The Long and Short of the Pension Protection Act of 2006

Transcription

1 The Long and Short of the Pension Protection Act of 2006 Long-Term Implications and Short-Term Actions for Plan Sponsors 2006 United States watsonwyatt.com

2 2 Watson Wyatt Worldwide Table of Contents Single-Employer Funding Requirements Benefit Restrictions PBGC Premiums Hybrid Pension Plans Defined Contribution Plans Disclosure Rules Multiemployer Plans Appendix

3 Watson Wyatt Worldwide 1 Overview The Pension Protection Act of 2006 (PPA) was signed into law on August 17, This landmark legislation makes sweeping changes to our nation s pension laws. The PPA has been years in the making and concludes a complex and often contentious debate about the U.S. pension system. In this new pension environment, all sponsors of defined benefit and defined contribution plans will have to do things differently. The prospect of stricter requirements and fresh opportunities will shape sponsors short-term decisions and long-term strategies for their plans. Key provisions: n Establish the interest rate used to calculate liability and Pension Benefit Guaranty Corporation (PBGC) premiums for 2006 and 2007 n Establish new liability targets and funding requirements for all single-employer defined benefit plans beginning in 2008 n Provide an age-discrimination standard for defined benefit plans including hybrid plans such as cash balance and pension equity plans (PEPs) and establish new requirements for existing hybrid plans and plan conversions n Provide new opportunities for automatic enrollment and investment advice under defined contribution plans n Impose new requirements for defined contribution plan vesting and investments in employer securities n Change the rules governing disclosures to participants and federal government agencies n Establish new rules for multiemployer defined benefit plans, including special rules for certain underfunded plans Most of the PPA s provisions will take effect in 2008, but their complex technical nature and far-reaching financial implications warrant early review and careful planning. The PPA demands more of plan sponsors, but it offers them new opportunities as well. After years of uncertainty, sponsors can base their contribution and funding strategies on a much more predictable future. The act provides a unique opportunity for sponsors to evaluate their overall pension strategy and plan design under the brighter light provided by long-awaited legal clarifications. No single approach will be right for all plan sponsors. This reference guide discusses the major provisions of the PPA. It doesn t include everything sponsors will need to know implementation will require reams of additional guidance. But this guide suggests issues to consider as you analyze the new law and what it will mean for your retirement benefit programs.

4 2 Watson Wyatt Worldwide Single-Employer Funding Requirements: New Funding Targets and How to Calculate Them New Funding Targets Current pension funding rules include several definitions of plan liability and different sets of funding requirements. Many though not all sponsors fund to 90 percent of their plan s current liability. Beginning in 2008, sponsors must fund to 100 percent of all liabilities (including lump sum distributions and early retirement benefits) accrued to participants and beneficiaries as of the beginning of the plan year. Interest Rates, Plan Assets and Mortality Assumptions The assumptions and measurements used to calculate funding targets have important consequences for plan funding and contributions. The PPA establishes new requirements for the major inputs to the calculation: interest rates, asset valuations and mortality tables. Interest Rates The PPA makes important short-term and long-term changes to the interest rates used to calculate benefit liabilities. For the short-term, the PPA extends the corporate bond rate that was enacted by the Pension Funding Equity Act of Highlights Among the biggest changes for plan sponsors are new funding targets and changes to the interest rates, asset valuations and mortality assumptions used to calculate them. Key provisions: n Establish new funding targets n Extend the use of the corporate bond rate for 2006 and 2007 n Change the methodology and smoothing period for interest rates used to determine liability n Change the smoothing period for asset valuations n Direct Treasury to issue new mortality tables The interest rate methodology will change in In general, funding requirements will be tied to three interest rates from a corporate bond yield curve, corresponding to separate liability segments: n Segment 1: Liabilities due within five years n Segment 2: Liabilities due between five and 20 years n Segment 3: Liabilities due after 20 years Through and Beyond Interest rates Asset valuations Mortality tables n Blended corporate bond rate n 4-year weighted average of rates on investment-grade corporate bonds n percent corridor n 48-month smoothing n percent corridor n Treasury required to prescribe table n Currently 1983 Group Annuity Mortality Table n Generally, 3 segment rates drawn from yield curve of rates on corporate bonds in top 3 quality levels n 24-month average n No corridor n Optional phase-in period n 24-month smoothing n percent corridor n Treasury required to prescribe table n 2005 proposed regulations used RP-2000 with projection requirements n Sponsors may request plan-specific tables

5 Watson Wyatt Worldwide 3 Smoothing or averaging of interest rates was a key issue during the pension reform debate. The administration and some lawmakers maintained that shortening or eliminating smoothing periods would yield a more accurate measurement of plan liabilities. Plan sponsors argued that smoothing reduces volatility and increases the predictability of required contributions. The new rules are a compromise: they shorten the smoothing period from four to two years. The modified yield curve will be phased in during 2008 and 2009, although plan sponsors may opt out of the transition. To determine their minimum required contribution, plan sponsors may use the full yield curve rather than the modified yield curve but in that case the interest rates on the full yield curve will not be averaged over two years. Asset Valuations The rules for asset valuations are changing. Plan assets may be averaged over up to 24 months. The values must fall within a corridor of 90 percent to 110 percent of the assets fair market value. The act also establishes new rules for discounting contributions made for previous years after the valuation date. Mortality Assumptions Mortality assumptions are another key component in determining plan liabilities. The U.S. Department of the Treasury will issue new mortality tables. While Treasury has broad discretion, it is expected to use the RP-2000 Mortality Table projected using Scale AA (which the department proposed in December 2005). There will be separate tables for disabled participants. Issues to Consider The changes in interest rates, asset valuations and mortality assumptions have important implications for plan sponsors. In the short term, the extension of the Pension Funding Equity Act should make plans funded status and contributions more predictable, enabling sponsors to focus on their preparations for the new rules. Over the longer term, shorter smoothing periods could increase the volatility of plan funding and contributions. Higher volatility makes it harder to budget for future pension contributions or to develop long-term funding strategies. The new yield curve approach may raise plan costs, depending on plan demographics and the duration of benefit liabilities. The effects of the new mortality assumptions will depend on the age and gender mix of plan participants. But many sponsors will face higher costs especially those with plans in which men outnumber women, because men are closing the longevity gender gap. Action Items: n Assess the effects of the new funding targets and actuarial assumptions on plan contributions. n Project 2006 and 2007 contributions and plan strategy in preparation for the new rules. n Gather plan mortality experience, if credible, to determine whether to request a plan-specific mortality table; watch for guidance on special rules for plan-specific tables for controlled groups. Large companies may propose to use a substitute mortality table to Treasury, as long as the proposed alternative reflects plan experience, and the plan has credible data to support its request. There will be special rules for controlled groups.

6 4 Watson Wyatt Worldwide Single-Employer Funding Requirements: New Contribution Rules Minimum Required Contributions Contributions will generally be based on the new funding targets, and funding shortfalls will be amortized over seven years. For underfunded plans, the minimum contribution will be the plan s target normal cost (i.e., the benefits accrued during the plan year) plus any shortfall amortization and waiver amortization charges. Calculating Shortfalls and Contributions Every year, the sponsor must determine whether the plan has a funding shortfall by comparing its funding target with the value of plan assets (reduced by all credit balances). If there is a funding shortfall, the sponsor measures the present value of future payments to amortize previous funding shortfalls. It then determines the plan s new shortfall amortization base. Each shortfall amortization Minimum Contributions $5 $100 $93 Normal Cost Funding Target Assets Amortize $7 funding shortfall over 7 years $1 $5 Minimum contribution is $6 Amortization of Funding Shortfall Normal Cost Minimum contribution = normal cost plus 7-year amortization of funding shortfall Future years shortfalls are also amortized over 7 years Highlights The PPA establishes new rules for determining minimum required contributions. Key provisions: n Set the general minimum required base is amortized in level payments over seven years. If assets gain enough value due to better investment performance, higher interest rates, more favorable demographics or another advantageous turn of events plan assets plus future amortization payments could exceed the funding target. This would create a negative amortization base and reduce required contributions. Exemption From New Shortfall Amortization Base and Special Transition Rules Under a special exemption, if the value of plan assets is 100 percent of the funding target, no new shortfall amortization base is required for one year. Under this rule, plan assets are measured by removing some but not all of the plan s credit balances (see Appendix B for a description of the rules for subtracting credit balances). So the funding shortfall and shortfall amortization base may differ. contribution as the plan s target normal cost plus required amortization payments n Require seven-year amortization of funding shortfalls n Provide special transition rules The exemption includes a transition for plans that are not subject to the deficit reduction contribution rules in These plans will not have to establish a shortfall amortization base if they meet phase-in percentages of the funding target:

7 Watson Wyatt Worldwide 5 Year Phase-in Percentage percent percent percent percent To continue qualifying for this transition, the plan must meet each phase-in percentage. Eliminating Existing Amortization Bases Amortization of each shortfall amortization base will continue for seven years, unless the value of plan assets (reduced by all credit balances) equals or exceeds the plan s funding target on any valuation date. In that case, all shortfall amortization bases and waiver amortization bases would automatically revert to zero, and the minimum contribution would be the plan s target normal cost for the year minus excess assets. Eliminating Amortization Bases $5 $102 $100 $5 $2 Minimum contribution is $3 Issues to Consider The new contribution and funding rules don t take effect until 2008, but plan sponsors should begin planning as soon as possible. Funding decisions that sponsors make in 2006 and 2007 will have significant ramifications when the new rules take hold, especially under the special transition provisions. Amortization of Funding Shortfall Normal Cost Action Items: n Evaluate short-term funding strategies in light of the new rules. Funding Target Assets Normal Cost n Consider the implications and financial feasibility of contributing more in 2006 and No contributions are required when assets exceed funding target + normal cost

8 6 Watson Wyatt Worldwide Single-Employer Funding Requirements: Special Rules for At-Risk Plans Defining At-Risk Plans A plan will be considered at risk if it meets both parts of a two-part test: 1. The value of plan assets (reduced by all credit balances) is less than 80 percent of the regular funding target for the preceding year. This 80 percent target will be phased in over four years. 2. The value of plan assets (reduced by all credit balances) is less than 70 percent of the at-risk funding target for the preceding year. At-Risk Funding Targets and Contributions To determine the at-risk funding target, the plan sponsor must assume that all employees who are eligible to retire within the next 10 years except those who are expected to be retired on the valuation date will retire on the earliest date possible after the plan year ends. Sponsors also must assume that retirees will elect to receive benefits in whatever form would create the highest liability. Also, if a plan were at risk for at least two of the preceding four years, its funding target would increase by 4 percent of liabilities plus $700 per plan participant. The minimum required contribution for at-risk plans is the atrisk normal cost plus required amortization payments. At-risk normal cost is generally based on the same assumptions the At-Risk Funding Target $6 $7 $100 $93 Additional At-Risk Target At-Risk Normal Cost Regular Funding Target Assets Amortize $14 funding shortfall over 7 years $2 $6 Minimum contribution is $8 Amortization of Funding Shortfall Normal Cost Minimum contribution = normal cost plus 7-year amortization of funding shortfall Highlights The PPA establishes special rules for plans that are deemed to be at risk. Key provisions: n Determine at-risk status using a two-part test based on the plan s funded status n Establish higher funding targets for at-risk plans n Impose a loading factor on plans that have been at risk for multiple years sponsor used to determine the at-risk funding target, but the $700 per plan participant component of the loading factor does not apply. At-risk funding targets will be phased in over five years. Issues to Consider Defining an at-risk plan was one of the most difficult issues for pension reform negotiators to resolve. The new at-risk tests may cast too wide a net, assigning at-risk status to plans that are reasonably well-funded especially plans that have accumulated credit balances, pay early retirement subsidies and/or cover many participants who will be eligible to retire within the next few years. However, some of the provisions may help sponsors avoid at-risk status or at least mitigate the penalties. The 80 percent portion of the at-risk test starts at 65 percent in 2008, which will enable many plans to avoid at-risk status. And the at-risk funding target will be phased in over five years, thus moderating annual increases to required contributions. Finally, the seven-year amortization provisions allow plan sponsors to spread out the payment of their at-risk contributions. Action Items: n Determine whether the plan would be considered at risk under new funding rules. n Evaluate whether the plan should forfeit credit balances or take other steps to avoid at-risk status.

9 Watson Wyatt Worldwide 7 Single-Employer Funding Requirements: New Rules for Credit Balances New Credit Balance Rules The PPA makes important changes to the rules that govern credit balances. The act generally requires sponsors to subtract credit balances from assets to determine the plan s minimum funding requirements, at-risk status and other funding triggers. (For a more detailed description of the rules for subtracting credit balances, see Appendix B). When using credit balances to offset the plan s minimum required contribution, plan sponsors must use carryover balances before using prefunding balances. Highlights Credit balances are amounts that plan sponsors contribute in addition to their minimum required contribution. The extra amounts are available to offset minimum required contributions in future years. The PPA establishes new rules for credit balances. Key provisions: n Require separate tracking of credit balances accumulated before 2008 and those accumulated in 2008 and after n Require sponsors to adjust their credit balances annually to reflect the plan s investment experience n Require sponsors to subtract credit balances from plan assets for many purposes, including determining the plan s funding shortfall and required contributions Current Law PPA Types of credit balances One type: credit balances Two types: n Funding standard carryover balances (carryover balances): amounts accumulated before 2008 n Prefunding balances: amounts accumulated after 2007 Annual adjustments Increase with interest at the rate used to determine plan liabilities Adjust each year to reflect assets investment gains and losses Subtract from plan assets Subtract for minimum required contributions Subtract for minimum required contributions, funding shortfall, at-risk status, benefit limitations and more Restrictions on use No Yes. Cannot use credit balance to reduce required contribution if previous year s funding was less than 80 percent (after subtracting prefunding balance) Requirements/ options to forfeit No Yes

10 8 Watson Wyatt Worldwide Credit Balances Under PPA $5 $100 $93 $7 Funding Target Assets Normal Cost Credit Balance Amortize $14 funding shortfall over 7 years (ignores special transition rule) $2 $5 Amortization of Funding Shortfall Normal Cost Total Minimum Contribution is Zero Minimum contribution is $7 before credit balance 5 (normal cost) + 2 (amortization of shortfall) - 7 (credit balance) Credit balances are generally subtracted from plan assets Issues to Consider New rules for credit balances may make them less attractive and will affect when and whether plan sponsors choose to make extra contributions to their plans. Sponsors must keep careful track of their credit balances to be sure they don t trigger at-risk status or benefit restrictions. Action Items: n Give careful consideration to a credit balance strategy and evaluate the effects of carryover and prefunding balances on the plan. n Establish a system to track carryover and prefunding balances separately. n Prepare to track investment experience and adjust credit balances to reflect gains and losses. Subtracting credit balances from plan assets could push some well-funded plans below certain funding thresholds such as those that trigger at-risk status, benefit restrictions and mandatory section 4010 filings with the PBGC. Plan sponsors may forfeit their credit balances to avoid these funding triggers. Plan sponsors must forfeit carryover balances before prefunding balances.

11 Watson Wyatt Worldwide 9 Single-Employer Funding Requirements: Maximum Deductible Contributions Higher Deduction Limits for Defined Benefit Plans For 2006 and 2007, sponsors may deduct up to 150 percent of current liability over the value of plan assets. After 2007, the maximum deductible contribution generally will be the larger of: n The minimum required contribution n The plan s funding target, plus target normal cost, plus a funding cushion over the value of plan assets n The plan s at-risk funding target, plus at-risk target normal cost for the year over the value of plan assets, even if the plan is not at risk Sponsors of a terminating plan may deduct the amount needed to pay benefits upon termination. The funding cushion is 50 percent of the plan s funding target, plus an additional amount to reflect expected future compensation increases. For hourly plans, the additional amount reflects imputed benefit increases based on the last six years. Relief from Combined Plan Limit The Internal Revenue Code imposes an additional deduction limit for employers that sponsor both defined benefit and defined contribution plans. But, effective immediately, the combined limit applies only to the extent that employer contributions to defined contribution plans exceed 6 percent of compensation. Beginning in 2008, the combined plan limit will not apply to single-employer plans insured by the PBGC. Highlights The act aims to give plan sponsors more flexibility by increasing deductible contribution amounts and providing relief to employers that sponsor both defined benefit and defined contribution plans. Key provisions: n Increase the maximum deductible contribution for single-employer defined benefit plans n Provide relief from the combined plan limit for employers that sponsor both defined benefit and defined contribution plans Issues to Consider The higher deduction limit allows plan sponsors to shore up plan funding when economic times are good, giving them a cushion for economic downturns. This may moderate some of the volatility that could result from other provisions in the PPA. But extra contributions create credit balances. As discussed under New Rules for Credit Balances, sponsors should consider the implications carefully before accumulating credit balances. Action Items: n Consider the feasibility and implications of contributing more than the minimum required contribution. n Consider how higher contributions in 2006 and 2007 would affect the transition and implementation of the PPA when the new rules take effect in n Consider the tax deduction rules and their effects for all international locations.

12 10 Watson Wyatt Worldwide New Benefit Restrictions for Single- Employer Plans and Nonqualified Deferred Compensation Benefit Restrictions Sponsors of underfunded plans may not be able to increase benefits, pay lump sum distributions, continue benefit accruals and pay shutdown benefits. The table below summarizes the benefit restrictions: Highlights The PPA imposes benefit restrictions on underfunded plans. Key provisions: n Limit the ability of underfunded plans to increase benefits, pay lump sum distributions, provide additional benefit accruals and pay shutdown benefits Funded Status Greater than 80% or at least 100% (phased in) without reducing assets for credit balances 60-80% funded restrictions n No restrictions n No benefit increases n Only partial lump sum payments n No benefit increases n Require sponsors of less than fully funded plans to subtract credit balances from plan assets in determining whether benefit restrictions apply n Require plan sponsors to forfeit credit balances to avoid restrictions in some cases n Impose restrictions on nonqualified deferred compensation in specified circumstances Less than 60% funded Less than 100% funded and plan sponsor is bankrupt n No lump sums n Benefit accruals frozen n Shutdown benefits frozen n No lump sums The rules are more complex than they first appear. For example, sponsors can contribute their way out of many of the benefit restrictions. There are special rules for credit balances and the timing for determining funded status. n If the benefit improvement would push funding below 80 percent, the sponsor must bring funding up to 80 percent of the plan s new funding target before the benefit increase could take effect. A special exception allows certain benefit increases for plans that do not base accrued benefits on compensation. Benefit accruals: The sponsor must contribute enough to increase the plan s funded percentage to at least 60 percent. Contributions to Avoid Restrictions on Benefit Increases, Benefit Accruals and Shutdown Benefits Plan sponsors can make additional contributions to avoid the restrictions on benefit increases and accruals and shutdown benefits. Benefit increases: n If the plan is less than 80 percent funded for the current year, sponsors may not improve benefits without funding the improvement first. Shutdown benefits: n If the plan is already less than 60 percent funded, the sponsor must immediately fund the shutdown benefits. n If the shutdown benefits would push funding below 60 percent, the sponsor must bring funding up to 60 percent of the plan s new funding target before paying the benefits. When Do Benefit Restrictions Apply? Determining whether a plan is subject to benefit restrictions may require several calculations. The formula will depend

13 Watson Wyatt Worldwide 11 on whether the plan must subtract credit balances from plan assets, whether it was subject to a benefit restriction during the previous plan year and other factors. In addition, the cost of annuity purchases for nonhighly compensated employees during the past two years will be added to both the numerator and denominator in calculating the plan s funded percentage. Credit balances: To determine whether the plan must subtract its credit balances, the sponsor must first determine the funded status with credit balances included. If the funded status is 100 percent, the plan is not subject to benefit restrictions. The 100 percent level will be phased in as follows: Year Phase-in Percentage percent percent percent percent As with the transition for the funding rules, the plan must meet each phase-in target. n Plans within 10 percentage points of benefit restrictions during prior year: These plans must assume a 10-point drop three months into the current year, unless the plan actuary certifies otherwise. For example, if funded status is 89 percent in 2008, it will be assumed to drop to 79 percent three months into the 2009 plan year. n Presumed underfunding for all plans after 9th month: If a funded percentage has not been certified after nine months, funded status will be assumed to drop below 60 percent. Options to Avoid Benefit Restrictions The PPA gives plan sponsors some options for avoiding restrictions on benefit increases and accruals, lump sum distributions and shutdown benefits. Providing cash or security: Plan sponsors can contribute cash or provide security, such as a surety bond or an escrow account containing cash or certain U.S. obligations, or another security approved by the Treasury Department. The security generally will be considered a plan asset in determining whether benefit restrictions apply. If the plan is less than 100 percent funded or less than the phase-in percentage it must subtract all credit balances from plan assets to determine whether benefit restrictions apply. So plans that are well funded but not fully funded when their credit balances are included could face benefit restrictions. Forfeiting credit balances: Under the PPA, credit balances cannot be counted as additional cash payments to avoid benefit restrictions. But plan sponsors may elect to reduce i.e., forfeit their credit balances before determining their minimum funding requirement to reach the desired funded level. Presumed funding levels: Benefit restrictions are based on the current year s adjusted funded percentage, which sponsors generally calculate well after the beginning of the plan year. So to determine whether restrictions apply early in the year, sponsors must use an assumed funded percentage. n Plans subject to restrictions during prior year: These must assume the same funded percentage for the current year, until the plan actuary certifies otherwise. In fact, plans sponsors may have to forfeit their credit balances to avoid benefit restrictions. All plan sponsors must forfeit their credit balances to avoid restrictions on lump sum distributions unless the credit balances are too small to make a difference. If they have sufficient credit balances, collectively bargained plans generally must forfeit credit balances to avoid the restrictions on benefit increases, benefit accruals and shutdown benefits as well.

14 12 Watson Wyatt Worldwide Participant Notices Sponsors must provide participant notices within 30 days after restrictions are imposed on shutdown benefits or lump sum distributions, or the funded percentage actual or assumed drops below 60 percent. Contribution Implications of New Benefit Restrictions The new benefit restrictions could affect collective bargaining, employee relations and other operations. Plan sponsors may decide that providing extra contributions or forfeiting credit balances is worth it to avoid benefit restrictions. The figure below shows additional contributions that could help sponsors avoid benefit restrictions. Restrictions on Nonqualified Deferred Compensation If an employer or a member of its controlled group is in bankruptcy, sponsors an at-risk qualified plan or terminates an underfunded pension plan, the PPA imposes restrictions on nonqualified deferred compensation. In those circumstances, income taxes, interest and penalties will be levied on amounts set aside or reserved in trust, or transferred to a trust or other arrangement, to pay nonqualified deferred compensation. The taxes, interest and penalties will also apply to any arrangement that would restrict assets to the payment of nonqualified deferred compensation in connection with those events. Employer gross-ups intended to cover penalties incurred under the restrictions are also subject to taxes, interest and penalties, and the employer may not deduct the payments. The provision is effective immediately. Issues to Consider The rules governing benefit restrictions are complex, and some issues and questions will require clarifying guidance. These questions and their answers will have important implications for plan sponsors. Action Items: n Sponsors of underfunded collectively bargained plans may have to make extra contributions before they can increase benefits. The restrictions may also affect the sponsor s bargaining strategy. n Sponsors of underfunded plans should consider the employee-relations and financial implications of a benefit freeze or suspension of lump sum distributions. n The timing requirements for presumed underfunding raise several important issues and require sponsors to complete their plan valuations early. This may affect data collection and other valuation activities for both sponsors and actuaries. Funding to Avoid Benefit Restrictions 60% 50% 40% 30% 20% 10% 0% 50% 55% 60% 65% 70% 75% 80% 85% 90% 95% 100% 110% 120% 130% 140% Funding Level

15 Watson Wyatt Worldwide 13 Single-Employer Plans: PBGC Premiums Premiums for 2006 and 2007 Flat-rate premium: In February 2006, the Deficit Reduction Act increased the flat-rate premium for singleemployer plans to $30 per plan participant. After 2006, the premium will be indexed to the Social Security wage base. Termination premium: The Deficit Reduction Act also established a new termination premium, which is imposed on plan sponsors that experience a distress termination in connection with bankruptcy reorganization or involuntary termination after 2005 and before Highlights The act makes important changes to PBGC variable-rate premiums: n Plan sponsors will use a corporate bond rate to calculate their PBGC variable-rate premiums during 2006 and n Beginning in 2008, all underfunded plans will pay a variable-rate premium, which will be based on the plan s new funding target and the new interest rate methodology. Variable-rate premium: Plan sponsors pay variablerate premiums based on the plan s funding level. The premium is $9 per $1,000 in underfunding. Under current law, sponsors whose previous-year contributions at least equaled the full funding limitation do not have to pay variable-rate premiums, and the premium is based on unfunded vested benefits. Under the PPA, sponsors will use the corporate bond rate from the Pension Funding Equity Act to calculate variable-rate premiums for the 2006 and 2007 plan years. Premiums After 2007 The PPA doesn t change the $30 flat-rate premium, but it makes important changes to the variable-rate premium and makes the termination premium permanent. Issues to Consider Under the PPA, plans generally must be fully funded to avoid variable-rate premiums. After 2007, plan sponsors may decide to contribute more or otherwise change their funding strategy to avoid having to pay these premiums. The PPA eliminates the current law cliff, which may simplify the management and administration of a PBGC premium strategy for some plan sponsors. Action Items: n Consider funding strategy in light of new variable-rate premium rules. n Consider making extra contributions to avoid the variable-rate premium. Beginning in 2008, all plans with unfunded vested benefits must pay variable-rate premiums, regardless of the plan s funding level or previous-year contributions. The value of unfunded vested benefits will be based on the plan s funding target, taking only vested benefits into account. The segment interest rates for the month before the first day of the plan year (without 24-month smoothing) will be used to determine the present value of benefits. Asset valuations used to determine the unfunded amount will be based on assets fair market value with no smoothing and without reducing plan assets by credit balances.

16 14 Watson Wyatt Worldwide Hybrid Pension Plans Legal Clarification: Age Discrimination Addressed While most courts have cleared cash balance and other hybrid plans of age discrimination, at least one court held that such plans are inherently age discriminatory, based on the theory that a longer interest-compounding period disproportionately benefits younger participants. The major ruling that found cash balance plans inherently age discriminatory Cooper v. IBM was recently overturned on appeal. In a strongly worded decision, the appeals court concluded that compound interest and the time value of money are not age discriminatory. The PPA clarifies that hybrid plans including cash balance and Pension Equity Plans (PEPs) are not inherently age discriminatory, but the clarification is prospective and takes effect for periods beginning on or after June 29, The law s prospective nature could be troubling for existing hybrid plans, but the act indicates that no inference should be drawn concerning the status of pre-clarification hybrid plans or conversions. In addition, existing plan sponsors should take some comfort from the appellate court decision in Cooper v. IBM. Hybrid Plan Conversions: Prohibiting Wear-Away The act establishes minimum requirements for conversions of traditional plans to cash balance or PEP designs. These requirements prohibit wear-away of early and normal retirement benefits. The specifics are still unclear, but the act calls for an A+B conversion preserving the prior plan benefit (A) and adding on the benefit under the new plan design (B). There is no exception for conversions that offer employee choice. Highlights Legislative controversy and conflicting court cases have created an environment of legal uncertainty for hybrid pension plans such as cash balance plans and PEPs. This ambiguity has essentially halted the adoption of new hybrid plans, cast doubt on the legitimacy of existing plans and contributed to the shift away from defined benefit plans. The act addresses these problems. Key provisions: n Clarify the age-discrimination standard for hybrid pension plan designs n Establish new requirements for existing hybrid plans and for future conversions from traditional to hybrid plan designs n Address lump sum distributions from hybrid plans when participants leave the employer s service New Vesting Requirements The act requires three-year cliff vesting for all existing and future hybrid plans. Final regulatory guidance is expected to clarify how this provision will apply to various plan designs and previously accrued benefits. For plans adopted by June 29, 2005, this change takes effect in 2008.

17 Watson Wyatt Worldwide 15 Lump Sum Distributions and Interest Crediting Rates The act eliminates the whipsaw requirement for hybrid plans a calculation that can inflate a lump sum distribution to more than the participant s hypothetical account balance. The act also establishes new interest crediting requirements for hybrid plans. The interest credit cannot exceed a market rate of return, with the IRS having authority for establishing a reasonable standard. Plans using certain variable interest crediting rates may have negative annual returns, but must protect participants principal the cumulative original pay credits from declining. IRS Moratorium The IRS has imposed a moratorium on hybrid plan determination letters since With the legal status of hybrid plans settled, the IRS is expected to lift the moratorium, possibly after the agency issues some of the guidance necessary to implement the new law. Issues to Consider The hybrid plan provisions have important financial and employee-relations implications for sponsors of existing hybrid plans and for sponsors thinking about switching to a hybrid design, although significant regulatory guidance is needed. n The new vesting schedule will raise various administrative and communication issues for hybrid plan sponsors in the coming months. n The new conversion standards are slightly retroactive, so conversions after June 29, 2005, must comply with the new requirements. n Legal clarity for hybrid plans reopens plan design opportunities for sponsors of traditional defined benefit plans. n The act creates a more level playing field between hybrid plans and defined contribution plans, so plan sponsors can consider the full range of plan design options when determining how to best meet their workforce management needs.

18 16 Watson Wyatt Worldwide Defined Contribution Plans EGTRRA Extended The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) enacted many important pension and retirement savings provisions. For example, the act increased benefit and compensation limits under the Internal Revenue Code, permitted employees to contribute more to their 401(k) and other defined contribution plans, and allowed older workers to make catch-up contributions. EGTRRA also authorized Roth 401(k) plans, sped up vesting of employer matching contributions, and made defined contribution plans and IRAs more portable. The act was slated to sunset December 31, The retirement and savings provisions have generally enjoyed bipartisan support, but many of the other provisions have been controversial, making it difficult for Congress to extend or repeal the sunset date and creating uncertainty for plan sponsors as 2010 approached. The PPA permanently extends EGTRRA s retirement savings and IRA-related provisions. Automatic Enrollment Congress strongly supported automatic enrollment arrangements during the legislative session. The PPA removes obstacles that have kept some employers from adopting these arrangements and establishes a safe harbor for 401(k) and 403(b) automatic enrollment arrangements. State law preemption: Many state laws require employers to obtain an employee s permission before making payroll deductions. The PPA amends ERISA to preempt state laws that conflict with automatic enrollment arrangements, effective immediately. To qualify for the preemption, the employer must notify employees of their rights and obligations under the arrangement, including the right to opt out and to change the contribution amount. Employees must have a reasonable period of time after receiving the notice to make such elections. The notice must also describe how the plan will invest contributions if the employee makes no investment elections. Default investments must conform to regulations that will be issued by the Secretary of Labor within six months of enactment. Highlights In addition to sweeping changes for defined benefit plans, the PPA makes important changes to defined contribution plans. Key provisions: n Permanently extend the retirement savings provisions from the Economic Growth and Tax Relief Reconciliation Act of 2001 n Encourage employers to adopt automatic 401(k) enrollment programs n Require the DOL to issue guidance on certain investment issues n Provide new options for offering investment advice n Require faster vesting of nonelective employer contributions n Establish new rights relating to employer securities n Establish new disclosure requirements for participant statements Withdrawals from automatic enrollment arrangements: Under the PPA, employers may allow employees who were automatically enrolled in a 401(k) plan, 403(b) arrangement or governmental 457 plan to withdraw all their elective deferrals within 90 days of making their first contribution to the plan. They will forfeit employer-matching contributions but will not have to pay the excise tax that normally applies to early withdrawals. Like the provision preempting conflicting state laws, this provision notes that automatic enrollment arrangements must meet notice requirements and contributions must be invested in accordance with the default investment regulations. The provision takes effect for plan years beginning after December 31, To avoid carrying small account balances, plans that do not provide nonelective contributions may want to alert participants who stop their deferrals to request a refund.

19 Watson Wyatt Worldwide 17 Corrective distributions under automatic enrollment arrangements: Automatic enrollment plans that comply with required notice and investment requirements will gain an extra 3½ months to distribute excess contributions to correct failed discrimination (ADP and ACP) tests. For these sponsors, the deadline will be six months after the end of the plan year (rather than two and a half months under the general requirement). Excess contributions or excess aggregate contributions distributed within the two and a half to six-month period will be taxable to recipients when distributed, eliminating a $100 de minimus rule under current law. In addition, the distributions will not include investment earnings for the gap from the end of the plan year to the date of distribution. This provision takes effect for plan years beginning after December 31, Safe harbor: The PPA also establishes a new safe harbor for automatic 401(k) and 403(b) enrollment arrangements. Plan sponsors do not have to adopt safe harbor arrangements, but those that do will be deemed to meet the top-heavy and discrimination (ADP and ACP) rules. To qualify for the safe harbor, the plan sponsor must: n Enroll new employees in the plan at a deferral percentage of at least 3 percent of compensation. Existing employees must be enrolled as well, unless they are already enrolled or elected not to participate. The act does not provide much guidance for what constitutes a nonparticipation election, but employers may have to enroll all employees without a zero election on file. n Increase the employee s deferral percentage by at least 1 percentage point annually up to 6 percent of compensation or until the employee stops the automatic increases. Sponsors may continue the automatic increases up to 10 percent of compensation. n Provide matching or nonelective contributions. The matching contributions for eligible nonhighly compensated employees must be 100 percent of the first percent of compensation and then 50 percent of the next 5 percent for a total match of 3.5 percent of compensation. The nonelective contribution will be 3 percent of compensation. Highly compensated employees cannot receive higher matching contributions. n Provide a notice that explains the employee s right to participate in the plan and to make contribution and investment elections. The notice must explain how contributions will be invested if the employee fails to make investment elections. The employee must have a reasonable amount of time to make these elections. The safe harbor takes effect for plan years beginning after December 31, Fiduciary Clarification for Default Investment Elections and Changes in Investment Options The PPA directs the Secretary of Labor to issue regulations governing the default investment of assets. The regulations are due within six months of enactment, but the DOL may release the regulations sooner. Plans that comply with the regulations will avoid fiduciary liability for investing a participant s account in the default funds liability shifts to the participant. The employer must provide a notice within a reasonable period of time before the plan year begins. The notice must discuss the participant s rights and responsibilities, explain the participant s right to control the investment of plan assets and describe how assets will be invested if no elections are made. The participant must have a reasonable period after receiving the notice to make investment elections. The regulations should be helpful to employers that offer automatic enrollment and those that make nonelective contributions. The act also clarifies that ERISA section 404(c) relief will continue to apply to a qualified change in investment options, as long as: n The participant s account is reallocated among one or more new investment options that are reasonably similar to the old options. n The employer meets all notice requirements. n The participant did not make affirmative investment elections contrary to the proposed reinvestment of the account. n The participant directed the account investments before the change.

20 18 Watson Wyatt Worldwide The regulations will provide guidance (and safe harbors) for plan sponsors and fiduciaries on satisfying fiduciary responsibility during a blackout period. The provision generally takes effect for plan years beginning after December 31, Investment Advice The PPA establishes a prohibited transaction exemption for investment advice provided by a fiduciary adviser under an eligible advice arrangement. The plan sponsor or other fiduciary has a continuing duty to prudently select and periodically review the fiduciary adviser, but has no duty to monitor the specific advice. To qualify as an eligible advice arrangement, either the adviser s fees may not be tied to participants investment choices, or the advice must be provided using a computer model that meets several requirements and is certified by an independent expert. Many other requirements also apply to eligible advice arrangements, such as disclosure of the adviser s fees and affiliations, and audit requirements. The provision takes effect for investment advice provided after December 31, Employers may find these new eligible advice arrangements intriguing but should evaluate such arrangements carefully. They may want to consider other options or alternatives, such as investment or retirement savings education, default investment options or managed accounts. New Requirements for Defined Contribution Plans The PPA includes new requirements for defined contribution plans including a faster vesting schedule for employer nonelective contributions and new diversification requirements for plans that hold publicly traded employer securities. Faster vesting: Under current law, employer matching contributions generally vest under either three-year cliff vesting or a graded vesting schedule that begins during the second year of service and continues for five years. But nonelective contributions are subject to five-year cliff vesting or graded vesting that begins in the third year. The act imposes the same vesting schedule on both matching and nonelective contributions. So all employer contributions will be subject to three-year cliff vesting or a graded vesting schedule of: Years of Service Percent Vested 2 20 percent 3 40 percent 4 60 percent 5 80 percent percent The new rules apply to contributions made in plan years beginning after December 31, 2006 so old money attributable to nonelective contributions before then may continue under the old vesting schedule. Employers that provide nonelective contributions should take note of this important mandatory change. Employer securities: In the wake of corporate scandals several years ago, Congress considered legislation to give employees more control over their 401(k) investments and more information about investing for retirement. Those provisions are part of the PPA. Under the PPA, employers cannot require employees to invest their own contributions and elective deferrals in employer securities. Employees can diversify amounts attributable to employer matching and nonelective contributions after three years of service. Under a special transition rule, employer stock acquired before the provision s effective date will be diversified over three years unless the participant is 55 or older and has at least three years of service. Employers must offer at least three investment options other than employer stock and may not have special rules for employer stock. For example, employers may not make larger matching contributions for employees who invest in employer stock.

21 Watson Wyatt Worldwide 19 Employers must inform employees of their right to diversify their investments at least 30 days before they become eligible to exercise the rights. The notice must describe the importance of diversification. These provisions do not apply to stand-alone employee stock ownership plans (ESOPs). In addition, the act increases the maximum bonding amount for plans that hold employer securities from $500,000 to $1 million. Participant Benefit Statements Defined contribution plans must furnish employees with periodic statements providing information about their benefits and investments. Participants who have the right to direct their investments must receive quarterly statements. Other participants may receive annual statements. The notice will generally resemble periodic benefit statements for defined benefit participants it must indicate accrued benefits as well as vested amounts and vesting dates. It must also explain any offset if the plan provides for permitted disparity or is part of a floor-offset arrangement. For individual account plans, the notice must state the value of each investment, including the amount invested in employer stock or real property. Quarterly statements must explain any limitations on the participant s right to diversify employer stock. They must also include a warning that the account may not be properly diversified if any single investment constitutes 20 percent of the account value, and direct participants to a U.S. Department of Labor (DOL) website for more information. The Secretary of Labor will develop model notices within one year of enactment, but the requirement takes effect after December 31, Statements may be provided electronically or through ongoing Internet access as long as access is reasonable. Issues to Consider The defined contribution provisions impose new requirements and offer new opportunities for plan sponsors. n Sponsors whose plans offer nonelective contributions including profit-sharing contributions should prepare to comply with the new vesting rules. They should also consider the complexity of communicating and administering separate vesting schedules for old and new money. n Plans that require participants to hold employer securities in their 401(k) plans should prepare for the new diversification and associated notice requirements. n Plan sponsors may wish to consider automatic enrollment arrangements, now that conflicts with state laws, fiduciary responsibility for default investments and other obstacles have been cleared. n The new automatic enrollment safe harbor may be less expensive than the existing 401(k) safe harbor and thus particularly attractive to plan sponsors that have run into problems with their ADP and ACP tests. n Plan sponsors may wish to consider adding a Roth 401(k) feature to their plans, which can help employees accumulate more retirement income. n Plan sponsors may wish to explore the new investment advice arrangements or consider other alternatives, such as more targeted education, default investment options or managed accounts. Sponsors may also wish to consider offering annuities.