Pension Protection Act
On August 17, 2006, President Bush signed the Pension Protection Act (PPA), which is over 900 pages long and makes many changes to the laws affecting retirement plans, sponsoring employers, and participating employees.
The changes include comprehensive pension funding reform and other significant changes affecting hybrid defined benefit plans, defined contribution plans, non-qualified deferred compensation, and health plans. Most funding reforms take effect for the 2008 plan year, with the 2004-2005 temporary funding rules basically extended through 2007, although with new generally higher deduction limits. Other changes have different effective dates.
Our understanding of the key changes affecting single employer defined benefit plans are:
I. Minimum Funding Standards
The bill replaces the minimum funding standard account rule and the deficit reduction contribution for certain plans with a single minimum funding calculation. The general effective date is for the 2008 plan year, but there are transition rules.
Basic minimum funding contribution. The amount is the sum of: (1) the target normal cost (present value of benefits expected to be accrued in the current year, including an increase in benefits attributable to services performed in prior years by reason of an increase in compensation during the current plan year), plus (2) shortfall amortization charge (determined over a seven-year period, but phased in through 2011), plus (3) waiver amortization charge, if any (over five years). If there is no funding shortfall for the year (i.e., plan assets, reduced by any credit balances, equals or exceeds the funding target for the year), the minimum contribution is the target normal cost for the plan year reduced by such excess (but not below zero).
Interest Assumption. Employers can use either the segmented yield curve derived from an unweighted 24-month average yield curve for high-quality corporate bonds (AAA, AA, and A ratings) or the full yield curve without 24-month averaging. The segmented yield curve (but not the full yield curve) will be phased in over three years for plans in existence in 2007, unless the employer elects to forego the phase-in. The employer can elect to use the prescribed interest assumption for the month in which the plan year begins, or any of the four preceding months.
Credit balances. Generally, the plan will retain credit balances in two pieces – a carryover balance from 2007 and a pre-funding balance from contributions in excess of funding rules in 2008 and later plan years. The plan may elect to use it’s credit balance to satisfy a minimum funding obligation only if the assets are at least 80% funded (from the prior valuation date) based on the pre-funding balance, but not carryover balance. Credit balances will reflect the investment performance of plan assets and will be subtracted from assets for most determinations under the bill.
Contribution deadlines/quarterly contributions. The due date for a required contribution is 8 ½ months after the close of the plan year (but adjusted for interest if made after the valuation date for the plan year). Quarterly contributions are required if there was a funding shortfall in the prior year.
II. Funding-based benefit limitations. The following suspensions and restrictions on plan amendments, accruals or distribution options will be applicable to single-employer defined benefit plans.
· Shutdown benefits (applies only to plans funded below a 60% level).
Shutdown benefits and other unpredictable contingent benefits will be restricted if the plan is below a 60% funding level, unless the employer makes a prescribed additional contribution. The PBGC guarantee for such benefits will be phased in over a five-year period commencing when the event occurs. This is not applicable for the first five years of a plan’s existence.
· Restrictions on benefit increases (applies to plans funded below an 80% level).
The bill will not allow a plan amendment that increases plan benefits if the plan is below an 80% funding level, unless the employer makes a prescribed additional contribution. An amendment is subject to this rule if it increases benefit liabilities due to an increase in benefits, the addition of new benefits, a change in the rate of benefit accrual or a change in the rate at which benefits become vested. This is not applicable for the first five years of a plan’s existence.
· Restrictions on accelerated distributions and lump sum payments (applies only to plans funded below a 60% level). The bill prohibits distributions in excess of the monthly life annuity payable under the plan when the plan’s funding level is less than 60%. This also applies if the employer is in bankruptcy unless the plan is 100% funded. The employer can put up security to permit larger distributions to be made. Plans less than 60% funded may not pay lump sums.
· Restrictions on accelerated distributions and lump sum payments (applies only to plans funded above a 60 % level, but below a 80% level). A limited payout, rather than a prohibition on any distribution in excess of the monthly life annuity is allowed if a plan’s funding level is above 60%, but below 80%. The employer can put up security to permit larger distributions to be made. Plans at least 60 % but less than 80% funded can make lump sum payments limited to the lesser of (i) 50% of the amount that will have been paid without restriction; and (ii) the present value of the participant’s PBGC benefit.
· Cessation of future accruals (applies to plans funded below a 60% level).
A plan will have to cease further accruals if funding falls below 60%, with an exception during the first five years of a plan’s existence, or if the employer makes an additional contribution prescribed by thePPA.
· Notice to participants. ERISA 101(j) will require notice to participants on the restrictions regarding shutdown benefits or accelerated distributions, as described above. This notice also will be required when future accruals cease under the rules described above. The notice is required within 30 days following the plan being subject to any of these restrictions.
· Effective date. These rules are generally effective in 2008, but not before 2010 for collectively bargained plans.
III. Lump Sum Distributions
Minimum lump sums under IRC 417(e). The bill will replace the current rules, which use 30 year Treasury rates under the three segment approach described above in the minimum funding rules, with a phase in of 20% a year from 2008-2012 (current rules remain in effect for 2006 and 2007).
IV. PBGC Rules
Flat rate premium. PPA makes no changes to the PBGC flat rate premium. The Deficit Reduction Act of 2005 already increased the per-participant flat rate premium to $30 for single-employer plans and to $8 for multi-employer plans.
Variable rate premium. The rules for 2004 and 2005 will continue for 2006 and 2007 and then be amended to reflect the interest rates in the new funding rules. In addition, starting in 2007 for employers with 25 or fewer employees, a per participant cap of $5 multiplied by the number of participants will apply to the variable premium. The full funding limitation exemption is repealed after 2007.
V. Benefit Accruals Under Hybrid Plans
Age discrimination. The law clarifies that all defined benefit plans (including cash balance and pension equity plans) are not inherently age discriminatory as long as benefits are fully vested after three years of service and interest credits do not exceed a market rate of return. The bill further provides that the age discrimination test is met if a participant’s accrued benefit is not less than the accrued benefit of any similarly situated younger employee. “Similarly situated” means that the participants are identical in every respect (e.g., period of service, compensation, position, date of hire, work history), except age. The accrued benefit can be tested on the basis of an annuity payable at normal retirement age, a hypothetical account balance (e.g., a cash balance plan), or the current value of the accumulated percentage of the employee’s final average pay (e.g., a PEP plan). No definition of a cash balance plan is provided with respect to the application of this rule, except any interest credited by a plan must be no more than a market rate of interest, effective for plan years beginning in 2008 or later (unless the employer elects to apply earlier). Corresponding amendments are made to the Age Discrimination in Employment Act (ADEA).
Conversions. The bill will prohibit wear away of pre-conversion accrued benefits if the conversion occurs after June 29, 2005. No inference is to be drawn with respect to earlier conversions.
Whipsaw. The bill will eliminate the “whipsaw” problem by allowing the lump sum distribution from a hybrid plan to be equal to the hypothetical account balance (e.g., cash balance plan) or the accumulated percentage of final average pay (e.g., PEP plan). This is effective for distribution made after the date of enactment.
Vesting. Hybrid plans (i.e., benefits based on a hypothetical account or as an accumulated percentage of final average pay) will have to have full vesting in no more than three years of service. This is effective for plan yeas beginning in 2008 or later, unless the employer elects earlier application.
No inference as to prior years. The bill’s provision is prospective only and will provide no clarification of the legal status of hybrid plans for past years. This, in effect, will leave unresolved the age discrimination and whipsaw issues under prior law.
VI. Spousal Protection
QDROs. The DOL will be required to issue regulations to clarify that an order does not fail to be a QDRO merely because of the time it is issued, or that it modifies a prior order or QDRO.
QJSA options. The bill will require a plan to offer a 75% survivor annuity option if the QJSA has a survivor percentage less than 75%, and a 50% survivor annuity option if the QJSA has a survivor percentage that is greater than 75%. Effective for plan yeas beginning in 2008 or later (delayed effective date for collectively bargained plan).
VII. Reporting and Disclosure
DB funding notice. An annual funding notice will be required of all single employer DB plans, along the lines of the current rules for multi-employer plans, starting with the 2008 plan year. The notice will have to be furnished no later than 120 days after the end of the plan year to which the notice relates. Small plans (100 or fewer participants) will furnish the notice coincident with the filing of the annual report (Form 5500).
Additional disclosures. Certain additional information will be required on the annual report (Form 5500). Defined benefit plans will be exempt from the Summary Annual Report (SAR) requirement, which essentially limits the SAR to DC plans. These rules will take effect for post-2007 years.
Simplified form 5500 for smaller plans. A simplified Form 5500 will have to be available for plans with 25 fewer participants, if the plan meets coverage without being combined with another plan, and no related group members or leased employees are covered by the plan. This is effective for plan years beginning in 2007 or later.
VIII. Miscellaneous Qualification and Tax Issues
IRC 415(b) limit. In a DB plan, average compensation may be calculated by taking into account years of service for which the employee was not an active participant in the plan. This will continue the rule in the current regulations that the Treasury had proposed to reverse. This is effective for post-2005 years. Also, for church plans, the compensation limit under IRC 415(b)(1)(B) will apply only to highly compensated employees.
Distribution notice and consent rules. The 90-day notice period will be expanded to 180 days. This is applicable to notice and consent requirements under IRC 402(f) (rollover notice), IRC 411(a)(11) (general consent rules) and IRC 417 (QJSA). This is effective for years beginning in 2007 or later.
Phased retirement. A DB plan will be permitted to allow for in-service distributions to a participant who has reached age 62, even if normal retirement age is later than age 62. This applies to distributions made in plan years beginning in 2007 or later.