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The Pension Protection Act of 2006 ("Act") was enacted into law on August 17, 2006. Much of the Act reforms the funding rules for single employer and multiemployer defined benefit pension plans. The Act also deals with a number of other areas, including cash balance plans, automatic 401(k) plan enrollment, investment advice, and participant disclosure. Most of the provisions of the Act become effective in 2007 or in later years. The provisions of the Act include the following:

1. Cash Balance Plans.

(a)    The Act provides that all defined benefit plans (including cash balance plans) will not be deemed age discriminatory if benefits are fully vested after three years of service and interest credits do not exceed a market rate of return. In addition, age discrimination will not exist if a participant's accrued benefit, determined as of any date, would be equal to or greater than that of any similarly situated, younger individual who is or could be a participant. A participant is similarly situated to any other individual if such participant is identical to the other individual in every respect (including period of service, compensation, position, date of hire and work history) except for age. An accrued benefit may be expressed either as an annuity payable at normal retirement age, the balance of a hypothetical account, or the current value of the accumulated percentage of the participant's final average compensation. The subsidized portion of an early retirement benefit or other retirement-type subsidy is disregarded in determining an accrued benefit.

(b)   A cash balance conversion after June 29, 2005 must provide that, with respect to each individual participant in the plan immediately before the conversion, the participant's accrued benefit after the conversion is not less than the sum of (i) the participant's accrued benefit for years of service before the conversion, determined under the terms of the pre-conversion plan, plus (ii) the participant's accrued benefit for years of service after the conversion, determined under the post-conversion plan terms. This will prohibit the "wear-away" of pre-conversion benefits by requiring that all participants begin accruing benefits as of the conversion date.

(c)   The Act permits lump sum distributions equal to either the present value of a participant's accrued benefit expressed as the balance in his or her hypothetical cash balance account or as an accumulated percentage of the participant's final average compensation. This provision is effective for distributions after the date of enactment.

(d)   The cash balance provisions of the Act are implemented by amendments to ERISA, the Internal Revenue Code and the Age Discrimination in Employment Act. Except with respect to the provision relating to lump sum distributions, the cash balance amendments apply to periods beginning on or after June 29, 2005. Accordingly, the Act's provisions do not apply to age discrimination and other issues affecting existing cash balance plans for periods prior to that date.

2. Automatic 401(k) Plan Enrollment.

The Act contains automatic enrollment rules for 401(k) plans that are applicable for plan years beginning after December 31, 2007. Automatic enrollment allows a plan sponsor to enroll an employee in a 401(k) plan without the employee's affirmative election, as long as the employee has the right to "opt out" of contributing or change the amount of automatic deferral.

Exemptions: These rules apply automatically to all employees eligible to defer, except for those employees who are already deferring under the plan and those employees who have filed an election not to defer. The plan sponsor may automatically enroll any employee who is eligible to defer and who is not in one of these two exempt categories.

Qualified Automatic Contribution Arrangement: If the plan includes a "qualified" automatic contribution arrangement, it will automatically satisfy 401(k) nondiscrimination testing. A qualified arrangement must contain the following provisions:

• Minimum deferral percentage. A qualified arrangement must have an automatic minimum contribution percentage that escalates each year. The minimum deferral in the first year is at least 3% but no more than 10% of compensation; in the second year the minimum increases to 4%; in the third year 5% and in the fourth year 6%.


• Minimum plan sponsor contributions. The plan sponsor is required to make either (a) a matching contribution for non-highly compensated employees at a rate of 100% of the first 1% of compensation deferred plus 50% of the next 5% deferred (for a maximum match of 3.5% of compensation), or (b) a non-elective contribution for non-highly compensated employees of at least 3% of compensation, whether or not the employees make deferrals.


• Two-year vesting requirement. Plan sponsor contributions must be 100% vested after an employee has completed no more than two years of service.

Effect on State Law: Effective immediately, the Act preempts state laws that prohibit wage withholding without employee consent. Thus, plan sponsors are no longer subject to challenges that automatic enrollment withholding is contrary to state wage and hour laws. This preemption of state law is only available, however, if an annual notice to the affected employees is provided before the start of each year.

Employee Notice Requirements: The automatic enrollment procedure requires that a notice be provided to employees upon hire, just before eligibility requirements are satisfied, and thereafter annually. The notice must explain the employee's right to decline automatic enrollment and to make changes to the election amount, including ceasing all deferrals.

90-Day Revocation: Employees must be permitted to withdraw automatic contribution amounts made within 90 days of the date of the first elective contribution. The deadline to request a revocation distribution is 90 days after the first payroll period in which automatic enrollment occurs. These amounts must be distributed no later than April 15th of the following year. The withdrawal is taxable to the employee as gross income in the year received as a distribution, but no 10% excise tax for early withdrawal under Code Section 72(t) applies. Related employer matching contributions are forfeited.

Six-Month Period for Refund of Excess Contribution without 10% Penalty: Nonqualified automatic enrollment arrangements will have additional time to test for discrimination, and, if needed, to make corrective distributions. The new deadline is six months after the end of the plan year, rather than 2½ months under pre-Act law.

3. Reporting and Disclosure Requirements.

The Act imposes new reporting and disclosure requirements on tax-qualified retirement plans. These requirements include:

(a)   Provision of periodic benefit statements for plan years beginning after December 31, 2006 (delayed date for collectively bargained plans). Plans with participant directed accounts must provide quarterly statements and all other defined contribution plans must provide annual statements. Defined benefit plans must provide statements every three years. The Act requires that the U.S. Department of Labor ("DOL"), within one year of enactment, must issue one or more model benefit statements that will satisfy this requirement. Statements must include an explanation of the importance of portfolio diversification, a discussion of the inherent risk of holding more than 20% of the portfolio in a single security, and a statement that additional information is available on the DOL Web site.

(b)   For plan years beginning after December 31, 2007, an annual funding notice for a defined benefit plan covered by the PBGC, which must be distributed to each participant and beneficiary, each labor organization representing participants or beneficiaries and the PBGC, within 120 days after the end of each plan year. In the case of a small plan the notice can be provided upon filing of the Form 5500 Annual Report.

(c)   For plan years beginning after December 31, 2007, no summary annual report is required to be delivered to defined benefit plan participants.

(d)   For plan years beginning after December 31, 2007, revised Form 5500 Annual Report requirements, including new electronic filing requirements.

(e)   For plan years beginning after December 31, 2007, revised rules as to which plans must file plan actuarial and employer financial information on a Form 4010 with the PBGC (generally plans that are less than 80% funded) and expanded content of filings.

(f)   The creation of a new notice of diversification rights for defined contribution plans that require investment in employer securities (generally effective in 2007), which must be provided at least 30 days before a participant is eligible to diversify out of employer securities and must include a description of the importance of diversification. The Treasury Department is to provide a model notice within 180 days of enactment of the Act.

(g)   For plan years beginning after December 31, 2007, the DOL must electronically display certain Form 5500 information within 90 days of receipt of the information. Plan sponsors are required to display the same information on their intranet Web site (if available).

4. Investment Advice.

The Act contains an exemption from the prohibited transaction provisions of ERISA and the Internal Revenue Code with respect to investment advice given to participants or beneficiaries in a plan that permits participant or beneficiary investment directions, if the advice is provided by a fiduciary adviser under an eligible investment advice arrangement. An eligible investment advice arrangement is an arrangement that either provides that fees received by the fiduciary adviser do not vary depending on the basis of any investment option selected, or uses a computer model under an investment advice program meeting the requirements of the Act. A fiduciary adviser includes a bank or similar financial institution, an insurance company, a registered investment adviser under the Investment Advisers Act of 1940, or a person registered as a broker or dealer under the Securities Exchange Act of 1934. This exemption applies to advice given after December 31, 2006.

5. Default Investment Arrangements.

The Act provides protection from fiduciary liability under ERISA Section 404(c) with respect to a participant-directed account when amounts are invested by the fiduciary by default in the absence of an investment election by the participant. This protection applies if the default investments are made in accordance with regulations to be prescribed by the Secretary of the Treasury within six months after the date of enactment, designating default investments that include a mix of asset classes consistent with capital preservation or long term capital appreciation or a blend of both. The provision also requires notice to the participant within a reasonable period of time before each plan year. This provision applies to plan years beginning after December 31, 2006.

6. Diversification of Investments in Publicly Held Employer Securities.

The Act permits a participant to transfer amounts in his or her account from investment in publicly held employer securities to other investment options offered under the plan (it is not clear why this option is not available with respect to non-publicly held securities). This option is available to a participant immediately in the case of amounts attributable to employee contributions and elective deferrals, and after completing three years of service with respect to amounts attributable to employer contributions. The plan must offer at least three other investment options, each of which is diversified with materially different risk and return characteristics. A notice of diversification rights must be given to a participant not more than 30 days before he or she becomes eligible to exercise diversification rights. This provision does not apply to a stand-alone ESOP without a 401(k) feature or to a one-participant plan. The provision is phased in over three years commencing with plan years beginning on and after January 1, 2007.

7. Faster Vesting.

Contributions to all defined contribution plans are subject to a faster 3-year cliff or 2-6 year graded vesting schedule. This change is effective for contributions made for plan years beginning on or after January 1, 2007.

8. Hardships and Unforeseeable Emergencies.

If an event would constitute a hardship under a 401(k) plan if it occurred with respect to the participant's spouse or dependent, it will also constitute a hardship if it occurs with respect to the participant's beneficiary under the plan. Thus, for example, a hardship withdrawal is permitted in order to pay for a beneficiary's medical expenses. The same rule applies to the definition of an unforeseen financial emergency under Code Section 409A. The Act directs the Secretary of the Treasury to issue regulations covering this provision within 180 days of enactment.

9. Rollovers by Non-Spouse Beneficiaries.

The Act permits a non-spouse beneficiary of a deceased participant to elect a direct rollover (via a trustee-to-trustee transfer) into an IRA. This provision applies to distributions after December 31, 2006.

10. Domestic Relations Orders.

The Act provides that a qualified domestic relations order may be issued at any time, including after a divorce, and after another domestic relations order or qualified domestic relations order has been entered. This provision is to be included in regulations issued by the Secretary of Labor not later than one year after the date of enactment.

11. Elimination of Gap Period Earnings.

Effective for plan years beginning after December 31, 2007, the Act eliminates the need to distribute gap period earnings on corrective distributions for all 401(k) plans.

12. Maximum Deductible Contributions.

The deductible limit for a single employer pension plan is increased to the applicable year's normal cost plus the amount necessary to fund the plan's funding target (as defined in the Act). An employer can also contribute and deduct a cushion of 50% of the funding target plus additional amounts related to projections for salary increases. The increased deductible limits are effective for years beginning after December 31, 2007. The combined deductible limit for sponsors maintaining defined benefit and defined contribution plans is eliminated beginning in 2006.

13. Plan Assets.

The Act codifies a provision previously found in DOL regulations indicating that the assets of an entity will not be treated as plan assets if, immediately after the most recent acquisition of any equity interest in the entity, less than 25% of the total value of each class of equity interest in the entity is held by benefit plan investors. The Act defines benefit plan investors as tax qualified retirement plans, ERISA plans and IRAs and does not include government and foreign benefit plans. Also excluded are investments made by plan investment advisers and their affiliates. The provision applies to transactions incurring after the date of enactment.

14. EGTRRA Changes Made Permanent.

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) overhauled many retirement plan and IRA rules. Thanks to the Act, the EGTRRA rules are now permanent and will not expire on December 31, 2010. Below are some of the EGTRRA changes that are now permanent:

Greater Participant Contribution Opportunities

• Higher maximum annual salary deferrals to 401(k) plans, 403(b) tax sheltered annuity plans, and 457 deferred compensation plans.
• Increased IRA contribution limits.
• Allowance of Roth-type contributions to 401(k) and 403(b) plans.
• Additional qualified plan and IRA contributions ("catch-up contributions") for individuals age 50 or older.
• A tax credit for lower-income individuals who save for retirement (the so-called "Saver's Credit").

General Retirement Plan Improvements

• Increase in maximum elective deferral percentage from 25% of compensation to 100% of compensation.
• Increase of profit sharing plan deduction limit to 25% of payroll.
• Allowance of direct rollover of after tax contributions and traditional IRA monies to tax-qualified retirement plans.
• Exemption from the top-heavy rules for 401(k) plans that provide safe harbor contributions.
• Reduction of the look-back period for a top-heavy plan test to one year.

15. Funding Retiree Health Benefits.

Under current law, a defined benefit plan may transfer excess assets to a separate account to fund retiree health benefits for the current year. The Act allows the transfer of excess assets to fund future retiree health benefits as well. This change applies to any transfer after enactment.

16. Restrictions on Funding of Nonqualified Deferred Compensation Plans.

The Act restricts an employer's ability to fund a nonqualified deferred compensation plan if the employer is experiencing certain financial difficulties. Funding is restricted during (a) any period in which the employer's defined benefit plan is in "at risk" status (as defined in the Act), (b) any period in which the employer is a debtor in bankruptcy, and (c) the 12-month period beginning six months before the termination date of a defined benefit plan, if the plan cannot satisfy its benefit liabilities. An employer who funds a nonqualified plan during this time violates Code Section 409A and thus triggers its tax, interest and penalty provisions. This provision of the Act applies to funding transfers or other reservations of assets after the date of enactment.

17. Funding Requirements.

The Act completely overhauls the funding rules for defined benefit plans in an attempt to make them more secure. The new rules generally apply to plan years beginning after December 31, 2007. The new rules include the following changes:

(a)    A plan's funding target has been increased to 100% of the plan's current liabilities.

(b)   A plan sponsor must contribute to the plan an amount sufficient to cover the year's normal cost (the amount of benefits accrued during the year). In addition, the sponsor must amortize the shortfall between the plan's assets and its target liability over a seven year period.

(c)   After a phase-in period, the interest rate used for plan funding purposes will be based on a high-quality corporate bond yield curve, averaged over 24 months. Plan sponsors may elect to use the full yield curve without averaging.

(d)   In determining the funded status of a plan, asset values can be based on market value with certain smoothing allowed over a period of up to 24 months.

(e)   The IRS is required to prescribe a mortality table to be used for funding purposes.

(f)   If a plan is "at-risk," it will be subject to higher required contributions and PBGC premiums.

(g)   There are new restrictions on the ability of underfunded plans to increase benefits and pay certain distributions. These include:

(i) Shutdown benefits and other unpredictable contingent benefits are restricted if the plan is below a 60% funded level, unless the plan sponsor makes a prescribed additional contribution. The PBGC guarantee for such benefits would 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.

(ii) No plan amendments that increase plan benefits are allowed if the plan is below an 80% funded level, unless the plan sponsor makes a prescribed additional contribution. This is not applicable for the first five years of a plan's existence.

(iii) Accelerated distributions and lump sum payments are restricted for plans funded below a 60% funded level. The Act prohibits distributions in excess of the monthly life annuity payable under the plan when the plan's funded level is less than 60%. This also applies if the plan sponsor is in bankruptcy unless the plan is 100% funded. The plan sponsor may post security to permit larger distributions to be made.

(iv) If a plan's funded level is above 60%, but below 80%, distributions in excess of the monthly life annuity are permitted but limited. Lump sum payments are limited to the lesser of (A) 50% of the amount that would have been paid without restriction; and (B) the present value of the participant's PBGC benefit. The plan sponsor may post security to permit larger distributions to be made.

(v) A plan must cease future accruals if the funded level falls below 60%, with an exception during the first five years of a plan's existence, or if the plan sponsor makes an additional contribution prescribed by the Act.

For more information on this matter, please contact a member of the Schiff Hardin Employee Benefits and Executive Compensation Group.

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