The Pension Protection Act of 2006
Why is it important and what does it mean for businesses?
By Al Schwartz
The Pension Protection Act (PPA) of 2006 that was signed into law by President Bush in August is intended to provide U.S. workers with greater assurance that pension funds would be available when they reached retirement age. The PPA made changes to both traditional defined benefit plans and defined contribution plans. In a defined benefit (pension) plan, the employer provides a specific monthly benefit to workers during retirement. A defined contribution plan, such as a 401(k), is an employer-sponsored retirement plan that allows employees to set aside tax-deferred money in an individual account that is sometimes matched by the employer and affected by outside factors such as income, loss, expenses and gains.
During the recent stock market decline, companies that offered defined benefit plans and invested these retirement funds in the market experienced drastic shortfalls and may have terminated their plans. In many circumstances when these under-funded plans terminated, the Pension Benefit Guaranty Corp. (PBGC) had to assume responsibility to make payments to plan participants.
As corporate America grew, businesses began to depend less on these traditional types of plans and more on defined contribution plans. While 401(k) plans typically provide participants with greater flexibility, they come at the cost of the participant funding part of their own retirement. Because both types of plans are less than ideal for supporting retirement funding, Congress began looking at the programs and recently enacted The Pension Protection Act of 2006.
Defined benefit plan funding changes
The new law has many complex rules regarding the funding of defined benefit plans. The interest rate assumption used by the plan actuary is based upon a yield curve and the number of years left before benefits are to be paid to the participant. If the ratio of plan assets to plan liabilities is less than 100 percent, a plan funding shortfall exists and must be funded over a period of seven years. Special rules are in place for plans that are deemed to be at risk. Any plan that is less than 80 percent funded will be considered "at risk" under the new Act.
In addition, plans with over 500 participants will have special rules for minimum contributions and PBGC requirements for reporting. Many small employers try to increase the amount of their tax deductions in order to reduce their taxes; therefore, many of these under-funding issues will affect primarily larger plans.
Because the funding rules are being changed to facilitate faster and greater funding, tax deduction rules will also change. While these new rules generally begin in 2008, the deduction limits are also being increased for 2006 and 2007. These rules are complex, and it is best to discuss them with the plan’s enrolled actuary to ensure that all of the regulations are followed. In order to strengthen the current funding status of a plan, plans that are less than 80 percent funded will have restrictions regarding amendments to increase employee payout benefits upon retirement. Plans that are 60-80 percent funded will have restrictions on paying out benefits in the form of a lump sum. Plans that are less than 60 percent funded will face additional restrictions.
Defined contribution plan changes - 401(k) plans
To encourage more employees to contribute to 401(k) plans, the law has several provisions regarding enrollment, contribution levels and investment advice. In a traditional 401(k) plan, employees decide to contribute to the plan and complete an enrollment form authorizing the employer to reduce their pay and to have that amount contributed to the plan. In effect, the employee is "opting into" the plan. The new law confirms that plans can be an "automatic enrollment plan" in which the employee is automatically enrolled into the plan without consent, and must "opt out." Certain state laws were in conflict with this approach, and the new federal law eliminates these conflicts.
Sponsors of automatic enrollment plans can opt not to do certain non-discrimination tests that are designed to prevent discrimination in favor of highly compensated employees if they are willing to make mandatory matching contributions and provide specified 401(k) deferral rates. A Safe Harbor automatic enrollment plan, for example, would require the employees to contribute 3 percent of pay in their first year of participation, 4 percent in their second year, 5 percent in their third year and 6 percent thereafter. A matching contribution would be required equal to 100 percent of the first 1 percent of pay contributed by the employees and 50 percent of the next 5 percent they contribute. Sponsors do not have to offer automatic enrollment, but if they do, and the participant does not designate investment selections, the employer must invest the contributions in a default fund in accordance with Department of Labor regulations.
Changes in financial
management advice
One of the benefits of 401(k) plans is that they allow participants to make investment decisions by offering various funds to choose from in which to invest their money. Each participant is allowed to make individual elections that meet their particular needs. These decisions are based upon factors such as age, lifestyle and risk tolerance. Over the years, investment providers have offered calculators, risk tolerance questionnaires and projection scenarios to assist the employee in making decisions without giving specific investment advice. However, plan sponsors, employees and investment providers all agreed that the employees need more professional advice. The PPA allows investment professionals who service the plan to offer investment advice without violating any rules. In order to assure that recommendations are not based upon the amount of compensation the advisor receives, the advisor will have fee-neutral arrangements or use strictly monitored and designed computer programs to assist in their recommendations. There will also be certain disclosure requirements that will go along with these services.
Distribution rules
Currently, employees who take distributions from plans cannot roll them directly into a Roth IRA. They must first rollover to a regular IRA, and then convert the regular IRA into a Roth. Beginning in 2008 they will be able to do the conversion directly into the Roth IRA.
Under current rules, only spousal beneficiaries can rollover into an IRA. Beginning in 2007, non-spousal beneficiaries will also have the ability to rollover into an IRA.
Options for smaller businesses
Defined benefit plans usually do not have provisions that allow employees to contribute to them. Beginning in 2010, the PPA will provide employers with the option of combining a defined benefit plan and a 401(k) plan and offering employees the opportunity to contribute to their defined benefit plan based on a percentage of compensation similar to 401(k) plans, but the new plan must have less than 500 employees. There will be specific contribution, vesting and matching requirements for these hybrid plans.
Who will benefit most
from the new law?
Regardless of the size or financial status of a company, the new law was created to protect employees. By tightening the rules about how employers fund their defined benefit plans, encouraging enrollment in 401(k) plans and providing employees with the opportunity to make better decisions regarding investment choices, the law provides the foundation for improved retirement planning. As the years pass, we will be able to better evaluate if the PPA has helped employees. In the meantime, whether you are an employer or employee, it is wise to get the advice of a plan service provider or investment advisor to ensure that all rules are followed properly.
Alan J. Schwartz is the director of CCR’s Retirement Planning Group, which assists employees and businesses with retirement plans including pension, profit-sharing, defined benefit and 401(k) programs. The group of 16 professionals currently manages over 800 retirement plans for many industries. Alan Schwartz can be reached at 860-781-6769.
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