Client Alert: The Pension Protection Act of Employee Benefits Group. August 14, 2006 Teleseminar Supplement II

Transcription

1 August 2006 Client Alert: If you have questions or would like additional information on the material presented herein, please contact: Sonia A. Chung Employee Benefits Group The Pension Protection Act of 2006 August 14, 2006 Teleseminar Supplement II THE PENSION PROTECTION ACT OF 2006 This outline describes selected issues of general interest as discussed in the Reed Smith Pension Protection Act of 2006 Teleseminar, held Monday, Aug. 14, A. Hybrid Plan Relief Employee Benefits Group Kristen E. Belz Ann C. Bertino Russell J. Boehner Dennis R. Bonessa Benjamin A. Bigler Michae Calvertl Sonia A. Chung Anthony T. Cicchino Laurie S. DuChateau Dodi Walker Gross John F. LeBlond John D. Martini Donald J.Myers David N.Pardys Carl R. Reisacher Michael B. Richman Daniel E. Wille Cher E. Wynkoop 1. Over the years, a significant amount of litigation has arisen over how the Age Discrimination in Employment Act, ERISA, and the Internal Revenue Code requirements apply to hybrid defined benefit plans and the conversion of traditional defined benefit final pay plans into hybrid plans. Indeed, just a few days ago, the Seventh Circuit Court of Appeals issued a much-anticipated decision in the IBM cash balance litigation, finding that the defined benefit plan conversion at issue in that case did not discriminate on the basis of age. This nicely illustrates the point that Congress decision to include provisions relating to the legality of cash balance plans in the legislation is both timely and appropriate. 2. The new legislation provides guidance and clarity in this contentious area by setting out rules for testing plans for age discrimination. However, while the legislation provides for general retroactive relief for existing hybrid plans going back to June 29, 2005, it does not provide any clarification of the legal status of hybrid plans for years prior to that time; so unfortunately, we ll continue to see courts struggling with this issue, even in light of this new guidance. 3. The new age-discrimination test essentially clarifies that plans will not be found in violation of the prohibition against ceasing or reducing the rate of benefit accruals solely because the employee attains a specific age as long as the participant s accrued benefit as of any date under the terms of the plan would equal or exceed that of a similarly situated younger individual who is, or who could be, a participant. The legislation permits plan sponsors to disregard subsidized early retirement benefits or retirement-type subsidies in applying this test.

2 4. The legislation also contains provisions which prohibit any wear-away after the conversion of a defined benefit plan to a hybrid plan. Under this provision, a participant s benefit under the hybrid plan must not be less than the sum of (i) his or her benefit under the prior plan formula as of the date of the conversion and (ii) the hybrid plan benefit as determined on the basis of service after the conversion. This prohibition is effective for conversions occurring on and after June 29, In addition, the legislation provides for whipsaw relief by clarifying that cash balance plans do not violate Code Section 417(e) when they pay lump sums equal to the participant s hypothetical account balance, provided that the plan s interest credit does not exceed a market rate of return. This provision is effective for distributions made after the date the legislation is enacted. 6. Beginning in 2008, the legislation also requires hybrid plans to provide for full vesting in three years, and interest credits at no more than the market rate of interest. Plans in existence on June 29, 2005, may, however, elect to apply these requirements for any period after June 29, 2005 and before the first plan year beginning after Dec. 31, A delayed effective date applies for the interest credit and vesting requirements for plans maintained under a collective bargaining agreement. B. Automatic Enrollment Plans 1. Under these new rules, which become effective on and after Jan. 1, 2008, 401(k) and 403(b) plans which meet certain specific automatic enrollment criteria will be deemed to satisfy the ADP/ACP nondiscrimination tests, as well as the top heavy requirements. The legislation also clarifies that ERISA preempts any state laws that directly or indirectly prohibit or restrict the ability of a plan to utilize the automatic enrollment safe harbor. To take advantage of these provisions: The initial default contribution limit must be set between 3 percent and 10 percent, and increase to at least 6 percent by the fourth year of participation. The default percentage must be uniformly applicable to all employees. The employer match must equal at least 100 percent of the first 1 percent deferred and at least 50 percent of the next 5 percent deferred. Matching contributions cannot exceed 6 percent of compensation and cannot increase as the rate of an employee s elective deferrals increases. Additionally, the rate of match with respect to elective deferrals for highly compensated employees must not be greater than the rate of matching contributions with respect to the same rate of deferral of a non-highly compensated employee

3 In lieu of providing a matching contribution, employers would be permitted to provide a minimum 3 percent nonelective contribution. Any employer contributions taken into account for purposes of determining if the automatic enrollment requirements have been met must fully vest after no more than two years, and these contributions must additionally be subject to the same withdrawal rules applicable to elective contributions. Practical Impact: While the new automatic enrollment plans may require a more complex ongoing administrative scheme resulting from the automatic yearly elective deferral increases, they may also be less expensive to offer than traditional safe harbor plans. Under current law, an employer can already adopt a safe harbor plan that is not subject to ADP/ACP testing by offering a minimum match equal to 100 percent up to 3 percent of elective deferrals and 50 percent up to the next 2 percent, with immediate vesting. That s a total of 4 percent in required employer matching contributions. Under the new automatic enrollment safe harbor, employers would need to offer a match equal to 100 percent of 1 percent and 50 percent on the next 5 percent, or a total employer match equal to 3.5 percent, with an allowable twoyear vesting period. Comparing these situations then, the standard safe harbor plan will end up requiring an additional 1/2 percent contribution, and will provide no flexibility on vesting. The new automatic enrollment plan may ultimately be less expensive by requiring a smaller amount of employer contributions (3.5 percent versus 4 percent) and permitting a vesting schedule. C. DB(k) Plans 1. Beginning in 2010, employers with fewer than 500 employees will be permitted to institute DB(k) plans, which are essentially combined defined contribution/defined benefit plans. Each piece of the combined plan would, however, remain subject to the respective rules for defined benefit/defined contribution plans under ERISA and the Code. 2. If certain criteria were met, the combined plan would be permitted to file a single Form 5500, and would be deemed in satisfaction of the top-heavy requirements and ADP/ACP testing. 3. To take advantage of these incentives, the defined benefit component would have to include a benefit equal to either a 1 percent of final average pay formula up to 20 years of service, or a cash balance formula that increases with participant s age. 4. The defined contribution component would be required to utilize an automatic enrollment feature using 4 percent as the default - 3 -

4 contribution rate, and would provide for a fully vested match equal to 50 percent on the first 4 percent of compensation deferred. 5. Benefits provided under the pension portion of the arrangement and nonelective contributions under the defined contribution portion must vest within three years of service. * * * In addition to the above guidance on these three plan design elements, the legislation contains a wide-ranging array of provisions intended to empower both defined benefit and defined contribution plan participants by providing them with more flexibility and protection with respect to their retirement savings. A. Diversification Requirements for Plans Holding Company Stock. In this post-enron era, the legislation mandates expanded diversification rights for defined contribution plans holding publicly traded company stock. All participants must be permitted to diversify their employee contribution accounts, and participants with at least three years of vesting service must be allowed to diversify their employer contribution accounts. These requirements are effective in 2007, with a delayed effective date for collectively bargained plans. The diversification requirement for stock acquired before 2007 with employer contributions is to be phased in by permitting diversification rights for 1/3 of the account each year for three years. The phase-in would not apply to participants age 55 or older with at least three years of service. B. Penalty-Free Withdrawals For Extended Active Military Service. 1. Under current law, participants who receive a distribution from a qualified retirement plan prior to age 59-1/2, or for reasons of death or disability, are generally subject to a 10 percent early withdrawal tax on the amount includible in income. 2. The Pension Protection Act adds a new exception to this 10 percent withdrawal tax for what it refers to as qualified reservist distributions which are made to individuals ordered or called to active duty between Sept. 11, 2001 and Dec. 31, To be qualified, a reservist distribution must meet three criteria: First, the distribution must be made from an IRA or must be attributable to elective deferrals under a 401(k) plan, 403(b) annuity, or certain similar arrangements Second, the distribution must be made to an individual who was ordered to or called to active duty for a period in excess of 179 days or for an indefinite period - 4 -

5 Third, the distribution must be made during the period beginning on the date of such order or call to duty and ending at the close of the active duty period 4. Qualified reservists who take advantage of these penalty-free distributions may, at any time after the end of the active duty period, make one or more contributions to an IRA in an aggregate amount not to exceed the amount of the qualified distribution. The dollar limitations otherwise applicable to IRA contributions don t apply to these contributions. C. Accelerated Vesting of Non-Elective Contributions. Under current requirements, employer non-elective contributions must vest on a fiveyear cliff vesting or three- to seven-year graduated schedules. The legislation changes this to a three-year cliff or two- to six-year graduated vesting schedule. Effective on and after Jan. 1, 2007, this will bring the nonelective contribution vesting schedules in line with the schedules that are currently applicable to matching contributions. 1. In applying the new vesting schedule, service before the effective date will be taken into account. 2. Delayed effective date for collectively bargained plans: earlier of (i) the later of date on which the last of the collective bargaining agreements terminates or Jan. 1, 2007 or (ii) Jan. 1, D. EGTRRA Provisions Made Permanent. The legislation contains language which will ensure that the EGTRRA provisions will not sunset in 2010 as originally intended. This means that higher contribution, benefit and compensation limits, the permissibility of catch-up contributions, and the existence of Roth 401(k) plans, among other things, are no longer in danger of expiring in a few years. * * * The legislation also includes additional flexibility for defined benefit plans, with two such provisions as follows. A. Distributions During Working Retirement. Effective on and after Jan. 1, 2007, the legislation will permit defined benefit plans to provide for in-service distributions to a participant who has reached age 62, even if the plan s normal retirement age is later than age 62. Again, this provision is effective for Plan Years beginning in B. New Annuity Option Requirement. Effective on and after Jan. 1, 2008, the legislation requires plans to offer a 75 percent survivor annuity option if the QJSA has a survivor percentage less than 75 percent and a 50 percent survivor annuity option if the QJSA has a survivor percentage that is greater than 75 percent

6 1. There is a delayed effective date for collectively bargained plans (earlier of (i) the later of Jan. 1, 2008 or the date the last CBA terminates or (ii) Jan. 1, 2009). * * * The legislation also contains two provisions that came about in response to added pressure to provide protection to domestic partners while still adhering to the Federal Defense of Marriage Act s prohibitions on samesex marriages: A. Revised Hardship Rules 1. Even though many plans are in the process of, or have recently been amended for, the final 401(k) regulations, the legislation directs the Secretary of the Treasury to again revise the rules for determining whether a hardship or unforeseeable emergency exists to include events occurring with respect to a beneficiary under the plan in the same way such rules would have applied to a participant s spouse or dependent. In this way, non-spouse domestic partner, for example, may also be eligible for hardship distributions. 2. These revised hardship rules are to be issued within 180 days of the legislation s enactment. B. Non-Spouse Beneficiary Rollovers Permitted After Dec. 31, Currently, rollovers are permitted in the case of a distribution to the participant s surviving spouse, but not to other individuals. 2. The legislation provides that benefits of a beneficiary other than a surviving spouse (such as a domestic partner) may be transferred directly to an IRA. The IRA will then be treated as an inherited IRA of the non-spouse beneficiary, with the distribution rules being those applicable to beneficiaries. This new rollover rule applies equally to beneficiaries under 403(a), 403(b) and 457 plans. Required Amendments: Any amendments required by this legislation or future regulations issued in accordance with the legislation may be retroactively made on or before the last day of the 2009 plan year. The legislation provides for anti-cutback relief for these amendments. Governmental plans have until 2011 to make these retroactive amendments