2006 Pension Protection Act

The majority of Americans are now covered by what we refer to as defined contribution plans. Defined benefit plans were at one time the backbone of the private pension system but in many industries are no longer. A defined benefit plan, or pension plan as it is more commonly known, promises regular payouts under a set formula throughout retirement. A defined contribution plan, on the other hand, focuses on the savings side of the retirement equation rather than the pay out. Defined contribution plans go by a number of now-household names, such as 401(k)s, profit sharing and Keogh plans.

After years of debate, compromise and often intensely partisan negotiations, the President has signed into law a comprehensive pension reform bill. Despite its name, this new law impacts benefits under defined contribution plans almost as much as it does under pension plans. If you have an IRA, a 401(k) or other defined contribution plan, this new law affects you.

It not only makes permanent some important retirement savings incentives that benefit almost everyone, it also creates some new ones. Some of the changes are effective immediately; others are retroactive; still others kick in next year or even later. Some of these changes also will prove to be more popular than others. This communication highlights most of the key changes in the new Pension Protection Act of 2006.

DEFINED CONTRIBUTION PLANS

Permanent retirement savings incentives. If you've been making higher contributions to 401(k)s and similar arrangements, catch-up contributions, and enjoyed greater portability, you've benefited from enhanced retirement savings incentives enacted in 2001. Five years ago, Congress passed the Economic Growth and Tax Relief Reconciliation of 2001 (EGTRRA). This law created many new incentives to encourage people to save more for retirement. However, because of its huge price tag, Congress made EGTRRA temporary. All of its tax breaks, including the retirement savings incentives, had been set to expire. Instead of expiring on December 31, 2010 as scheduled, they are now extended permanently.

Here are some of the highlights:

• Higher dollar limits on defined contribution plans. The new law makes permanent EGTRRA's higher dollar limits on contributions ($44,000 in 2006) as well as elective deferrals for 401(k)s ($15,000 for 2006). The new law also makes permanent EGTRRA's more generous treatment of compensation that may be taken into account under a plan.
• Catch-up contributions. If you are age 50 or older, you should be making catch-up contributions. EGTRRA allowed individuals age 50 and older to make additional contributions to IRAs, 401(k)s and other arrangements. For 2006, you can make an additional catch-up contribution of $5,000 to a 401(k) plan if you are age 50 or older. Because EGTRRA is temporary, you would not have been able to make catch-up contributions after 2010. The new pension reform law makes catch-up contributions permanent. It also indexes the $5,000 401(k) catch-amount amount for inflation.
• Roth 401(k)s. You've probably heard a lot about Roth 401(k)s over the past few months. While they were created as part of EGTRRA in 2001, employers could only start offering them this year. Roth 401(k)s are similar to Roth IRAs. Depending on your income and where you are at in your work life, if you're just starting out or nearing retirement, Roth 401(k)s can be a valuable addition to your retirement portfolio. Until this new law, many employers were reluctant to offer Roth 401(k)s because they would have expired after 2010. The new law makes them permanent.
• Tax Saver's Credit. Eligible low income taxpayers who satisfy certain income limits and make contributions to a defined contribution plan or IRA, receive tax credits as an incentive to save. The income limits will be indexed for inflation after 2006.
• Other EGTRRA Changes Made Permanent.
• Modification of the top-heavy, nondiscrimination and coverage rules;
• Elective deferrals not taken into account for purposes of the deduction limits and modifications to the deduction limits;
• Credits for retirement plan start-up costs;
• Faster vesting of employer matching contributions (full vesting under three- or six-year schedules);
• Ability of employers to disregard rollovers for purposes of cash-out rules;
• Expanded rollover options;
• The repeal of the multiple use test in 401(k) plans.

As you can see, there are a number of provisions that have been made permanent. The new law adds certainty to retirement planning. Both employers and employees will continue to benefit from the enhanced retirement savings incentives in EGTRRA.

New and enhanced incentives. Besides making the retirement savings breaks in EGTRRA permanent, the pension reform law also creates some new incentives. Retirement savings are encouraged by:

• Automatic Enrollment. For plan years beginning after December 31, 2007, another “safe harbor” from nondiscrimination testing (i.e. ADP/ACP) is possible if employers offer “qualified” automatic enrollment in 401(k) plans. In general, this program is designed to have an employee automatically defer to the plan a certain stated percentage of compensation unless the employee affirmatively elects a different percentage or elects to forgo withholding altogether. The initial automatic deferral rate must be between 3% and 10%. In addition, the automatic deferral rate for employees must increase to at least the following percentages by the second through the fourth year of participation:

• 3% - first year of participation
• 4% - second year
• 5% - third year
• 6% - fourth year and thereafter

Current employees on the date the arrangement is implemented would be exempt from the automatic enrollment requirements if they have already made a deferral election or elected not to participate. However, a plan sponsor could elect to cover such existing employees under this new automatic enrollment program.

To qualify for the automatic enrollment safe harbor (and thereby be excluded from ADP/ACP nondiscrimination testing and not subjected to top heavy plan rules) an employer must make either (i) a contribution of at least 3% of compensation on behalf of all eligible  compensated employees or (ii) a 100% match on non-highly compensated deferrals up to 1% of pay plus a 50% match on deferrals that exceed 1% up to 6% of pay. This safe harbor contribution must fully vest within two years. To escape top heavy rules there must be no other employer contributions to this plan.

A notice requirement similar to existing safe harbor plans must be provided on an annual basis for plans that wish to comply. The contribution and vesting requirements are not quite as costly as current safe harbor 401(k) plans.

A plan may distribute any automatic deferral contribution made to an “eligible automatic enrollment plan” (does not have to elect safe harbor treatment but does provide for a default investment provision and provides an annual notice) no later than 90 days after the employee's first automatic deferral is made. The total amount made during this 90-day period (plus earnings) can be refunded and not subject to the 10% premature distribution penalty tax and is not taken into account for applying the ADP test. Any matching contributions made on the amount withdrawn must be forfeited. Excess contributions refunded do not have to be made within 2.5 months as provided in current law but rather within 6 months after the close of the plan year.

• Default Investments. ERISA section 404(c) provides relief to fiduciaries to the extent participants or beneficiaries exercise control of the investment of their own accounts. Relief from fiduciary responsibility is not currently provided where the participant does not exercise control of his or her account and is invested in the plan's “default” investment as a result. Under the new law, safe harbor guidance will be provided on the designation of default investments. The default investments should include “a mix of asset classes consistent with capital preservation or long-term capital appreciation, or a blend of both.” A participant shall be treated as having elected to have the plan sponsor invest his or her account in the plan's default fund if the participant receives an annual notice explaining the employee's right under the plan to make investment elections and explaining how contributions will be invested in the absence of an election. The plan sponsor must provide the participant with a reasonable period after the receipt of the notice and before the beginning of the year to make a change. Effective for plan years beginning after December 31, 2006.

• Rollovers by Non-spouse Beneficiaries. Effective January 1, 2007, a non-spouse beneficiary may roll over the benefits they receive from a retirement plan to an IRA. The IRA would be treated as an inherited IRA and subject to the minimum distribution rules that apply to inherited IRAs. Previously only a participant's spouse was eligible to roll over their spouse's account balance into an IRA or other eligible retirement plan in the event the participant dies.

• Direct Rollovers into Roth IRAs. Effective January 1, 2008 plan participants may roll over both the Roth and non-Roth portions of their retirement plan accounts directly into Roth IRAs. The taxable portion of the rollover distribution will be taxed at the time of the rollover. The Roth rollover distributions would be subject to the Roth IRA conversion eligibility rules including the current income restrictions.
• Other IRA Provisions. Starting in 2007 you can ask the IRS to deposit your tax refund directly into an IRA. The new law permits those 70-1/2 years of age and older the option, in 2006 and 2007 only, to give all or part of their IRA savings to charity without paying tax on its withdrawal.
• Faster Vesting Rules. All employer contributions must now become 100% vested on either a three-year cliff or six-year graded vesting schedule (100% after three years or 20% for each year of service beginning with the second year of service). These changes are identical to the current top heavy vesting requirements but vest sooner than current law (except for matching contributions which remain the same). This provision would effectively apply for contributions made for plan years beginning after December 31, 2006, provided the employee has at least one hour of service after the effective date.
• New DB(k) Plans. Beginning in 2010 small employers will be able to adopt a new type of plan. This is a combination of a defined benefit plan with a 401(k) plan with a single trust account and a single 5500 filing. There is a minimum defined benefit formula along with an automatic 401(k) deferral of 4% and a 50% match. Profit sharing contributions can be made. All matching contributions would be fully vested and other employer contributions could use a 3-year cliff vesting schedule. The plan will automatically satisfy top-heavy and nondiscrimination testing.

Other Defined Contribution Changes. Besides those provisions to encourage retirement savings, many other changes have been made. Among them:

• Requirement to Provide Periodic Benefit Statements. For plan years beginning after December 31, 2006 (except for certain collectively bargained plans), a plan administrator must provide participants or beneficiaries who have the right to direct their investments in a defined contribution plan with a benefit statement on a quarterly basis. For participants or beneficiaries who do not have the right to direct their investments, a benefit statement must be provided on an annual basis. The Department of Labor is directed to issue model benefit statements that will satisfy these requirements. The model will include language that advises participants of the risk of investing more than 20 percent of his or her account in the securities of any single entity (such as employer securities).
• Providing Investment Advice to Participants. Under current law fiduciaries are restricted from entering into specific “prohibited transactions”. It is difficult for a party to provide investment advice to a plan participant regarding asset allocation without violating one or more of ERISA's prohibited transactions if the adviser receives varying amounts of payments depending on which investment alternatives are selected.

  The new law provides an exemption to ERISA's prohibited transaction rules for advice provided by a “fiduciary adviser” under an “eligible investment advice arrangement.” The exemption covers advice provided to a participant in the plan, but not advice to the plan. In order to qualify for the exemption, the eligible arrangement must either (1) provide that the fees or other compensation received by the fiduciary adviser do not vary depending on the investment option chosen (fixed) or (2) use a computer model under an investment advice program meeting certain criteria. An independent fiduciary would need to approve the arrangement. An audit would be performed annually. The adviser also would be required to provide advice in a format designed to be reasonably understood by the average investor.

  The advice would have to be provided by a “fiduciary adviser,” which may include a registered broker-dealer, a registered investment adviser under the Investment Adviser Act of 1940, a bank or similar financial institution, or an insurance company. The bill defines an “adviser” to include all affiliates or registered representatives of the fiduciary adviser. In addition, the fiduciary adviser must specifically acknowledge in writing that it is a fiduciary of the plan with respect to the provision of the advice. The plan sponsor (and/or other plan fiduciary) would still be subject to general fiduciary requirements on the prudent selection and periodic review of a fiduciary adviser. However, the plan sponsor would not have a duty to monitor the specific advice given by the fiduciary adviser to any particular participant, as the adviser would be acting as a fiduciary with regard to the specific investment advice given.

  This provision applies to investment advice provided after December 31, 2006. Note: while this could become a very useful service, we believe it may take some time to sort out all the details and prove difficult to begin in early 2007.

• Expansion of Hardship Withdrawals. Distributions are generally limited to hardships incurred by the participant or his or her dependents. Effective immediately, the Act expands the definition of hardships to that person(s) who is designated as the participant's beneficiary under the plan, even if that beneficiary is not the participant's spouse or dependent.
• Distributions to Qualified Reservists. Effective immediately, 401(k) plans and IRAs will be able to make distributions to Qualified Reservists provided such persons were called up to active duty for a minimum period of 180 days between September 11, 2001, and December 31, 2007. Distributions under this rule would not be subject to the 10% premature distribution penalty tax. The reservist can roll over the distribution at any time within a two-year window following the end of the active duty period.
• Distributions to Public Safety Employees. Effective immediately, distributions made to a Public Safety Employee (defined generally as a state or local employee who provides police, firefighting, or emergency medical services) who has attained age 50 and has separated from service, will not be subject to the 10% premature distribution penalty tax.
• 5500s. Effective for 2007, an employer eligible to file a form 5500-EZ will not need to file anything as long as assets do not exceed $250,000. Previously the threshold was $100,000.

  Effective for 2008, the Department of Labor is required to display in electronic format, 5500 information within 90 days of receipt. In addition, employers who maintain an Intranet Web Site that is used to communicate with employees must display the plan's 5500 on that Intranet site.

• Mapping Investments. Beginning in 2008, 404(c) relief would be provided to a plan fiduciary during a plan's “blackout period,” when proper notice is given and the investing of a participant's account in the new investment options is reasonably similar in characteristics to the prior options.
• Plan Amendments. The Act allows employers to comply operationally with the new law until the end of the 2009 plan year without making an amendment.

DEFINED BENEFIT PLANS

Traditional pension plans in trouble. Traditional pension plans, which pay a defined benefit over a period of time, are in trouble. Many are under-funded (assets do not cover the liability for benefits currently earned). Others have been turned over to the Pension Benefit Guaranty Corporation (PBGC), the pension payor of last resort.

Currently, about 30,000 traditional pension plans are under-funded. Some are teetering on collapse. Congress wants these plans to survive, so it is giving plans seven years (longer for the airline industry) to become fully funded. “At-risk” plans, which are critically under-funded, get some additional help but they also have more responsibilities to their participants. The new law aims to prevent any more troubled plans from folding and dumping the obligations on the PBGC, which already has a deficit of nearly $30 billion. The new law also changes the rules for valuing pension liabilities. Most of the pension reform provisions take effect in 2008 with some exceptions.

• Funding rules. The existing ERISA funding rules are replaced with a single set of rules. Both single employer and multiemployer defined benefit pension plans are affected. The Pension Act requires most plans to become fully funded over a seven-year period. The minimum required contribution is the sum of the "target" normal cost and a “shortfall” contribution (an amortization of unfunded past-service liability), with the resulting sum potentially reduced by existing credit balances, if any. The pension funding provisions are generally applicable to plan years beginning after December 31, 2007. Special rules apply to collectively bargained plans.
  

  Funding transition rules will apply to most plans. Plans that are not fully funded at the beginning of 2008 may focus on meeting interim targets of 92 percent in 2008, 94 percent in 2009, and 96 percent in 2010. Plans in existence in 2007 with a pre-funding balance may maintain a funding standard carryover balance until it reaches zero. The transition rules will not apply to new plans established after 2007.

• Stricter funding requirements will apply to "at-risk" plans. The Act applies special “at-risk” assumptions in determining the funding target and normal cost of a plan in at-risk status. A plan falls into at-risk status because of unfavorable computation of credit balances and early retirement subsidies, i.e., the prior year funding ratio based on non-risk assumptions is below 80 percent and the prior year funding ratio based on at-risk assumptions is below 70 percent. If a plan is at risk, the plan's funding target and normal cost are determined based on the assumption that all participants eligible to elect benefits during the current plan year and the 10 succeeding plan years will retire at the earliest retirement date under the plan and will elect benefits under the plan that will result in the highest present value. The at-risk rules do not apply if a plan had 500 or fewer participants on each day during the preceding plan year.

• Deduction limits. Under current law, you are allowed a tax deduction for contributions to raise your plan's funding level to 100 percent. Contributions above that amount are subject to a 10-percent excise tax. Under the Pension Act, the maximum deductible amount for single-employer defined benefit plans is increased to 150 percent of current plan liabilities (140 percent for multi-employer plans) for 2006 and 2007. For tax years beginning after 2007, the maximum deductible contribution is equal to the greater of:

  1. The excess of your plan's funding target, normal costs, and "cushion account" over the value of your plan's assets and
  2. minimum required contributions for the plan year.

  In the case of contributions to a multi-employer defined benefit plan, the maximum amount is not less than the excess of 140 percent of your plan's current liability, over the value of plan assets, for tax years beginning after 2005. Allowable deductions are increased for businesses that maintain both a defined benefit plan and a defined contribution plan. For contributions for tax years beginning after 2005, the dual contribution limits will apply only if defined contributions exceed a six-percent ceiling.

• Annual funding notice. The Pension Act expands the multiemployer funding notice requirement to single-employer plans. Plans must provide an annual funding notice to the PBGC, each participant and beneficiary, each union representing participants, and each participating employer (for multiemployer plans only). The notice is to be provided within 120 days after the end of the plan year to which it relates. The notice requirements generally apply to plan years beginning after December 31, 2007. This annual funding notice requirement replaces the Summary Annual Report requirements for single-employer plans, which are repealed, for plan years beginning after December 31, 2006.
• Benefit Restrictions and limitations on lump-sum payments. Beginning in 2008, plans with a funding ratio of less than 80%, are prohibited from amendments to increase benefits. For plans between 60% and 80%, lump sums and certain “accelerated benefits” will be restricted to the lesser of (a) one-half of the full amount or (b) the PBGC guaranteed amount. For plans with a funding ratio below 60%, benefit accruals must be frozen, lump sums and accelerated benefit payments are prohibited and certain “plant shutdown benefits” cannot be triggered.
• Other provisions applicable to defined benefit plans. The Pension Act also includes, among others, the following:

• New interest rate assumptions for funding.
• New mortality tables (to be prescribed by the Treasury).
• Limitations on benefit increases.
• Availability of in-service distributions to participants who have attained age 62.
• Restrictions for funding nonqualified deferred compensation for sponsors of certain under-funded pension plans.
• Benefit limitations for bankrupt plan sponsors.
• Changes in the calculation of the maximum limit for lump sums and other decreasing annuity forms.
• PBGC variable premium capped at $5 per participant for small plans (25 or less participants).

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The new pension reform law is 900+ pages long. It impacts all types of qualified retirement plans. Many of these provisions will need to be discussed with your accountant or other financial advisor. While most details are beyond the scope of this summary, we will be happy to assist you with any of those areas related to your qualified plan. We consider it a privilege to be of service!

Sincerely,

The Retirement Plan Company, LLC


John K. Kopra
President and CEO

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“ The information provided is from sources we consider reliable but we do not represent that the information is accurate or complete. The information provided herein is for general informational purposes only. Our professional staff would be pleased to discuss with you how the information provided may apply to you. "

THIS ARTICLE IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND IS NOT INTENDED AS LEGAL, TAX OR INVESTMENT ADVICE.