August 18, 2006 PENSION PROTECTION ACT President Bush signed the Pension Protection Act of 2006 ("PPA") on August 17, 2006. The PPA contains many changes for both defined contribution plans and defined benefit plans. The provisions have various operational effective dates. If you have a defined benefit plan and we have already provided your 2006 valuation, we will revise it to reflect the changes in the 2006 funding requirements and deduction limits required by the PPA. Plan amendments are required by the end of the 2009 plan year for non-government plans and by the end of the 2011 plan year for government plans. Although it will take some time for pension professionals to digest all of the provisions of the new law, we are offering a summary of the major changes. This Newsletter also includes an update on the new accounting rules for defined benefit plans. (See page 6.) Single-Employer and Multiple-Employer Defined Benefit Plans Determination of Current Liability: To determine a plan's Current Liability, each participant's accrued benefit is converted to a present value. The interest rate used to determine the present value is a key element in determining the plan's Current Liability. The PPA provides a new interest rate effective in 2008. The interest rate to be used in calculating Current Liability will be determined from an average of high-quality corporate bond rates over a two-year period. Instead of the single rate used in prior law, a "segmented" yield curve approach will be used under the new law. This "segmented" yield curve will have three values short term (0-5 years), medium term (6-20 years) and long term (over 20 years). The segmented yield curve will be phased in over three years starting in 2008. Alternatively, the full yield curve without averaging or phase-in may be used. The yield curve may be selected based on the first month of the plan year or any of the four prior months. The Internal Revenue Service ("IRS") has proposed updated required mortality tables that will be required in the future (the effective date is under consideration). The impact of the interest rate change and the mortality table change will depend on your plan demographics. After the yield curve is developed, we will be able to analyze the impact on your plan. Current Liability Interest Rate for 2006 and 2007: During 2006 and 2007, plans may continue to use an interest rate based on the 4-year average yield of investment-grade corporate bonds. This extension will also provide relief when calculating Pension Benefit Guaranty Corporation ("PBGC") variable rate premiums for 2006 and 2007. This provision extends the interest rate relief previously granted for 2004 and 2005. Asset Smoothing: Effective in 2008, up to a 24-month period may be used to average asset values. However, the final averaged value must be in the range of 90-110% of market value as of the plan's valuation date.
Credit Balances: A "credit balance" is the result of an employer making a contribution in excess of the minimum amount required for a year. Prior to the PPA, plans could increase the value of their credit balances based on an assumed rate of return, regardless of the actual performance of the plan's assets. Beginning in 2008, credit balances must be adjusted annually to reflect their market value. Credit balances will be maintained in two parts. One part will be the carryover balance from the 2007 plan year. The other part will be a pre-funding balance due to contributions in 2008 and later years in excess of the minimum funding requirement. The credit balance may be used to offset the minimum funding requirement if the plan is at least 80% funded when the pre-funding balance is excluded from the assets. The pre-2008 carryover balance must be used first. The entire credit balance will be subtracted from plan assets for most other purposes, including testing at-risk status, determining whether benefit restrictions apply (unless the plan is fully funded without deducting credit balances), and determining the minimum required contribution. Under some circumstances, it will be advantageous for the employer to waive the credit balance in order to meet a funding target. Funding Target: The Funding Target is increased from 90% to 100% of Current Liability. The credit balance is subtracted from the assets in determining unfunded Current Liability. Plans will be required to fund the unfunded Current Liability over seven years, and fund the entire normal cost for the current year. For plans that did not have an additional funding charge in 2007, the 100% target will be phased in beginning in 2008: only plans less than 92% funded will have to amortize their unfunded liability in 2008; this percentage increases to 94% in 2009, 96% in 2010, and 100% in 2011. Funding Target Attainment Percentage: Many provisions of the PPA depend on the plan's Funding Target Attainment Percentage beginning in 2008. Generally, it is the ratio of plan assets, reduced by any credit balance, to the plan's Funding Target. See the discussion under Credit Balances for a more complete discussion of when the assets are reduced by the credit balance. Limitations on Lump Sums and Benefits: If the Funding Target Attainment Percentage is less than 80%, the plan cannot increase benefits unless the increase is funded immediately. (However, benefits that are not pay-related (such as X dollars per year of service) may be increased if the rate of increase does not exceed the rate of increase in the average pay of participants covered by the amendment.) If the Funding Target Attainment Percentage is between 60% and 80%, there is a restriction on payment of lump sums. If the Funding Target Attainment Percentage is less than 60%, there can be no lump sum payments, benefits must be frozen, and plant shutdown benefits are not permitted. These rules are generally effective in 2008 with a delayed effective date for collectively bargained plans. Participant Disclosure: Effective in 2008, an annual funding notice will be required for all plans. Also effective in 2008, plans with a Funding Target Attainment Percentage less than 80% must make a "4010 filing" with the PBGC. Beginning in 2007 (with a delayed effective date for collectively bargained plans), plans must either provide a benefit statement to each participant every three years or a notice once every year to participants of the availability of a benefit statement and how to obtain one. At-Risk Plans: Plans with more than 500 participants that are determined to be "at-risk" have a higher Funding Target and higher normal cost. (All defined benefit plans maintained by the same employer, or any member of the employer's controlled group, are treated as one plan for purposes of determining if there are more than 500 participants.) A plan is considered at-risk if its Funding Target Attainment Percentage is a) less than 80% using standard assumptions and b) less than 70% assuming all participants within 10 years of retirement retire at the earliest possible time and that all employees elect the most valuable form of payment. Credit balances will be subtracted from the assets for purposes of this test. In addition, plans that have been at-risk two out of the last four years will have the Funding Target and normal cost increased 4% (using standard assumptions), and a $700 expense load per participant will also apply. The additional contributions Page 2
due to at-risk status are phased in over the first five years the plan is at-risk. The 80% test is phased in, using 65% in 2008, 70% in 2009, 75% in 2010, and 80% in 2011. As a result of this change, we will be talking to our clients with more than 500 participants about strategies to avoid at-risk status. Deduction Limit for Defined Benefit Plans: For 2006 and 2007, the deductible limit has been changed to 150% of Current Liability less assets, and the prior deductible limit based on a lower interest rate no longer applies. Beginning in 2008, the limit has been increased to a) the normal cost for the year, plus b) 150% of the Funding Target, plus c) an allowance for future pay or benefit increases, less d) plan assets. Deduction Limit for Combined Defined Benefit Plans and Defined Contribution Plans: For tax years beginning in 2006 and 2007, only employer contributions to the defined contribution plan in excess of 6% of compensation are counted toward the deduction limit. For tax years beginning in 2008, most defined benefit plans are no longer required to be aggregated with defined contribution plans for purposes of determining the deduction limit. However, defined benefit plans that are not covered by the PBGC (for example, plans maintained by professional corporations that have never had more than 25 participants) continue to be aggregated with defined contribution plans for purposes of the deduction limit, and only employer contributions to the defined contribution plan in excess of 6% of compensation will be counted toward the limit. This change only affects the limit on how much of the contribution can be deducted. It is important to note that the 415 limit on contributions to a defined contribution plan (e.g., $44,000 for 2006) and the 415 limit on benefits payable from a defined benefit plan (e.g., $175,000 for 2006) continue to apply. Lump Sums: Lump sums will be calculated using the three-segment yield curve (described above) but averaged over one month (rather than 24). This change will phase in over 5 years, starting in 2008. In general, we anticipate that this change will reduce lump sums. Hybrid Plans: Cash balance plans and pension equity plans are considered "hybrid plans." Hybrid plans are not agediscriminatory after June 29, 2005 if the following requirements are satisfied: a) benefits must be fully vested after three years of service, b) interest credits cannot exceed a market rate of return, and c) a participant's accrued benefit cannot be less than the accrued benefit of any similarly situated younger employee. For plans in existence on June 29, 2005, it appears that the vesting and interest credit requirements will not take effect until plan years beginning after 2007. The "whipsaw" problem is eliminated for distributions after August 17, 2006, by allowing the lump sum distribution from a cash balance plan to equal the hypothetical account balance and by allowing the lump sum distribution from a pension equity plan to equal the accumulated percentage of final average pay. Wearaway is prohibited for a defined benefit plan that converts to a hybrid plan after June 29, 2005. That means that an employee's benefit under the hybrid plan cannot be less than the sum of a) the employee's benefit under the defined benefit plan formula as of the date of conversion (including any subsidized early retirement benefit the participant has earned) plus b) the employee's hybrid plan benefit based on service after the conversion. It appears that the resolution of any age-discrimination, whipsaw and wearaway issues prior to June 29, 2005, has been left to the courts. PBGC Premiums: Prior to the PPA, in addition to the flat-rate premium, certain single-employer plans also had to pay a variable rate premium of $9 per $1,000 of unfunded vested current liability. Plans that contributed at least the full funding limit for the prior year were exempt from the variable rate premium. Beginning in 2008, the full funding limitation and the resulting exemption no longer apply. The value of vested benefits will be determined using the segmented yield curve for the month before the plan year begins, not a 24-month average. A cap on the variable rate premium has been added effective for plan years beginning in 2007 for employers with 25 or fewer employees. Phased Retirement: Effective in 2007, plans can be amended to allow participants who have attained age 62 and are still employed to commence their retirement benefit. Page 3
Multiemployer Defined Benefit Plans Certain funding benchmarks have been established to determine if a plan is "endangered" or "critical." The plan's actuary will have to file annual certifications with the IRS during the first 90 days of the plan year indicating whether the plan is endangered or critical. An endangered or critical plan will have to adopt an approach to improve the funding (reductions in future benefits, additional contributions, or both) that is anticipated to improve the funding status. There is a new 15-year amortization schedule for "regular" funding standard account bases (e.g., initial unfunded, plan amendments, assumption changes, and gains and losses) established after 2007. There is an exception for plan amendments that pay increased benefits over shorter periods. Multiemployer plans will now have to use valuation assumptions that are "individually reasonable" rather than "reasonable in the aggregate." The maximum deductible contribution cannot be less than 140% of current liability minus the actuarial value of plan assets. An interest rate within 90-105% of the 4-year weighted-average 30-year Treasury rate will be used to determine current liability. Defined Contribution Plans EGTRRA Permanency: As hoped, the new law makes permanent the changes made in 2001 under the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) that were scheduled to sunset in 2010. Some examples of EGTRRA provisions that are now permanent include annual "catch-up" contributions for participants age 50 and older ($5,000 for 2006), allowing rollovers between different types of plans (403(b) plans to 401(k) plans for example), increased annual dollar limits for individual contributions ($15,000 for 2006), increased annual compensation limits ($220,000 for 2006); higher limits for annual additions to plans ($44,000 per participant in 2006), Roth contributions, and simplified top-heavy rules. Vesting: The PPA accelerates the time period for a participant to fully vest in employer contributions held in a defined contribution plan. Beginning in 2007, employer contributions must vest using a 3-year cliff vesting schedule (eliminating the 5-year cliff schedule) or a 2 to 6 year graded schedule (eliminating the 3 to 7 year graded schedule). There is a later effective date for collectively bargained plans. An exception to the vesting rule applies for Employee Stock Ownership Plans that have a current outstanding loan. Automatic Enrollment: The PPA provides guidance on automatic enrollment, including safe harbor provisions which will allow a 401(k) plan to add automatic enrollment and meet the nondiscrimination rules at the same time. The new rules allow employers to include automatic enrollment provisions in their plans even if state laws require employees to actively elect any deductions from their pay. The automatic enrollment rules are designed to encourage employees to defer some of their own money for retirement by permitting employers to require employees to contribute to the company's 401(k) plan at a deferral rate set by the employer unless the employee actively elects not to defer or elects another percentage. The PPA contains rules regarding distribution of contributions that were "erroneous contributions" (contributions that were made under an automatic enrollment provision that an employee says were made erroneously). A participant would have to elect to reduce or eliminate the automatic election within 90 days after the first payroll that included automatic enrollment contributions. Beginning in 2008, plans that comply with the automatic enrollment safe harbor will be able to avoid ADP/ACP testing, and they will be exempt from the top-heavy rules. The safe harbor automatic enrollment provisions require that an employer must make one of the following contributions to non-highly compensated participants: a) a match equal to 100% of the first 1% of deferrals and 50% of the next 5% deferred (resulting in a 3½ % match for a participant who contributes 6%) or b) a 3% profit sharing contribution. The automatic deferral applies to any employee who becomes a Page 4
participant after the automatic enrollment rules are adopted. In a plan that is already in existence, the arrangement would not have to apply to employees who are already participating in the employer's plan (or who have opted not to participate). To qualify for the safe harbor, employer contributions must be fully vested after two years of service. The automatic deferral rate cannot exceed 10%, and must be at least 3% in the employee's first year of participation, at least 4% in the second year of participation, at least 5% in the third year of participation, and at least 6% in subsequent years. Also, a notice to participants regarding the safe-harbor contribution will be required each year. Investment Advice and Default Investments: A special exemption from the prohibited transaction rules has been carved out to permit fiduciary advisors to recommend their own funds beginning in 2007. To qualify for the exemption the advisor's fees must not change depending on the investment option selected or the investment advice must be based on an independently certified, unbiased computer model. Under the PPA, plan sponsors can offer default investments as long as participants have sufficient advance notice and the assets are invested pursuant to Department of Labor guidelines (these guidelines are not yet published by the "DOL"). Gap Period Income: The 401(k) regulations that became effective earlier in 2006 require the calculation of "gap period income" (a calculation of income from the end of the year for which the contributions were made to the date of distribution) on refunds after a testing failure. The PPA eliminates this requirement by stating that income only needs to be calculated through the end of the year for which contributions were made. This change is effective for plan years beginning in 2008. Plans Investing In Employer Stock: Defined contribution plans that allow investment of employee and employer contributions in employer stock and whose stock is publicly traded must allow participants to diversify their investments. This requirement does not apply to an ESOP unless it has a 401(k) feature. All participants will be allowed to diversify their employee contributions in 2007. Participants with at least three years of vesting service will be allowed to diversify their employer contributions over a three-year period (33% in year one, 66% in year two, and 100% in year three). Employees who are at least age 55 with 3 years of service will not be subject to the phase-in rules and will be able to diversify all of their contributions beginning in 2007. There is a delayed effective date for collectively bargained plans. Missing Participants: The PBGC's program for "missing participants" will now be available for missing participants from defined contribution plans. This program will be available to defined contribution plans on a voluntary basis and will be effective after final regulations are issued. Benefit Statements: Participant benefit statements will have to be furnished once each quarter in a plan that allows participants to direct investments and once each calendar year in other defined contribution plans. The statements must include total account balance, vested account balance, the value of each investment, and an explanation of integration or floor-offset, if applicable. In a plan with directed investments, the statement must also include an explanation of any limitations or restrictions on any right to direct investment and a notice that investments may not be adequately diversified if the value of any investment in the account exceeds 20% of the total account balance. The statute permits delivery in written or electronic form to the extent electronic delivery is reasonably accessible to the participant. The DOL will issue a model benefit statement. This requirement is generally effective for plan years beginning in 2007, with a later effective date for collectively bargained plans. Defined Benefit Plans with 401(k) Provisions (DB(k)): The PPA permits a new type of plan, which will combine a defined benefit plan (which focuses on providing a monthly dollar amount of benefit at retirement determined under a benefit formula) with a 401(k) plan (which focuses on accumulating an account balance from employee contributions). The defined benefit portion will have to provide either a 1% final average pay formula for up to 20 years of service or a cash balance formula that increases with the participant's age. The 401(k) portion will have to include the automatic Page 5
enrollment feature and will have to provide a fully-vested match of 50% on the first 4% of deferrals. Other employer contributions will also be permitted. Full vesting will be required on the defined benefit portion and on any other employer contributions after no more than three years of service. The DB(k) only applies to employers with 500 or fewer employees. This provision is not effective until 2010. Other Items to Watch: o New rules will be issued by the DOL regarding spousal protection under Qualified Domestic Relations Orders. o Small plans (with 25 or fewer participants) will be able to use a simplified 5500 format for 2007 and later plan years. o The bonding limit for plans holding employer securities will be increased to $1,000,000 (from $500,000). o New rules will relieve plan sponsors of some fiduciary responsibility under 404(c) of ERISA during a blackout period, provided mapping procedures are followed. o The PPA permits hardship withdrawals by the beneficiary of a participant. (The beneficiary does not have to be the participant's spouse or dependent.) o The 10% early withdrawal penalty will not apply to certain distributions to qualified reservists called to active duty after September 11, 2001, and before December 31, 2007. o All government plans will be exempt from nondiscrimination testing (currently only state and local government plans are exempt). o A special rule extends an unrelated business taxable income exemption for real estate investments to retirement income accounts of church plans. UPDATE ON NEW ACCOUNTING RULES FOR DEFINED BENEFIT PLANS The Financial Accounting Standards Board (FASB) has proposed significant changes to the accounting rules for benefit plans under Statements 87/88/106/132R. The FASB Board has completed a process of receiving public comments on the changes. On July 27 th, the FASB tentatively adopted the changes effective for fiscal years ending on or after December 15, 2006. However, the FASB is still deliberating over the exact form of the final rules. It is anticipated that the FASB will issue a final statement by September 30, 2006. For nonpublic companies the effective date is for fiscal years ending on or after June 15, 2007. The provision requiring the measurement date to align with the fiscal year end will be effective for fiscal years ending on or after December 15, 2008. There are many changes in the new accounting rules that may affect you if you have a GAAP financial statement. McCready and Keene recommends that you contact your accountant to determine how the new rules will affect you. Several weeks ago, McCready and Keene sent a letter describing the many proposed rule changes to our clients who may be impacted. Please contact your McCready and Keene consultant if you would like a copy of this letter. If you have questions or would like additional information about the items presented in this newsletter, call your McCready and Keene consultant. Employee Benefit News is not intended as legal advice. Readers should seek legal advice before acting on any of these subjects. Page 6