Some of the new pension and 401(k) plan opportunities enacted in 2006 under the Pension Protection Act (PPA) are not immediately available for current planning.  However, one significant PPA change to the deduction limits for a combination defined benefit/defined contribution plan was first effective in 2006 and offers larger tax deductions in 2007. This new statute opens the door to a more widespread use of two retirement plans for small and medium size employers with multiple owners.

Prior to the PPA, an employer with a defined benefit plan (DB) and a defined contribution plan (DC) covering at least one participant common to each plan generally could not deduct more than 25% of the total participant compensation if any employer contributions were made to the DC plan (typically a 401(k) plan). Nondeductible contributions were subject to a 10% excise tax. This limitation often discouraged the combined use of a 401(k) and defined benefit pension plan when total expected contributions were close to the combined deduction limit. This limitation affected many small employers looking for larger contributions than $44,000 per owner. This limitation can now be largely avoided with the PPA law change.

According to the explanation prepared by the Joint Committee on Taxation, the overall limitation applies to contributions to DC plans “only to the extent that such contributions exceed six % of compensation otherwise paid or accrued during the taxable year” [to participants].  Under the PPA law changes, the 25% limitation does not apply as long as the DC plan only contains a profit sharing contribution of 6% of pay and 401(k) salary deferrals. This means that a plan sponsor with a DB plan (e.g., a cash balance plan) could also have a safe harbor 401(k) plan with a total contribution of no more than 6% of compensation and then the full DC and DB contribution is deductible, regardless of the amount of the contribution to the cash balance plan.

This larger plan deduction limit allows new plan design options. One possibility is a safe harbor 401(k) plan with a 3% nonelective contribution and 3% profit sharing contribution. For most employers who are currently maximizing an owner’s contribution under a cross-tested 401(k) plan, they can reduce the profit sharing contribution and maximize their funding under a defined benefit pension plan. This design could be a significant benefit for many professional service employees.

Note, the PPA adds another wrinkle for plan years beginning after December 31, 2007.  Under that change, contributions to a single-employer defined benefit plan covered by the PBGC are never subject to the 25% of pay deduction limit. Under current rules, many planners try to avoid PBGC coverage for small DB plans, but this new provision could tip the scales toward being PBGC covered.

The massive Pension Protection Act scatters the effective dates of the provisions over several years.  In part, this was done to meet certain budgetary projections required by Congress on the effect of the provision. Many provisions have received public attention, even though they will not be available to plan sponsors for several years.  On the other hand, some less publicized provisions are effective in 2007 and require immediate attention of plan sponsors.

One of the most significant provisions effective in 2007 is a new notice to participants of defined contribution plans sponsored by publicly-traded companies that hold employer securities. These plans are required to give participants the right to diversify out of company stock held in their plan accounts.  This diversification requirement is part of the PPA and is  effective for plan years beginning after December 31, 2006, although there are special effective dates for collectively bargained plans with employer stock. These rules do not apply to ESOPs holding publicly traded securities if (1) there are no contributions to the plan (or earnings thereunder) held within the plan and subject to Code §401(k) or (m), and (2) the plan is a separate plan for purposes of Code §414(l) with respect to any other defined benefit plan or defined contribution plan maintained by the same employer or employers.  

In addition, the PPA added ERISA § 101(m), requiring the plan sponsor to inform participants of this right to diversify out of employer stock for these plans no later than 30 days before participants are eligible to make the diversification election. For a calendar-year plan, the notice is due by December 2, 2006. Note that this due date precedes the date in PPA to issue a model notice which is not due until February 13, 2007.

The diversification notice to be given to participants must include a description of the importance of diversifying participants’ accounts.  The PPA provides special rules for eligibility to diversify assets in 401(k) deferral accounts and assets in profit-sharing and matching accounts.  The plan must allow immediate diversification of elective deferrals and after-tax contributions that are held in employer securities but may require a participant to complete at least three years of service before granting diversification rights regarding the investment of nonelective employer and matching contributions.  Note also that existing plans with employer stock subject to the new rule may phase in the diversification election over three years beginning in 2007. According to the Technical Explanation issued by the Joint Committee on Taxation, if a participant is eligible for different diversification rights at different times, then “separate notices are required.”

Another PPA notice requirement effective for plan years after December 31, 2006 requires quarterly statements to participants and beneficiaries in defined contribution plans who have the right to direct the investment of assets in their plan accounts.  This participant statement must identify (1) the total benefits accrued, (2) the vested accrued benefit or the earliest date on which the participant’s accrued benefit will become vested, and (3) an explanation of any permitted disparity or floor-offset arrangement that may apply in determining the accrued benefit. 

Other defined contribution plans that do not have participant directed investments must provide this statement at least annually to participants and beneficiaries who have their own accounts under the plan.  In addition, the plan sponsor must provide this statement to other beneficiaries upon written request, but these beneficiaries are limited to one request per year.  Prior law only required a participant statement when it was requested. Sponsors of defined benefit plans must provide this statement at least once every three years to participants who have a vested benefit and are still employed by the plan sponsor.

One of the more difficult issues relating to the COLA changes applicable to qualified plan limitations is applying the new limits to a non-calendar year plan. The chart below identifies the key limitations for 2007 and how they apply to a calendar and fiscal plan year.

This time of year, many employees review their accrued vacation/sick pay, because some leave plans forfeit unused leave exceeding a specified limit (e.g., two weeks) at the end of the calendar year. That means you either “use it or lose it.” In industries that require staff to be available during the holiday season (e.g., the plan administration business) and that limit the amount of unused pay that may be carried over, here’s a way to keep those employees at work and to provide an attractive benefit: Contribute the value of the forfeitable leave to your 401(k) or profit sharing plan.

Such a contribution, if properly structured, is not taxable to the employee, nor is it subject to FICA and other payroll taxes. This tax benefit is available as long as the employee cannot elect to receive the unused pay as a taxable benefit or cash. Then, the contribution by the employer to the plan isn’t a salary deferral; it’s merely an additional profit sharing contribution. This taxation was discussed in a 1996 Technical Advice Memorandum (TAM 9635002) where the Service noted that such a program enabled “employees…to earn [profit sharing] contributions by working additional weeks.”

The plan in the TAM gave the employee the right to elect to have any vacation pay in excess of two weeks applied in one of three ways: (1) take the vacation, (2) forfeit it, or (3) have the value of the excess leave contributed to the plan as an additional employer contribution. The TAM states that taxation did not arise to the employee under IRC §401(k) or §451, nor was it subject to payroll taxes under IRC §3121(a)(5)(A).  Of course, any profit sharing contribution of this type would need to satisfy nondiscrimination and coverage testing.

According to media reports, the law firm of Schlichter, Bogard & Denton has filed a wave of lawsuits against large 401(k) plans alleging improper conduct regarding 401(k) plan fees.  This firm is known for representing plaintiffs in class action lawsuits regarding a variety of matters.  The complaints in these cases have been described as “cookie-cutter” documents because their language is very similar.  They reportedly name the employer sponsoring the 401(k) plan as the defendant and sometimes also name plan fiduciary committees and various individual members of these committees.  The suits allege various breaches of fiduciary duties and prohibited transactions regarding investment-related fees paid by 401(k) plans, including revenue-sharing arrangements between the plans and service providers.  In some of the cases, the plaintiffs also allege that the plan suffered losses from improper fee arrangements and the holding of excess cash in company stock funds.

In a related development, the law firm of Keller Rohrback has a posting on its website, www.erisafraud.com, stating that is currently investigating companies that serve as “investment providers” for 401(k) plans and the company fiduciaries that retain them.  The posting states that the investigation is trying to determine whether these companies “have breached their fiduciary duties under ERISA by, among other things, causing 401(k) plans to incur excessive management and administration fees or entering into improper fee sharing arrangements with mutual fund companies that are selected by them.”  The posting asserts that “these abuses” can be difficult to detect in part due to the information plan participants receive but “can cost plans millions of dollars and substantially reduce the retirement savings” of plan participants.  Finally, the posting urges the reader to contact the law firm if he or she is “concerned” about a 401(k) plan or would like more information about the firm’s “401(k) Excessive and Improper Fee Investigation.”

I believe that these developments grow out of the recent publicity regarding the size and scope of the various fees plans have been paying from plan assets.  It was perhaps inevitable that the plaintiffs’ bar would sniff out another opportunity to pursue litigation against larger companies.  These lawsuits and investigations will surely trouble larger plan sponsors and the many companies providing services to those plans.  Time will tell whether these actions will be a temporary inconvenience for 401(k) plan sponsors or will result in a permanent setback to the decades-long growth of these plans.