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Sweeping New Pension Law to Impact Employers

September 3, 2006

by Employment & Labor Law / Employee Benefits Group
Stinson Morrison Hecker LLP
Copyright © 2006

The Pension Protection Act of 2006 – proclaimed as "the most sweeping reform of America’s pension laws in over 30 years" – was passed by Congress and signed into law by President Bush on August 17, 2006. The massive (906 page) Act made sweeping changes to defined benefit pension plan funding rules, most of which are not effective until 2008, and other changes to both defined benefit pension plans and defined contribution plans. Some of the changes in this landmark legislation are as follows:

Pension Plan Funding Rules

• The goal of the new funding rules for single employer pension plans is to require that employer contributions be made to a target of 100% funding of current liabilities in seven years.

• The actuarial methodology is prescribed in the new rules.

• The methodology for determining the assumed interest rates is also prescribed in the new rules. The assumed interest rates are based on a corporate bond yield curve, not the interest rate on 30-year treasury bonds.

• The smoothing of the assumed interest rate and plan assets must be over no more than 2 years (rather than up to 5 years).

• Generally, prior years contributions in excess of the then minimum required funding cannot be used to satisfy the new minimum funding requirements.

• Single employer plans that are less than 80% funded will not be allowed to make benefit improvements or accelerate vesting and, in some cases, may only be able to make lump sum payments equal to 50% of the amount otherwise payable.

• Single employer pension plans that are less than 60% funded will be required to freeze benefit accruals and cannot pay any benefits in a lump sum.

• Complex transition rules over three years (2008-2010) are provided.

• Each year multi-employer plan trustees will be required to forecast liabilities over the next seven years. If the pension plan's funded status is "endangered" (generally because the plan is less than 80% funded) the plan trustees must adopt a "funding improvement plan". If a multi-employer pension plan's funded status is "critical" (generally, because the plan is less than 60% funded), the trustees must adopt a "rehabilitation plan", which could require the trustees reduce benefits that are not in pay status, such as subsidized early retirement benefits.

• The above described changes will become effective in 2008.

• These changes will result in higher, more volatile minimum required contributions to underfunded pension plans.

Cash Balance and Other Hybrid Pension Plan Changes

• Cash balance plans are defined benefit plans that provide benefits based on pay credits and interest credits to a notional account. Other hybrid pension plans are defined benefit plans with plan design features that look like a defined contribution plan, such as a pension equity plan.

• The Act provides, that cash balance and other hybrid pension plans do not violate age discrimination laws under ERISA, the IRC and ADEA. This is consistent with the decision of the Seventh U.S. Circuit Court of Appeals in Cooper v. IBM Personal Pension Plan (August 7, 2006). The combination of these two positive recent developments should give sponsors of cash balance and other hybrid pension plans some comfort. The disappointing news for cash balance plan sponsors is that the new legislation is prospective only (i.e., for periods after June 29, 2005) and cannot provide any inference regarding prior law (or be considered in current cash balance class action lawsuits).

• Under the Act, cash balance plans must:

1. beginning in 2008, provide full vesting in three years; and
2. treat the plan's notional account balance as the participant's accrued benefit for lump sum benefit payment purposes (rather than discounting the plan's accrued normal retirement benefit to a present value), provided the plan's interest credit is at a rate that is within an IRS prescribed "market rate" corridor. This change is effective for distributions after August 17, 2006, the date of enactment.

• Furthermore, new cash balance plans that are converted from traditional defined benefit plans after June 29, 2005 must (i) have opening cash balance accounts that are equal to the total accrued benefit at conversion, (ii) with no wear away (i.e., be based on a "present value of the accrued benefit at conversion, plus future pay credits and interest credits approach", which will result in no gaps in the continuity of benefit accruals) and (iii) include the value of any early retirement subsidy under the prior traditional defined benefit plan in the early retirement benefit payments from the cash balance plan.

Other Defined Benefit Plan Changes

• A "phased retirement" provision permitting in-service distributions after age 62; and

• The addition of a qualified joint and 75% survivor annuity ("QJSA") optional form of payment.

• These changes will be effective in 2007.

Defined Contribution Plans

The Act:

• Requires, beginning in 2007, the vesting of all employer contributions, (not just matching contributions), to be either: (a) 100% cliff vesting after three years; or six year graded vesting (shown below).

1. Years of Service - Vested Percentage
2. Less than 2 years - None
3. 2 years - 20%
4. 3 years - 40%
5. 4 years - 60%
6. 5 years - 80%
7. 6 years or more - 100%

• Provides that fiduciary relief under ERISA § 404© will only be available if default investments satisfy criteria to be established by the U.S. Department of Labor. This is expected to provide fiduciary protection for default investments in balanced funds, risk tolerance asset allocation funds and target retirement age asset allocation funds.

• Encourages automatic enrollment by amending ERISA to preempt state wage withholding laws.

• Establishes an automatic enrollment 401(k) safe harbor for 2008 and later years, based on current rules, provided the minimum automatic elective deferral is initially at least 3% of pay and automatically increases annually in 1% increments to at least 6% of pay (after 4 years). Automatic increases in elective deferrals cannot rise to a level of more than 10% of pay. (Eligible employees can, of course, cancel, either an automatic enrollment or an automatic increase in deferrals). The safe harbor eliminates the ADP/ACP nondiscrimination testing requirements. Other current law 401(k) safe harbor requirements will continue to apply.

• Requires defined contribution plans holding publicly traded employer securities give participants a right to diversify into at least three other investment options (with materially different risk and return characteristics). These diversification rights must be immediate for elective deferrals or after-tax employee contributions and must be provided after three years for employer contributions. This change is effective beginning in 2007 and includes a 30-day advance participant notice requirement (i.e., by December 1, 2006 for a calendar year plan.). Failure to provide this required notice can subject the plan administrator to a $100 per day, per plan, penalty.

Other Changes

The Act also:

• Allows non-spouse beneficiaries to rollover (an otherwise eligible) distribution from a qualified retirement plan to an individual retirement account, beginning with distributions, made in 2007.

• Limits an employer's exclusion from income for death benefits paid to the employer under a corporate owned life insurance policy to the amount of premiums and other amounts paid by the employer for the contract, unless certain prescribed conditions are satisfied.

• Makes the tax savings provisions in the Economic Growth Tax Relief and Reconciliation Act of 2001 ("EGTRRA") permanent, such as 401(k) catch-up contributions, Roth 401(k) contributions and 529 college tuition savings plans.

Bottom Line - Most of the changes made by the new law do not take effect until 2008. In the interim, employers will need to review their existing plans – particularly their funding obligations – as well as their plan design, and make appropriate changes.

Stinson Morrison Hecker LLP is one of the country's largest law firms with more than 335 attorneys in more than 45-industry-focused areas. If you would like more information regarding this summary, please contact one of our Employment & Labor Law and Employee Benefits attorneys.

Law at Work is designed to give general information and is not intended to be a comprehensive summary or to treat exhaustively the subjects and matters covered. The information appearing herein does not constitute legal advice or opinions. Such advice and opinions are provided only upon engagement with respect to specific factual situations. Nothing contained herein shall be considered as an admission in any matter or controversy.

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