IMPACT OF THE PENSION PROTECTION ACT OF 2006 ON TAX-QUALIFIED PLANS AND OTHER ENTITIES December 2006

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1 LOWENSTEIN SANDLER PC CLIENT ALERT EMPLOYEE BENEFITS IMPACT OF THE PENSION PROTECTION ACT OF 2006 ON TAX-QUALIFIED PLANS AND OTHER ENTITIES December 2006 Although the Pension Protection Act of 2006 (the Act ), signed into law by President Bush on August 17, 2006, is best known for the sweeping changes it makes to the funding rules governing defined benefit pension plans, there also numerous other changes that will effect the operation of pension and 401(k) plans and the duties and responsibilities of plan administrators and fiduciaries. Signed into law on August 17, 2006, the Act is a comprehensive pension reform bill intended, in large measure, to improve the funding status of defined benefit pension plans and the financial health of the Pension Benefit Guaranty Corporation ( PBGC ), the U.S. governmental agency that insures defined benefit pension plans. However, the Act also contains numerous provisions that will effect 401(k) and other defined contribution plans, cash balance pension and other types of hybrid plans, IRAs, as well as charities and other tax-exempt organizations. In addition, the Act modifies many provisions of the Employee Retirement Income Security Act ( ERISA ) that relate to fiduciary duties and responsibilities, including an important change to ERISA s longstanding plan asset rules that will impact private equity funds and other entities that invest pension funds. Following are some of the highlights of the Act: The Act implements funding rule changes for both single employer and multiemployer defined benefit pension plans and increases deduction limits for contributions to pension plans as an incentive for employers to accelerate the funding of such plans. The Act prohibits the funding of nonqualified deferred compensation arrangements for certain key employees if the company sponsors a pension plan that is significantly underfunded. The Act will permit a defined benefit pension plan to allow active employees to begin commencement of their pensions at age 62 even though they have not retired. The Act establishes new rules for cash balance pension plans, resolving much of the uncertainty that has surrounded such plans and paving the way for the IRS to issue determination letters on plans that have been in limbo for several years. The Act provides a new safe harbor from non-discrimination testing for 401(k) plans for plans that permit automatic enrollment with a minimum matching contribution. The Act sets forth a new, accelerated vesting schedule for employer contributions under a defined contribution plan. The Act requires that defined contribution plans of public companies allow participants to diversify holdings in employer securities. The Act allows IRA owners over the age of 70 1 /2 to take tax free distributions of up to $100,000 for each of 2006 and 2007 for contributions to tax exempt charities. The Act expands the deduction limitations on contributions to qualified plans.

2 LOWENSTEIN SANDLER PC CLIENT ALERT EMPLOYEE BENEFITS The Act creates a new type of plan, the DB/K, which small employers can adopt that provides both defined benefits and defined contributions under a single plan document. The Act adds new requirements for notices and other disclosures to plan participants. The enclosed chart summarizes many of the Act s provisions that are likely to effect most employers, fiduciaries and administrators who sponsor, maintain or administer tax qualified retirement plans. The chart also provides some observations for employers to consider when evaluating their plans for compliance with the Act. The Act has varying effective dates, with some provisions taking effect immediately upon its enactment (August 17, 2006) and others becoming effective for plan years beginning on and after either January 1, 2007 or January 1, In general, the new pension plan funding obligation are effective for plan years beginning on and after January 1, 2008, subject to certain transitional or phase-in rules. Accordingly, employers, fiduciaries and administrators should begin consulting with their actuaries, counsel and other benefit plan advisors to determine the impact of the Act on their retirement programs and to make appropriate changes to ensure compliance. While this Alert summarizes certain provisions of the Act, the application of the law to each employer s plans will differ on a case-by-case basis. To discuss how the Act affects your plans, please contact Andrew E. Graw, chair of Lowenstein Sandler s Employee Benefits and Executive Compensation Practice, at (973) or at agraw@lowenstein.com. Lowenstein Sandler PC 65 Livingston Avenue 1251 Avenue of the Americas Roseland, NJ New York, NY

3 IMPACT OF THE PENSION PROTECTION ACT OF 2006 ON TAX-QUALIFIED PLANS AND OTHER ENTITIES CHANGES AFFECTING SINGLE EMPLOYER DEFINED BENEFIT PENSION PLANS Provision Old Law Provision Funding Changes Under current law, an employer must make annual minimum contributions to fund benefit obligations under a defined benefit pension plan. The funding standards generally require an employer to make contributions in amounts sufficient to cover the normal cost of funding the plan and to amortize unfunded past service liabilities. If a plan is less than 90% funded, additional contributions are required. Actuaries had some flexibility in deciding the assumptions and methodology for determining minimum funding requirements. The Act significantly changes the methodology for determining the contributions that must be made to defined benefit plans effective for plan years beginning after The Act increases the funding target to 100% of target or current liabilities. An employer with a plan that is not 100% funded (that is, a plan whose assets are less than the present value of accrued benefit liabilities) must make a minimum contribution that is sufficient to amortize the deficit over a period of seven (7) years. Under a special phase-in rule, the funding targets of a plan that is in existence prior to 2007 are as follows: 92% for 2008, 94% for 2009, 96% for 2010, 100% for 2011 and later. A plan s funding target is generally equal to the present value of accrued benefit liabilities. The Act sets forth actuarial assumptions and methodologies for the determination of required contributions, valuation of plan assets, and evaluation of liabilities. The new funding rules represent a dramatic change over existing law. The summary to the left is just a very brief overview of some of the changes, which are quite numerous and detailed. All employers with defined benefit plans will need to have their actuaries assess the impact of the new funding rules on their defined benefit pension plans.

4 Employee Benefits LOWENSTEIN SANDLER PC CLIENT ALERT IMPACT OF THE PENSION PROTECTION ACT OF 2006 ON TAX-QUALIFIED PLANS AND OTHER ENTITIES CHANGES AFFECTING SINGLE EMPLOYER DEFINED BENEFIT PENSION PLANS Provision Old Law Provision At Risk Plans Not Applicable. Plan sponsors of plans that have more than 500 participants are required to make greater contributions to plans that are considered at risk. A plan is at risk if the plan is (1) less than 80% funded using generally required actuarial assumptions, and (2) less than 70% funded using special actuarial assumptions applicable to atrisk plans. The 80% threshold is phased in over four (4) years. Defined benefit pension plans with more than 500 participants should consult their actuaries to determine whether the plan is at risk. If a plan is at-risk for two (2) of the four (4) preceding plan years, the required contributions are increased by a loading factor designed to reflect the cost of purchasing annuities should the plan terminate. Contribution Deduction Limitation An employer s tax deduction for contributions to a defined benefit pension plan for a year cannot exceed the greater of: (i) the minimum funding contribution for the plan year, or (ii) the plan s normal cost for the plan year plus the amount required to amortize unfunded liabilities over ten (10) years. Contributions are also subject to a cap called the full funding limit. For 2006 and 2007 the maximum deduction limitation cannot be any less than a plan s unfunded current liability, after subtracting the value of the plan s assets from 150% of the current liability of the plan. For plan years beginning after December 31, 2007, the annual deduction limitation is the greater of (i) the minimum contribution required under the Act or (ii) an alternative amount which includes a cushion plus the plan s target normal cost minus the plan s unreduced assets. The cushion is generally equal to the sum of 50% of the funding target for the plan year and the amount by which the funding target would increase for the year if the plan took into account expected future increases in compensation, or expected increased in benefits in succeeding plan years for those plans that do not base benefits on past services. Plan sponsors should consider, based on their tax position and their plan s funded status, the availability of increased funding deductions, which were expanded to facilitate funding of defined benefit plans.

5 CHANGES AFFECTING SINGLE EMPLOYER DEFINED BENEFIT PENSION PLANS Provision Old Law Provision Deferred Compensation Restrictions A sponsor of a defined benefit plan can fund a nonqualified deferred compensation plan without regard to the funding status of the defined benefit plan. If an employer, during a "restricted period," sets aside, reserves, or transfers to a trust assets for purposes of paying a covered employee deferred compensation under a nonqualified arrangement (such as to a rabbi trust ), the covered employee will be required to recognize income as if the employer transferred the assets directly to the employee. A "restricted period" includes (1) any period during which the employer's defined benefit plan is in "at-risk (see above); (2) any period during which the sponsor of the defined benefit plan is bankrupt; or (3) the twelve (12) month period beginning on the date that is six (6) months before the termination date of the defined benefit plan if, as of the termination date, the plan is not sufficiently funded to cover benefit liabilities. A covered employee generally means the CEO and the four (4) highest compensated officers of the employer. If an employer s pension plan is atrisk, care should be taken to avoid depositing new monies on behalf of restricted employees into the rabbi trust established to accumulate monies for the satisfaction of obligations under the its nonqualified deferred compensation plan. This new restriction carries an effective date of August 17, However, the corresponding at-risk rules are not effective until the first plan year beginning on or after January 1, Accordingly, it is not clear whether this new funding prohibition regarding nonqualified deferred compensation plans is effective immediately or in The IRS has informally advised us that a technical correction to the Act concerning the effective date of this rule may be needed.

6 Employee Benefits LOWENSTEIN SANDLER PC CLIENT ALERT IMPACT OF THE PENSION PROTECTION ACT OF 2006 ON TAX-QUALIFIED PLANS AND OTHER ENTITIES CHANGES AFFECTING SINGLE EMPLOYER DEFINED BENEFIT PENSION PLANS Provision Old Law Provision Lump Sum Distributions For purposes of determining the minimum value of a lump sum distribution, plan sponsors must use the 30-year Treasury rate. For plan years commencing after December 31, 2007, plan sponsors must use a modified yield curve published by the Treasury Department. This yield curve will be based on investment-grade corporate bonds of the three highest quality levels (AAA, AA, and A rated). Employers, fiduciaries and administrators should review their pension plans to determine if the plans allow for lump sum distributions (except for amounts under $5,000), and consult with their actuaries to determine the impact of the revised interest rate assumptions. Joint and Survivor Annuities Defined benefit plans (and money purchase plans) are generally required to provide participants with a joint and 50% survivor annuity form of benefit distribution. For plan years commencing after December 31, 2007, defined benefit and money purchase pension plans must offer a joint and 75% distribution option if the standard form of benefit is less than a 75% survivor benefit. If the standard form is 75% or more, then the plan must also offer a 50% survivor option. Plan sponsors will need to review their plans to determine whether amendments are required to meet the new distribution rules. Many plans will likely need to revise their annuity distribution options. In-Service Premiums Under current law, pension distributions generally cannot be made before a participant terminates employment, unless the participant has attained normal retirement age (typically, age 65). The Act allows a defined benefit pension plan to commence or pay pension benefits once a participant attains age 62, even if the participant has not terminated employment. The new rule is effective for plan years beginning after December 31, The rule may afford an opportunity to allow valued employees to begin receiving their pensions without having to retire. However, an employer cannot pick and choose to whom the new provision will apply. As a result, the new rule will likely not be attractive to a company with many employees.

7 CHANGES AFFECTING SINGLE EMPLOYER DEFINED BENEFIT PENSION PLANS Provision Old Law Provision PBGC Premiums An underfunded plan must pay a $30 per participant premium each plan year and a variable rate premium of $9 per $1,000 of unfunded vested benefits. A plan at the current law s full funding limit (which applies a 90% funding level) is not required to pay a variable rate premium. The $30 per participant premium remains unchanged, but the full funding limit exception for the variable rate is repealed. For plan years beginning in 2008, the variable rate premium will be based on the excess of the plan s funding target over the fair market value of the plan s assets. Cash Balance Plans Cash balance plans have been the subject of considerable litigation and uncertainty regarding age discrimination issues and questions as to whether benefit accruals comport with ERISA accrual requirements. The Act expressly authorizes cash balance plans and provides that credits to cash balance accounts will not be deemed age discriminatory merely because older participants have fewer years to accumulate such credits (as has been alleged in litigation). The Act also eliminates the whipsaw issue by permitting lump sum distributions to be based on the credit value of the cash balance account, rather than based on the present value of an annuity that could be provided with the cash balance account. The present value calculation sometimes had the effect of requiring a payment to a participant that exceeded his or her cash balance account. A plan s actuaries will be able to assess the additional financial impact of this change, if any. For several years the IRS has had a moratorium on the issuance of determination letters with respect to cash balance plans that involved conversions from traditional defined benefit plans. Because the Act resolves the uncertainty surrounding cash balance plans, the IRS is expected to begin issuing determination letters on long-delayed cash balance plan applications. Employers who had been reluctant to establish cash balance plans or convert existing traditional pension plans to cash balance plans due to the uncertainty of the treatment of cash balance plans and the litigation that has involved some cash balance plans may wish to take a fresh look at these options again in light of the Act.

8 Employee Benefits LOWENSTEIN SANDLER PC CLIENT ALERT IMPACT OF THE PENSION PROTECTION ACT OF 2006 ON TAX-QUALIFIED PLANS AND OTHER ENTITIES CHANGES AFFECTING DEFINED CONTRIBUTION PLANS Provision Old Law Provision Automatic Enrollment Safe Harbor There are two existing alternative safe harbor contribution formulae that allow an employer to automatically pass ADP/ACP nondiscrimination testing. One requires a matching contribution equal to 100% of the first 3% contributed by participants, plus 50% of the next 2% of contributions. The other requires a nonelective employer contribution equal to 3% of compensation. Both types of contributions must be fully vested at all times. For plan years beginning after December 31, 2007, a 401(k) plan with a qualified automatic contribution arrangement automatically meets the ADP and ACP tests. Under a qualified automatic contribution arrangement, unless an employee elects to opt out of such arrangement, the employer must treat the employee as if he or she automatically elected to defer a "qualified percentage of compensation." A "qualified percentage of compensation" is any uniformly applied percentage determined under the arrangement, up to a maximum of 10% of compensation, and must be at least (i) 3% of compensation in the first plan year of participation, (ii) 4% of compensation in the second plan year, (iii) 5% of compensation in the third plan year, and (vi) 6% of compensation in each subsequent plan year. The employer must make either matching contributions to nonhighly compensated individuals equal to the sum of 100% of employees elective contributions to the extent that such contributions do not exceed 1% of compensation plus 50% of so much of such compensation as exceeds 1% but does not exceed 6% of compensation, or nonelective contributions equal to at least 3% of employees compensation. Employees must vest in the matching and nonelective contributions after no more than two years of service. Consideration should be given to adopting automatic enrollment contributions as a way to automatically satisfy the ADP and ACP tests. The automatic enrollment safeharbor is likely to be less costly than the existing ADP/ACP safe harbors, and is therefore worth consideration by employers. Employees must receive written notice about the rights and obligations under the arrangement, the right to opt out of the automatic contribution arrangement, and how contributions will be invested.

9 CHANGES AFFECTING DEFINED CONTRIBUTION PLANS Provision Old Law Provision Diversification Under current law, only ESOPs must allow a participant to diversify the investment of his/her account out of employer securities if the individual has attained age 55 and has at least ten (10) years of plan participation. Under the Act, non-esop defined contribution plans of companies whose stock is publicly-traded must allow participants to diversify their own contributions at all times. In addition, participants of such plans must have the ability to diversify nonelective employer contributions and matching contributions if they have at least three (3) years of vesting service. The new rule is effective for plan years beginning after December 31, 2006 but will be subject to a three year phase-in rule for participants who were under age 55 and did not have at least three years of service as of the beginning of the first plan year after December 31, Beginning with the 2007 plan year, plan administrators must provide notice to individuals who are eligible to direct the investment of their account balances of their right to divest the investment of their accounts in employer securities. The notice must be given to a participant not later than thirty (30) days before the first date on which the participant becomes eligible to divest employer securities. The IRS is directed to issue a model notice for this purpose within the 2006 calendar year. The new diversification requirements will effect many 401(k) plans of publicly-traded companies. Employers, administrators and fiduciaries should review the terms of their plans governing investments of employer securities and make appropriate changes to conform to the Act. The effective date of this change for calendar year plans is January 1, 2007 so swift action should be taken to ensure compliance at that time. Plans that allow employees to invest in employer securities should prepare administrative mechanisms for the preparation and distribution of such notices.

10 Employee Benefits LOWENSTEIN SANDLER PC CLIENT ALERT IMPACT OF THE PENSION PROTECTION ACT OF 2006 ON TAX-QUALIFIED PLANS AND OTHER ENTITIES CHANGES AFFECTING DEFINED CONTRIBUTION PLANS Provision Old Law Provision Vesting Matching contributions must vest no slower than pursuant to a three-year cliff schedule or a six-year graded schedule. Other employer contributions must vest no slower than under a five-year cliff schedule or a seven-year graded schedule. The Act requires all that all employer contributions vest no slower than under the existing matching contribution schedules (i.e., three-year cliff schedule or a six-year graded schedule.) The new rule is effective for plan years beginning after December 31, Employers will need to review the vesting provisions of their defined contribution plans to determine if any changes are need to their plans vesting schedules to conform to the new law. Investment Advice Department of Labor regulations set forth standards that employers may follow if they wish to provide investment information to participants. However, many employers remain reluctant to provide investment educational materials and other information for fear of exposure to fiduciary liability. Others are concerned that not providing such information may also expose fiduciaries to liability. The Act creates a prohibited transaction exemption beginning in 2007 for investment advice given to participants by a fiduciary adviser. A bank, insurance company, broker, dealer, registered investment adviser, and all of their affiliates, employees, agents, and registered representatives qualify as a fiduciary adviser. The advice must be given pursuant to an eligible investment advice arrangement. Such an arrangement requires that the advice be provided pursuant to (i) an unbiased computer model that has been certified and audited by a independent third party, or (ii) by fiduciary advisers whose service fees do not vary depending on the participant s investment option. Under the new law, employers and fiduciaries are not treated as failing to meet ERISA s fiduciary standards solely because they make investment advice available in accordance with the new rules. However, the employer or other fiduciary remains responsible for the prudent selection and periodic review of any fiduciary adviser that is selected to provide investment advice. As a result of these provisions, there are certain to be host of new educational services offered by financial advisors and institutions. However, the Act does not completely relieve fiduciaries of responsibility with respect to such advice, as they remain responsible for conducting periodic reviews of the fiduciary advisers.

11 CHANGES AFFECTING SINGLE EMPLOYER DEFINED BENEFIT PENSION PLANS Provision Old Law Provision Default Investment Election Under current law, fiduciary responsibility over the investment of 401(k) accounts can generally be shifted from the plan s fiduciaries to participants if participants are afforded an opportunity to choose from among a diversified group of investment funds. The accounts of participants who fail to designate one or more investment funds are invested in one or more default funds specified by the plan fiduciaries. Arguably, plan fiduciaries are not relieved of fiduciary responsibility when a participant s account is invested by default because the participant has not exercised control over the investment of the account. Effective for plan years beginning after December 31, 2006, participants will be deemed to have control over accounts invested by default if they receive notice before each plan year explaining a participant s right to direct the investment of his or her account and how the account will be invested in the absence of such direction. The Department of Labor is required by the Act to issue regulations regarding default investments and notice requirements within six (6) months after the Act s date of enactment. This change will be transparent to most participants as employers and fiduciaries typically would inform participants of the various investment funds available under the plan and the procedures for directing the investment of their accounts. Once regulations are issued by the Department of Labor, they should be reviewed to determine whether any changes in procedures are appropriate.

12 Employee Benefits LOWENSTEIN SANDLER PC CLIENT ALERT IMPACT OF THE PENSION PROTECTION ACT OF 2006 ON TAX-QUALIFIED PLANS AND OTHER ENTITIES CHANGES AFFECTING SINGLE EMPLOYER DEFINED BENEFIT PENSION PLANS Provision Old Law Provision Disclosure Rules A defined benefit plan must file a Form 5500 each plan year. The plan sponsor must include an actuarial statement with the Form A defined benefit plan must provide participants with a summary annual report shortly after it files the Form A plan with unfunded vested benefits greater than $50 million must report to the PBGC its assets and liabilities, as well as certain confidential business information. For plan years beginning after December 31, 2007, a single-employer defined benefit plan must provide to the PBGC and each participant a notice detailing certain items, including the plan s identification information, funding status, funding policy, asset allocation, scheduled benefits increases or decreases, a summary of the rules regarding plan termination, and a description of the benefits guaranteed by the PBGC. A plan less than 80% funded must provide the PBGC with information concerning the plan s liabilities and funding status. With Forms 5500 filed in 2008 and thereafter, a plan s actuary must provide an explanation of actuarial assumptions used and the funding status of each plan if participants are covered under multiple plans. In addition, this information must be made available on a plan sponsor s website or intranet. Effective in 2008, the summary annual report requirement is eliminated, but the information required on Form 5500 is expanded. Benefit statements must be furnished to participants at least once every three years (or annually issue a notice of the availability of the statements) or provide a benefit statement upon request (but no more than once per year.) The new disclosure requirements will require additional administrative and actuarial time and effort. The PBGC is required to produce a form of notification that can be used to fulfill the participant notice obligations, but there will likely need to be considerable attention spent on compliance with the new reporting and disclosure rules. In addition, the requirement to furnish periodic benefit statements to participants may result in considerable expense. Notice Period for Distributions Current law generally requires that participants receive notice of distributions involving qualified joint and survivor annuities at least thirty (30) days, but not more than ninety (90) days, prior to the annuity starting date. Beginning in 2007, the ninety (90) day provision is increased to 180 days. Benefit distribution forms should be reviewed/adjusted to reflect the new provision.