, the introduction of catch-up contribution for individuals age 50 and older, and the expansion of the types of plan distributions that can be rolled over to various other retirement plans. These changes were scheduled to expire at the end of 2010. The Act repealed the sunset of EGTRRA’s changes such that they will now become permanent provisions of the Code.
Reporting and Disclosure. An employer is required to file an annual return (Form 5500) with the DOL for each of its retirement plans and health and welfare plans that are subject to ERISA’s reporting and disclosure rules. The Act now requires that an employer file the Form(s) 5500 with the DOL in electronic format and also electronically post such information on the employer’s intranet for plan years beginning after 2007.
While qualified retirement plans must operationally comply with the Act as of the effective date of each provision, the Act generally provides that qualified plan documents may be retroactively amended to comply with the Act and regulations if amended on or before the last day of the first plan year beginning on or after January 1, 2009.
The future of U.S. retirement benefits
Some have predicted that the Act will hasten the abandonment of defined benefit pension plans and confirm that the 401(k) plan, with or without an employer match, will sweep the field. The decision of IBM, the antithesis of a faltering manufacturing company, earlier this year to freeze, effective as of December 31, 2007, its defined benefit pension plan and move its entire retirement program to a company- and employee-funded 401(k) plan has been seen as emblematic of this shift. Whether the Act’s more stringent funding requirements for defined benefit pension plans will put more of them on a sound financial footing or instead cause their sponsors to freeze and terminate them remains to be seen in the coming years.
The Act’s encouragement of automatic enrollment arrangements through a new employer contribution-ADP/ACP safe harbor, preemption of state laws regulating wage withholding, and default investments that do not carry fiduciary risk may increase overall plan participation, which has hovered around 50% of the private sector workforce since at least 1991. When the new investment advice rules are added to the mix, the U.S. retirement system may now be poised to turn its back completely on the idea of employers bearing the investment and longevity risks inherent in defined benefit pension plans and to make the best of the rugged individualism of 401(k) plans.
1. Generally, a plan is "at-risk" for a year if, for the preceding year: (1) the plan’s funding target attainment percentage, determined without regard to certain at-risk assumptions, was less than 80%, and (2) the plan’s funding target attainment percentage, determined using the at-risk assumptions, was less than 70%. A plan’s funding target attainment percentage is the ratio, expressed as a percentage, that the value of the plan’s assets (with certain reductions) bears to the plan’s funding target for the year.
2. The matching contribution requirement is met if the employer makes a matching contribution on behalf of each non-highly compensated employee equal to 100% of the first 1% of the compensation deferred by the employee and 50% of the employee’s deferrals which exceed 1% but do not exceed 6% of the employee’s compensation.
3. An "automatic contribution arrangement" is an arrangement of an ERISA pension benefit plan: (1) under which a participant may elect to have the plan sponsor make payments as contributions under the plan on behalf of the participant, or to the participant directly in cash, (2) under which a participant is treated as having elected to have the plan sponsor make such contributions in an amount equal to a uniform percentage of compensation provided under the plan until the participant specifically elects to have such contributions made (or elects to have contributions made at a different percentage), and (3) under which contributions are invested in accordance with regulations issued by the Secretary of Labor relating to default investments as provided under the Act.
4. ERISA §404(c) provides relief to plan fiduciaries from liability for investment decisions made by a plan participant who "exercises control" over the investment of his or her plan account.
5. A "qualified change in investment options" is a change in the investment options offered to a participant or beneficiary under the terms of a plan, under which: (1) the participant’s account is reallocated among one or more new investment options offered instead of one or more investment options that were offered immediately before the effective date of the change; and (2) the characteristics of the new investment options, including characteristics relating to risk and rate of return, are, immediately after the change, reasonably similar to the characteristics of the investment options offered immediately before the change. This process is commonly called "mapping" of investments.
6. For this purpose, a plan holding employer securities that are not publicly traded is generally treated as holding publicly-traded employer securities if the employer (or any member of the employer’s controlled group of corporations) has issued a class of stock that is a publicly-traded employer security. However, this is not the case if neither the employer nor any parent corporation of the employer has issued any publicly-traded security or any special class of stock that grants particular rights to, or bears particular risks for, the holder or the issuer with respect to any member of the employer’s controlled group that has issued any publicly-traded employer security.
7. These rules prohibit certain transactions between an employer-sponsored retirement plan and a "disqualified person" (or a "party in interest" under ERISA). The Code’s rules also extend to IRAs and other non-employer-sponsored plans. A disqualified person includes a plan fiduciary, a plan service provider and the employer sponsoring the plan for its employees. Prohibited transactions include (1) the sale, exchange or leasing of property, (2) the lending of money or other extension of credit, (3) the furnishing of goods, services or facilities, (4) the transfer to, or use by or for the benefit of, the income or assets of the plan, (5) in the case of a fiduciary, any act that deals with the plan’s income or assets for the fiduciary’s own interest or account, and (6) the receipt by a fiduciary of any consideration for the fiduciary’s own personal account from any party dealing with the plan. Penalty taxes are assessed against a disqualified person who engages in a prohibited transaction.
8. "Restricted period" means (1) any period during which the employer’s defined benefit pension plan (only plans with more than 500 participants are covered) is "at-risk" (as described in Footnote 1), (2) any period during which the employer is in bankruptcy, and (3) the 12-month period beginning six months before the date the employer’s defined benefit pension plan is terminated in an involuntary or distress termination.
9. "Applicable covered employee" means the chief executive officer, the four highest compensated employees (other than the chief executive officer), and individuals subject to Section 16(a) of the Securities Exchange Act of 1934 of the plan sponsor or a member of the plan sponsor’s controlled group. Such term also includes a former employee who was an applicable covered employee at the time of his or her termination of employment.
10. Donor-advised funds and private foundations are not proper charitable organizations for purposes of this income exclusion.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.