Pension Protection Act of 2006 August 2006 Friends and Colleagues: On August 17, 2006, President Bush signed into law the Pension Protection Act of 2006 (the Act ). This client alert provides general highlights of some of the significant aspects of the Act and is intended for in-house counsel, plan sponsors, plan fiduciaries, plan administrators and other employee benefits professionals involved in the compliance, design or administration of employee benefits programs. The following is a breakdown of the client alert. Part 1 summarizes the new pension funding rules and the new restrictions on the funding of nonqualified deferred compensation arrangements; Part 2 describes new company stock diversification requirements and auto-enrollment provisions for defined contribution plans; Part 3 covers key aspects relating to bankruptcy; Part 4 sums up the increases in participant disclosures; Part 5 describes plan investment issues particularly with respect to plan asset rule changes, the provision of investment advice to participants and changes to ERISA Section 404(c) (fiduciary relief for participant-directed plans); Part 6 discusses the Act s clarifications of cash balance and hybrid plan age discrimination rules; and Part 7 covers miscellaneous aspects of the Act including EGTRRA permanency. 1. PENSION IMPLICATIONS Funding of Single Employer Defined Benefit Pension Plans In an effort to address the recent funding concerns underlying the nation s defined benefit pension plan system, the Act transforms the rules governing the funding of such plans. The Act replaces the prior funding rules with a new standard based solely on a plan s funded status. 1 The new rules are generally effective for the 2008 plan year, but there are transition rules as well. Plan sponsors should consult with their plan actuaries to assess the impact the new funding rules will have in the upcoming years. Below is a brief summary of certain aspects of the Act s new funding rules: Generally. Under the Act, the general notion is that a plan s required contribution equals the normal cost (i.e., the present value of the benefits earned by participants) for the current year plus an amount needed to amortize any funding shortfall over a period no longer than seven years. Such contribution determination may be impacted by any funding waiver, carryover of a funding standard account or prefunding balances. In the case of at-risk plans (see below), the Act imposes special rules geared to increase the funding obligation. Contributions. The Act requires plan contributions if the plan s assets are exceeded by the sum of (i) the plan s normal cost for the year and (ii) 100 percent of the plan s liability on the valuation date.
There is a phase-in transition period for the 100 percent funding target. 2 At-Risk Plans. Plans are considered at-risk under the Act if in the preceding plan year, the plan s assets were (i) less than 80 percent of its liabilities using non-risk assumptions and (ii) less than 70 percent of its liabilities using at-risk assumptions (except the loading factor ). 3 Credit balances are subtracted from plan assets for these purposes, and the 80 percent prong is phased in over the period from 2008 to 2011 (i.e., 65 percent in 2008, 70 percent in 2009, 75 percent in 2010, 80 percent thereafter). 4 At-risk plans are required to assume during the next ten years that all participants will retire at their earliest retirement age and that benefits will be paid in the form that results in the largest liability for the plan. 5 Additionally, if a plan is at-risk for two out of four years, an extra loading factor is applied in determining the plan liability. 6 Measuring Benefit Obligations Interest Rate. The Act requires that plans value benefit obligations utilizing different interest rate assumptions depending on the expected benefit payment dates. This segment approach breaks out benefits into the following expected payment periods: (1) zero to five years, (2) five to twenty years, and (3) after twenty years. The segment rates are based on a corporate bond yield curve to be published by the Treasury Department monthly. Alternatively, plans may elect to use a single blended interest rate and such election may be revoked only with IRS consent. 7 The corporate bond yield curve method will be phased in, with full implementation in 2010. Measuring Benefit Obligations Mortality. The Treasury Department is directed to establish (and update every ten years) a new mortality table for valuing benefits, including a separate mortality table for disabled participants. 8 Large plans may request permission from the Treasury Department to use mortality tables based on their own experience. Measuring Plan Assets. The Act allows smoothing of plan assets to reduce the effect of market fluctuations, but with less flexibility than in the past. The averaging period is now limited to two years (instead of five), and the plan asset value is required to be between 90 percent and 110 percent of the fair market value. 9 By using a shorter period with a more narrow corridor, plans may experience greater volatility in plan assets, and therefore, their funding obligation. Possible Benefit Limitations. For plans whose funded status falls below certain levels, the Act imposes a variety of new benefit restrictions, including limitations on benefit accruals, benefit increases, and/or benefit forms. 10 Government Contractor Plan Exception. The effective date of the funding and benefit restriction rules is delayed for certain large defense contractor plans until the earlier of (i) the date the Cost Accounting Standards Board allows recovery of the new contribution rates or (ii) 2011. 11 Limitations on Funding Nonqualified Deferred Compensation Arrangements The Act prohibits employers from setting aside or reserving money to pay nonqualified deferred compensation for certain executives if the employer or a member of its controlled group is bankrupt, has a plan that is considered at-risk (as described above in this Part 1) or has a plan that is terminated without sufficient assets to pay all benefits. 12 If amounts are set aside in violation of these rules, the executive will be taxed, including the interest and 20 percent penalty taxes of the Internal Revenue Code (the Code ) Section 409A, on such amounts. 13 This amendment to Section 409A treats any amount transferred or reserved to a trust (including a rabbi trust) during a restricted period as taxable to executives benefiting under plans funded by such trust. Such trust amounts are treated as property transferred in connection with the performance of services under Section 83 of the Code making them taxable. Further, the Act specifies that if an employer provides directly or indirectly for the gross-up payment of any taxes or penalties associated with improper funding of nonqualified deferred compensation arrangements: (1) such payment will be taken into account in determining the amount of the interest and 20 percent penalty taxes of Code Section 409A in the 2
same manner as if such payment was part of the deferred compensation, and (2) no deduction will be allowed to the employer under this title with respect to such payment. 14 These provisions of the Act are effective as of the date of the Act s enactment. However, it is worth noting that plans cannot be considered at-risk prior to the 2008 plan year. 2. DEFINED CONTRIBUTION PLAN IMPLICATIONS Diversification of Employer Securities in Certain Defined Contribution Plans Intending to increase diversification rights, the Act, generally as of January 1, 2007, will require defined contribution plans to allow participants to divest and reinvest the portion of their account attributable to employee contributions and elective deferrals that are invested in publicly-traded employer securities. 15 With respect to the portion of a plan account that is attributable to employer contributions (other than elective deferrals) which is invested in publicly-traded employer securities, the Act will grant to each participant who has completed at least three years of service diversification and reinvestment rights similar to those above. 16 If the employer contribution portion of the account consists of publicly-traded employer securities acquired in a plan year beginning before January 1, 2007, the diversification requirement with respect to such employer securities will be phased in generally over three years (i.e., 33 percent of such securities in the first plan year, 66 percent of such securities in the second plan year, and 100 percent of such securities in the third plan year). However, this phase-in approach for such employer securities acquired in a plan year beginning before January 1, 2007 will not apply to a participant who has attained age 55 and completed at least three years of service before the first plan year beginning after December 31, 2005. 17 As for the options for reinvesting the proceeds from divested employer securities, the Act requires affected plans to offer no less than three investment alternatives, other than employer securities, each of which is diversified and has materially different risk and return characteristics. 18 Plan administrators may limit the time for divestment and reinvestment to periodic opportunities that occur no less frequently than quarterly. 19 Further, except as provided in regulations or in accordance with any securities law restrictions or conditions, a plan will not meet this requirement if it imposes restrictions or conditions on the investment of employer securities that are not imposed on other plan assets. Rules on and Treatment of Automatic Contribution Arrangements Finalized After several months of anticipation by the benefits community, the Act permits the implementation of automatic enrollment features in 401(k) plans. 20 The Act outlines various safe harbor requirements such as default contribution rates, match rates, vesting and notice requirements. The Act also ends the debate on whether the Employee Retirement Income Security Act of 1974 ( ERISA ) preempts various state wage deduction laws by amending ERISA Section 514 to add provisions that indicate that any law of any state which will directly or indirectly prohibit the inclusion in any plan of an automatic contribution arrangement is superseded. 21 This means that state laws which might have barred wage withholding without the employee s consent will not pose any obstacles if the employee was participating in an automatic contribution arrangement as defined in Section 514 of ERISA. The effective date of these automatic enrollment provisions is generally for plan years beginning after 2007, provided that the clarification of the extent of the ERISA preemption is effective as of the date of enactment. 3. BANKRUPTCY & PBGC New Termination Timing Rules for Bankrupt Plan Sponsors Section 404 of the Act adds provisions related to employers in bankruptcy. Generally, PBGC guarantees are tied to the date of a defined benefit plan s termination. Under the Act, if a contributing sponsor of a plan files a petition seeking liquidation or reorganization under Chapter 11 or under a similar law, then for PBGC purposes, the plan will be treated as having terminated as of the date of the petition. 22 These amendments apply with respect to proceedings initiated on or after 30 days after the enactment of the Act. 23 3
Also, please see the discussion in Part 1 regarding limits on funding non-qualified deferred compensation arrangements while in bankruptcy. PBGC Premiums The Act provides new rules for determining variablerate premiums based on yield curve segment rates, which will be phased in beginning in 2008. 24 Additionally, defined benefit plan sponsors are subject to premiums of $1,250 per participant for up to three years if they transfer plan liabilities to the PBGC and then emerge from bankruptcy. 25 This $1,250 per participant premium was previously in place, but its temporary status has been made permanent. 26 Miscellaneous PBGC Changes Interest on Overpayment. Of particular interest to PBGC creditors, the Act now authorizes the PBGC to pay interest on premium overpayments. 27 Change in Controlled Groups. Significant to mergers and acquisitions, the Act changes how a controlled group splits impact plan funding and asset allocation. Historically, plan spin-offs from a controlled group have been valued using PBGC termination rates. Under the new rule, well qualified plan sponsors may now use the plan s interest rate (i.e., the rate used to calculate benefit liabilities). 28 The Act defines which plan sponsors are considered well qualified. 29 For example, a plan sponsor with outstanding senior unsecured debt which is rated investment grade will generally qualify. The new rule is effective for transactions occurring after the date of enactment of the Act. 30 Missing Participants. Pending the issuance of final regulations implementing the new rule, plan balances associated with missing participants of terminated defined contribution plans (and terminated multiemployer plans) will be eligible for transfer to the PBGC s missing participant program. 31 4. PARTICIPANT DISCLOSURE Notice of Freedom to Divest Employer Securities In an effort to further encourage participants to diversify their benefits accounts, the Act requires a plan administrator to provide notice to a participant (1) setting forth the participant s right to diversify his or her account and (2) describing the importance of diversifying the investment, within a given time frame of the participant becoming eligible to diversify his or her account. 32 This new rule is effective for plan years beginning after 2006. 33 Periodic Pension Benefit Statements Previously, a plan administrator was required to provide benefit statements once per 12-month period and only upon written request from a plan participant. However, under the Act, participants in individual account plans (other than stand alone ESOPs) who have the right to direct their investments must now be given quarterly benefit statements by the plan administrator. 34 However, participants who do not have the right to direct their investments must still be given a benefit statement, but only on an annual basis. In the case of a defined benefit plan, the statement is required every three years (and upon a participant s request) with an option to provide annual notice of the availability of a benefits statement instead of providing a statement every three years. 35 Part of the purpose of these new disclosure rules is to minimize requests for such information from plan participants throughout the plan year. This rule is generally effective for plan years beginning after 2006. 36 5. PLAN INVESTMENT ISSUES Plan Asset Rule Change When a defined benefit plan invests in a hedge fund, private equity fund or other similar investment fund vehicle, the underlying assets of such fund will be considered plan assets unless an applicable exemption applies. 37 Fund managers typically do not want plan assets as such status subjects the fund managers to a spectrum of ERISA rules, including its fiduciary and prohibited transaction rules. One exception commonly relied upon by funds is the significant benefit plan investor exception, where if the investment of benefit plan investors in each equity class of the fund is less than 25 percent, the fund will not be considered to hold plan assets for ERISA purposes. Previously, the term benefit plan investors included any employee benefit plan, whether or not subject to 4
ERISA. Thus, foreign and governmental defined benefit plans were included in the 25 percent test determination, which limited a fund s ability to take in plan money when there was an ERISA plan investor. The legislation will revise the test by limiting the term benefit plan investor to any employee benefit plan that is subject to ERISA. 38 This will permit funds to attract and utilize more assets of defined benefit plan investors while still avoiding the plan asset issue. Issues for Fiduciaries and Plan Administrators Subject to meeting the requirements of ERISA Section 404(c), fiduciaries of participant-directed plans cannot currently be held liable for any loss or breach which results from the participants control of their assets. The Act extends this relief to situations where participants fail to make investment elections, and the plan sponsor makes default investment elections on their behalf; provided certain notice requirements are met and the default elections comply with future DOL regulations. 39 The Act also eliminates this relief during any blackout period in which the ability of participants to direct the investment of their account assets is suspended by a plan sponsor or fiduciary, unless the blackout period is properly authorized and implemented. 40 The Act creates a prohibited transaction exemption that generally allows fiduciary advisers to provide investment advice to participants and/or beneficiaries of participant-directed individual account plans so long as certified computer models are used or the advisers fees do not vary depending on the investment option selected. 41 Issues for Investment Managers and Others Subject to a number of requirements specific to each exemption, the Act creates prohibited transaction exemptions for: (1) block trading (any trade of at least 10,000 shares or with a market value of at least $200,000 which will be allocated across two or more unrelated client accounts), (2) transactions executed through an electronic communication network, alternative trading system, or similar execution system or trading venue subject to federal regulatory oversight, (3) non-fiduciary service providers who receive adequate consideration, (4) foreign exchange securities transactions where the bank or brokerdealer does not have investment discretion or provide investment advice, and (5) cross trading between plans with at least $100 million in assets that are managed by the same investment manager. 42 6. BENEFIT ACCRUAL STANDARDS: AGE DISCRIMINATION Cash Balance and Hybrid Plans One of the most significant provisions of the Act is the clarification of the age discrimination rules of the Code, ERISA, and the Age Discrimination in Employment Act of 1967 to hybrid pension plans and to the conversion of traditional defined benefit plans into hybrid plans. 43 Under the Act a defined benefit plan is not age discriminatory if, on any date, a participant s accrued benefit will be equal to or greater than the accrued benefit of any similarly situated, younger individual. Further, a plan will not be treated as violating the prohibition against ceasing or reducing the rate of an employee s benefit accrual solely because the employee attains a particular age so long as a participant s accrued benefit meets the above requirement. 44 Cash balance plans are therefore not age discriminatory so long as pay and annual interest credits for older workers are not less than that for younger workers. Hybrid plans will also now be permitted to treat hypothetical account balances as the lump sum value for distributions after the enactment of the Act. 45 The Act also clarifies that a plan does not violate the continued accrual requirements because the plan: (1) provides offsets against plan benefits that are allowable to applying Code Section 401(a); (2) provides a disparity in contributions or benefits with respect to the Code Section 401(a) requirements; or (3) provides indexing of accrued benefits. 46 These new rules in the Act apply to all defined benefit plans, including, but not limited to cash balance plans, pension equity plans, and other hybrids. A hybrid plan will violate the continued accrual requirements of the Act unless the terms of the plan provide that any interest credit for any plan year must be at a rate that is at or below the market rate. 47 The terms of the plan must also include specific language 5
related to plan termination. A plan, however, may provide for a reasonable minimum guaranteed rate of return or a rate of return that is equal to the greater of a fixed or variable rate. 48 Additionally, under the Act, a hybrid plan will be treated as meeting the vesting requirements of the Code and ERISA only if an employee who has completed at least three years of service has a non forfeitable right to 100 percent of the employee s accrued benefit derived from employer contributions. 49 If an amendment to a defined benefit plan converts the plan to an applicable defined benefit plan and is adopted after June 29, 2005, the plan will be treated as failing to meet the continued accrual requirements unless each participant s post-amendment accrual benefit is not less than the sum of the participant s accrued benefit for years of service before and after the plan amendment s effective date. 50 Generally, this new standard becomes effective on or after June 29, 2005. However, the interest credit and vesting rules are not effective until plan years beginning after 2007. 7. MISCELLANEOUS These changes, in effect since 2001, were previously set to expire at the end of 2010. However, effective as of the passing of the Act, these provisions shall remain permanent. Faster Vesting of Employer Nonelective Contributions In an attempt to increase the portability of retirement benefits, the minimum vesting standards applicable to defined benefit and defined contribution plans have been amended by the Act. The effect of this amendment is a faster vesting period for participants under both types of plans for contributions made after the effective date. With respect to a defined benefit plan, the plan must either vest after five years of service or vest according to a 3-7 year graded schedule. 53 With respect to a defined contribution plan, the plan must either vest after three years of service or vest according to a 2-6 year graded schedule. 54 This amendment will generally be effective for contributions made beginning in 2007 for participants with at least one hour of service after such effective date. 55 Pensions and Individual Retirement Arrangement Provisions of Economic Growth and Tax Relief Reconciliation Act of 2001 Made Permanent The Act now makes permanent the changes in the Economic Growth and Tax Relief Reconciliation Act of 2001 ( EGTRAA ) related to pensions and individual retirement arrangements. 51 The EGTRRA changes made permanent include modifications of elective deferral contribution limits; catch-up contributions for individuals age 50 or older, higher Code Section 415(c) limits and after tax contribution rollovers. 52 For additional clarification on how any of the items covered in this alert may apply to your specific benefits situation, please contact: William L. Scogland wscogland@jenner.com 312 923-2878 Matthew J. Renaud mrenaud@jenner.com 312 923-2958 S. Tony Ling tling@jenner.com 312 923-2640 Jorge M. Leon jleon@jenner.com 312 923-2815 *Special thanks to summer associates Michaelene Martin and David Saunders for their assistance on this client alert. 6
Endnotes 1. Section 102 of the Act amending ERISA Section 303 and establishing Code Section 430. 2. Id. 3. Id. 4. Id. 5. Id. 6. Id. 7. Section 112 of the Act creating Code Section 430. 8. Section 102 of the Act amending ERISA Section 303. 9. Id. 10. Section 103 of the Act amending ERISA Sections 101 and 206. 11. Section 106 of the Act. 12. Section 116 of the Act amending Code 409A. 13. Id. 14. Id. 15. Section 901 of the Act amending ERISA Section 204 and Code 401. 16. Id. 17. Id. 18. Id. 19. Id. 20. Section 902 of the Act amending ERISA 514 and Code Section 401, 414, 415, 4979. 21. Id. 22. Section 404 of the Act amending ERISA Sections 4022, 4044. 23. Id. 24. Section 401 of the Act amending ERISA 4006. 25. Id. 26. Id. 27. Section 406 of the Act amending ERISA Section 4007. 28. Section 409 of the Act amending ERISA Section 4041. 29. Id. 30. Id. 31. Section 410 of the Act amending ERISA Sections 206, 4050. 32. Section 507 of the Act amending ERISA Sections 101, 502. 33. Id. 34. Section 508 of the Act amending ERISA Section 105. 35. Id. 36. Id. 37. Section 611 of the Act amending ERISA Section 3. 38. Id. 39. Section 624 of the Act amending ERISA Section 404. 40. Section 621 of the Act amending ERISA Section 404. 41. Section 611 of the Act amending ERISA Section 408 and Code Section 4975. 42. Id. 43. Section 701 of the Act amending ERISA Section 204, Code Section 411 and ADEA Section 4. 44. Id. 45. Id. 46. Id. 47. Id. 48. Id. 49. Id. 50. Id. 51. Section 811 of the Act amending Title IX of the Economic Growth Tax Relief Reconciliation Act of 2001. 52. Section 904 of the Act amending ERISA Section 203 and Code Section 411. 53. Id. 54. Id. 55. Id. Chicago Office One IBM Plaza Chicago, IL 60611-7603 312 222-9350 Dallas Office 1717 Main Street Suite 3150 Dallas, TX 75201-4647 214 746-5700 New York Office 919 Third Avenue 37th Floor New York, NY 10022-3908 212 891-1600 Washington, DC Office 601 Thirteenth Street, N.W. Suite 1200 South Washington, DC 20005-3823 202 639-6000 Copyright 2006 Jenner & Block LLP, One IBM Plaza, Chicago, IL 60611. Jenner & Block is an Illinois Limited Liability Partnership including professional corporations. Under professional rules, this communication may be considered advertising material. The material contained in this document has been authored or gathered by Jenner & Block for informational purposes only. It is not intended to be and is not considered to be legal advice. Transmission is not intended to create and receipt does not establish an attorney-client relationship. Legal advice of any nature should be sought from legal counsel. The attorney responsible for this publication is Matthew J. Renaud. Cover image from the Collection of the Supreme Court of the United States. 7