Note: With this issue, we begin quarterly commentary on the Pension Protection Act of 2006 (PPA). This issue’s entries offer a brief overview of the PPA, automatic enrollments, how the new law aims to enhance savings, and the benefits of cash balance plans.

A saver couldn’t have asked for better legislation than the Pension Protection Act that was signed into law on August 17, 2006. It will take tax professionals several months to ferret through all of the legislation and how it will help save for retirement. It is filled with many minor law changes designed to appeal to a variety of special interests. It is not surprising it passed 93 to 3 in the Senate and 270 to 131 in the House.

Probably one of the more significant changes that will immediately impact many is the provision allowing non-spousal beneficiaries to “roll over” death benefit distributions from qualified retirement plans, governmental § 457 plans, and tax-sheltered annuities to IRAs. This will be a significant benefit to participants with no spouses, including children and non-spousal domestic partners. Under this law change, a surviving non-spouse beneficiary will be able to transfer the deceased participant’s retirement funds into an individual retirement account where distributions can be stretched over the beneficiary’s lifetime. This rollover will also apply to certain trusts that are named as a plan beneficiary. The transfer must be done as a direct rollover (trustee-to-trustee transfer) from the plan to an “inherited-IRA.”

The Act also added non-spousal beneficiaries to dependents for events that can trigger a hardship distribution in a 401(k) plan. Under this change, a participant in a 401(k) plan may now request a hardship distribution arising from a medical or financial emergency of the participant, a dependent, and a non-spousal partner who is a plan beneficiary. The latter includes brothers, sisters, parents, or an adult child.

Another provision allows employees who participated in a 401(k) plan of a now bankrupt employer whose officers were convicted of fraud to make additional IRA contributions if that employer matched at 50 percent an employee’s salary deferrals with employer stock. Then, an additional $3,000 for 4 years may be contributed. Without naming Enron or WorldCom, participants in these plans will benefit from this provision. In addition, there is a special provision for reservists who withdrew funds from an employer’s retirement plan or IRA that were subject to income tax—and the 10 percent additional income tax if pre-age 59½. The reservist meeting the statutes provision can get an immediate refund of the 10 percent additional tax, if paid. A reservist can also “recontribute” that withdrawal and recover all taxes paid. This provision applies to individuals ordered or called to active duty after September 11, 2001, and before December 31, 2007. Such an individual is given a two-year period for making recontributions of the distributed amount from the date of enactment of the law. All of this, and we haven’t even mentioned the defined benefit provisions. Small employers implementing new defined benefit plans and the airline industry’s plans will benefit.

Another new provision entitles fiduciaries to the protections of ERISA § 404(c) in transactions where participant accounts are “mapped” over to new default investment options at the time of change in investment providers as long as certain procedural rules are met. Similar default investment rules will be available for participant direct 401(k) plans with automatic enrollments.

The Pension Protection Act of 2006 has added another 401(k) safe harbor option: Qualified Automatic Enrollments (QAE). Employers implementing this feature, which is first available in 2008, will avoid certain compliance tests required of other 401(k) plans. Moreover, QAEs and automatic enrollment provisions that do not qualify as a QAE get the benefit of a delayed correction date – an additional 3 1/2 months -- for failed ADP and ACP tests.

To qualify as a QAE, the plan’s design and operation must impose minimal thresholds of automatic deferrals, a required employer contribution (match or nonelective), shortened vesting for the match, a withdrawal restriction on those employer contributions and additional employee notices. When a plan meets all of these requirements, it is treated as satisfying the ADP and ACP tests. In addition, if the plan consists solely of deferrals and employer contributions necessary to satisfy these QAE requirements, the plan is treated as a non-top-heavy plan.

Minimal automatic deferrals for QAE

A QAE must provide that unless a participant elects otherwise, the employee is treated as having made an election to salary defer at least 3 percent of his or her compensation. This requirement must apply to the first year of participation after implementation of the automatic enrollment feature. That minimum deferral increases to 4 percent during the second year; 5 percent during the third year; and 6 percent for the fourth and future years. Higher levels of automatic deferrals are permitted, but may not exceed 10 percent in any year and as long as they meet these minimums, the rate of automatic deferral that is selected must be applied uniformly to all eligible employees. If the plan is participant-directed, the deferral and employer contributions must be deposited in a default investment under regulations to be released by the DOL.

The automatic deferral must apply to any eligible participant who has not made a formal election to either defer or not to defer by the date the plan implements the feature. Thus, it appears that a plan must also apply an automatic enrollment election to current participants with no deferral election under rules that will be established by future regulations.

Matching or nonelective contributions for QAE

A QAE must provide either a minimal employer matching contribution, as defined below, or a nonelective contribution of at least 3 percent of each eligible non-highly compensated (NHC) employee’s compensation. A plan using the QAE matching contribution must comply with two additional requirements. First, the employer will match dollar-for-dollar the first 1 percent of pay that the employee defers and 50 percent of all additional deferrals of up to 6 percent of compensation. Second, the rate of match with respect to any elective deferrals of a highly compensated (HC) participant is no greater than the rate of match for a non-HC employee. Thus, the minimal employer match for an employee making a salary deferral of at least 6 percent of pay is 3.5 percent, a slightly lower level of maximum match than is required under a match safe harbor 401(k) plan, which requires 4 percent.

A plan using a matching contribution to meet the QAE requirements will be treated as satisfying the ACP test when four requirements are met. First, the plan does not match elective or automatic deferrals in excess of 6 percent of compensation. Second, the rate of matching contribution does not increase as the rate of an employee’s deferrals increases. Third, the rate of matching contribution for any HC is no greater than the rate of matching contribution for any non-HC at the same deferral percentage. Fourth, employer contributions must vest in two years. Vesting is determined under existing rules for vesting under IRC § 411.

Withdrawal restrictions for QAE

Employer contributions made to qualify the plan as having a QAE are subject to the same withdrawal restrictions as salary deferrals (i.e., not before a distribution event or age 59 1/2). This requirement is similar to requirements for other safe harbor 401(k) plans.

Notice requirement for automatic enrollments

Automatic deferrals come with a new set of required notices. Not surprisingly, these notices must be provided to each eligible employee and be written to be understood by the employee. The notice must include an explanation of the employee’s rights and obligations under the automatic enrollment, including the employee’s right to elect not to make any elective contributions or to have deferrals made in a different amount. The notice must explain how contributions under the automatic enrollment arrangement will be invested in the absence of any investment election by the employee. Employees must receive this notice in a reasonable period of time before the first automatic deferral is processed. That time period must be of sufficient length for the employee to make an election with respect to the amount of contributions and investments of the participant’s account. Violations of the new notice requirements are subject to a penalty of $1,100 per-day. Note that other Act provisions establish new rules for operating a participant-directed plan with a default investment option.

Correcting an “erroneous” deferral under automatic enrollments

Congress anticipated that employees might postpone making a decision to revoke an automatic deferral until after the first deferral is made from their paychecks. This could result in the maintenance of small accounts, adding to the cost of administration. As a result, Congress added a new provision that will simplify the administration of the plan. A plan may distribute a salary deferral (and associated employer contributions and earnings) if the employee elects to classify the deferral as an “erroneous” contribution. An “erroneous contribution” must be distributed in the first 90 days after the date of the first automatic contribution for the employee. These distributions are treated as a payment of compensation, rather than as a contribution to the plan and then a distribution from the plan. Thus, erroneous automatic contributions are not subject to the 10 percent early withdrawal tax, nor are they taken into account in applying the ADP and ACP tests. Regulations will need to explain the full implementation of these requirements.

All 401(k) plans using automatic enrollment may apply the “erroneous” deferral distribution rules, even if the plan does meet the requirements of a QAE.

Testing delay for plans with “eligible” automatic deferrals

Beginning in 2008, any 401(k) plan with an automatic deferral—not just plans that qualify as a QAE—will be given an additional 3½ months to make a corrective distribution of an excess contribution or an excess aggregate contribution. Thus, if an excess contribution (failed ADP test) or excess aggregate contribution (failed ACP test) is distributed with allocable earnings within six months after the close of the plan year, the 10 percent penalty will not apply. In addition, excess contributions or excess aggregate contributions (and allocable income of these plans) meeting this requirement that are distributed within this 6-month period are treated as having been earned and received by the recipient in the taxable year in which the distribution is made. This feature alone could drive many employers to implement an automatic contribution in 2008 for their 401(k) plans, even if it is not a QAE.

Preemption of state labor law for all automatic enrollments

The Act amends ERISA to preempt any state labor law that would directly or indirectly prohibit an automatic contribution arrangement. Some states have laws prohibiting payroll withholding without an affirmative election by the employee. This state preemption is immediately available to any 401(k) plan with automatic enrollments, not just those arrangements meeting the requirements for a QAE. Thus, a failure to comply with all of the QAE rules does not result in a violation of a state’s labor law. The preemption is effective on the date the President signed the bill, August 17, 2006.

Over the next few months, we’ll discuss the impact of the Pension Protection Act of 2006 on 401(k) and other retirement plans. There is a much material to cover. The Act contains 160-plus separate sections that amend one or more provisions of the Tax Code, ERISA, and other federal laws.

This month we address in detail automatic enrollments (see above) that may be implemented in 2008. This change is one of several highlights of the new law, if you are not a defined benefit aficionado. The new law does appear to send a clear signal by Congress of its intent to encourage the expansion of individual and employer sponsored savings accounts.

Automatic enrollments are a sure bet to increase employee contributions to 401(k) and 403(b) plans. What readers may not know is that many employers have already implemented an automatic enrollment for their 401(k) plan. This was reported in a survey by the consulting firm, Hewitt Associates, LLC. As a sign of how this new law could increase savings by employees in 2008, that survey reported that the  participation rates in companies that switched to automatic enrollment rose from 75 percent to almost 95 percent. Remember, today about one-third of all employees with access to 401(k) plans don’t contribute to the plan. Of those that do contribute, one in five employees does not contribute enough to obtain the full match. With 401(k) plans becoming the primary source for retirement income outside of Social Security for an increasing number of working Americans, this change could have a major impact on the growth of 401(k) plans.

More savings are needed. Last year, according to one survey, the average 401(k) account balance was only about $76,000; and the median account balance was placed at $27,100.

No discussion of the new pension law would be complete without some discussion of how defined benefit pension plans will benefit from the new laws. We look at benefits for new plans this quarter.

Cash balance plans will become more common for several reasons we will discuss below. Bottom line: For many employers, the unique structure of a cash balance plan offers the best opportunity for meeting a unique need. However, the uncertain legal climate that has surrounded cash balance and other hybrid defined benefit plans discouraged many employers from implementing these plans. These same uncertainties have resulted in other employers freezing, or even terminating, their cash balance plans to limit their exposure to possible adverse regulations or participant legal actions. Many of those potential problems are gone, thanks to new legislation. For new plans that is no longer a problem.

The Pension Protection Act of 2006 (“PPA”) addresses three troubling uncertainties of hybrid defined benefit pension plans. There should be no further questions regarding the basic legality of a cash balance design, and there are now severe limits on the ability to impose a “wearaway” provision when converting a traditional plan to a cash balance plan. The Act even addresses the “whipsaw” problem that arose in calculating the lump sum benefit from a cash balance plan. It will now be easier to sell hybrid designs to employers who see no continuing benefit in maintaining their traditional defined benefit plan designs.

Legality of cash balance plans

Many legal challenges have been attached to cash balance plans, especially benefit changes involving conversions from existing defined benefit plans. The most significant was a very technical argument that the cash balance design discriminated on the basis of age. The PPA provides that a plan is not treated as violating the age discrimination rules under ERISA, the Code, or the Age Discrimination in Employment Act (“ADEA”) if one requirement is met: A participant’s accrued benefit, determined as of any date under the plan, must be equal to or greater than that of any similarly situated, younger person who is or could be a plan participant. The PPA also provides that for this purpose, the employer may determine the accrued benefit under the terms of the plan, using an annuity payable at normal retirement age, the balance of the participant’s hypothetical accumulation account, or the current value of the accumulated percentage of the employee’s final average compensation. The PPA has other provisions that answer other technical arguments regarding this issue.

One of the political problems surrounding these changes for cash balance plans was the impact on litigation involving existing plans. The PPA states that nothing in the new rules is to be construed to infer that the treatment of hybrid plans or conversions to such plans is valid under the age discrimination rules of ERISA, the Code, or the ADEA that were in effect prior to the effective date of the PPA. This approach is labeled the “no inference” provision.
For those who do not understand the key benefits of adopting a defined benefit pension plan – larger participant contribution – we have provided a chart below showing the possible per-participant contributions at various ages under defined benefit pension plan.

Elimination of the “Whipsaw” in cash balance plans

The key feature of a cash balance plan is the “accumulation account,” which is a hypothetical account that
defines the participant’s accrued benefit. Cash balance plans usually allow lump sum distributions to terminated participants, but IRS guidance did not permit the simple approach of paying out the participant’s accumulation account balance. Instead, the plan had to perform certain calculations to determine a minimum present value. That calculated value frequently exceeded the accumulation account balance. The calculated value applied actuarial factions not included in the determination of the accumulation account balance. The calculations require the plan to first project the participant’s current benefit to normal retirement age using the rate of interest specified in the document for interest credits. Then that benefit is discounted back to the date of payment using a different statutory rate. If the first interest rate is greater than the second, the calculation results in a lump sum benefit payment that exceeds the participant’s accumulation account balance. This has been referred to as an interest rate “whipsaw.”

The PPA eliminates the whipsaw problem by allowing a plan to comply with the minimum present value rules by specifying that the present value of a participant’s accrued benefit is equal to the balance of the participant’s accumulation account. This is a huge change and will lead to many defined benefit pension plans being structured as a cash balance plans.

Conversions and “Wearaway” conversions

IRS guidance has generally permitted a plan sponsor to eliminate a benefit feature prospectively and place participants who benefited from that feature on a “benefits plateau.” That is, their benefits did not increase until their benefits under the new design equaled their vested accrued benefit under the old design. This is referred to as the “wearaway” because the participant receives no additional accruals until the protected benefit equals the result under the new formula.

Many cash balance conversions have used this approach to hold participants at their protected accrued benefit under the old benefit formula until benefits calculated under the new cash balance formula reached the level of the protected benefit. In some cases, the conversion process meant that participants did not accrue additional benefits for several years after the conversion.

The PPA forbids use of the wearaway with cash balance conversions adopted after June 29, 2005. Instead, the converted plan must specify that a participant’s benefit is not less than the sum of (1) the participant’s accrued benefit for years of service before the conversion, plus (2) the participant’s accrued benefit for years of service after the conversion, using the new cash balance formula. The PPA also includes a special rule for plans that have an early retirement subsidy (i.e., the optional benefit is other than the actuarial value of the normal form of benefit).

Other provisions

The PPA provides that cash balance and other hybrid plans must use a 3-year cliff vesting schedule. In addition, when a plan sponsor terminates a cash balance plan that uses a variable interest rate, the Act requires that the rate used to determine accrued benefits must equal the average of the interest rates used under the plan for the 5-year period ending on the termination date.

Effective dates

These provisions are generally effective as of June 29, 2005. The provision regarding the minimum value rules is effective for distributions after the date of the enactment of the PPA, which is August 17, 2006. For plans in existence on June 29, 2005, the interest crediting and vesting rules apply to plan years beginning after December 31, 2007, except that the plan sponsor may elect to apply those provisions earlier. For a plan sponsor implementing a conversion before June 29, 2005, that is effective after that date, he/she can elect to apply the new conversion rules to that conversion.

Beginning in 2006, The Economic Growth and Tax Relief Reconciliation Act of 2001, permits employers who sponsor a 401(k) plan to amend their plan to add “designated” Roth contributions. A participant who designates his or her elective deferrals as Roth contributions has the amount of the contribution included in his or her taxable income. This taxation at the time of contribution results in a tax benefit for a “qualified” distribution of a designated Roth account: None of the distribution is included in the participant’s gross income!  Thus, all earnings growth on the Roth contribution escapes taxation at the time of a “qualified distribution.” This change in the document requires an amendment to the plan.

The IRS provided a sample plan amendment (Notice 2006-44) for plan sponsors to use to add a Roth feature to their 401(k) plans. Because this is a sample amendment rather than a model amendment, a plan sponsor need not adopt the IRS model amendment verbatim. The sample amendment follows the structure of pre-approved plans that employ an adoption agreement and basic plan document. The Notice explains that a plan sponsor may have to revise the sample amendment to conform its provisions to the plan’s terms or administration. Sponsors of plans with a different format will need to modify the sample amendment to incorporate the appropriate selections into the design of their plan. In fact, we recommend that our clients modify the amendment to simplify administration. In addition, the notice states that the adoption of an amendment based on the sample amendment will not affect the preapproved status of a master and prototype plan or a volume submitter plan.

The sample amendment addresses the following items:

• separate accounting of Roth contributions,
• correction of excess contributions,
• direct rollover of Roth contributions from the plan to another plan or IRA, and
• acceptance by the plan of a direct rollover of Roth contributions from another plan.

The sample amendment does not contain any discussion of the distribution rules applicable to Roth contributions, however. Nor does it address the extent to which a participant may elect to take a distribution from the Roth contribution account or other plan accounts. The IRS has left guidance on these topics for another day.

Implementing a Roth contribution

The new Roth provisions are effective for plan years beginning on or after January 1, 2006. A plan sponsor that wishes to add Roth contributions to its plan must adopt a discretionary amendment as provided in Notice 2005-95 [2005-51 I.R.B. 1172]. Section 5.05(3) of Revenue Procedure 2005-66 provides that the deadline to adopt a discretionary amendment such as this is the end of the plan year in which the discretionary amendment is effective. The timely adoption of the amendment must be evidenced by a written document that is signed and dated by the employer sponsoring the plan. Thus, plan sponsors who wish to add Roth contributions to their plans for the plan year beginning January 1, 2006, must adopt the necessary written amendment no later than December 31, 2006. We recommend it be adopted prior to enrolling any participant in the Roth contribution account. Contact us for more information.