By David S. Foster
Thelen LLP

President Bush has signed the Pension Protection Act (PPA) of 2006, which recently was enacted by Congress. At more than 900 pages, PPA extensively overhauls the funding requirements for single-employer and multi-employer defined benefit plans and makes several other significant changes to the pension provisions of the Internal Revenue Code and the Employee Retirement Income Security Act.

Some of the major changes made by PPA include:

		Making permanent the pension provisions in the Economic Growth and Tax Relief Reconciliation Act of 2001. Before PPA, certain changes were set to "sunset" in 2010. Now, these pension provisions are permanent, including increased limits on annual additions, deductible contributions, Roth 401(k) plans, catch-up contributions to 401(k) plans and increased pension portability.
		Making sweeping changes to the determination of minimum required funding for defined benefit plans, including the calculation of benefit obligations, the measurement of plan assets and special rules for "at risk" defined benefit plans.
		Clarifying rules surrounding cash balance and hybrid plans, including issues related to age discrimination, conversion of existing defined benefit plans to a cash balance or hybrid plan, and determination of lump sum distributions from such plans.
		Allowing plan fiduciaries to be compensated for providing participants with investment advice under certain circumstances.
		Mandating diversification for defined contribution plans (other than stand alone ESOPs) that contain publicly traded employer securities.
		Adopting provisions to encourage the use of automatic enrollment in 401(k) plans, including introduction of a non-discrimination safe harbor for certain automatic enrollment plans, and explicit protection of automatic enrollment features from state law impediments.
		Providing accelerated minimum vesting schedules (three-year cliff or six-year graded) for most defined contribution plans.

PPA also includes provisions related to phased retirement, calculation of Pension Benefit Guaranty Corp. premiums, prohibited transactions, plan asset rules, pension portability, required disclosures to participants, executive compensation arrangements, health and welfare arrangements, and many more changes.

Although the new funding requirements apply only to plan years beginning after 2007, many other provisions take effect in 2006 and 2007.


Cash Balance and Hybrid Plans

Under PPA, hybrid plans (called "applicable defined benefit plans") are generally defined as plans under which the accrued benefit is calculated as the balance of a hypothetical account maintained for the participant or as an accumulated percentage of the participant's final average compensation. A cash balance plan is the most frequent example of an applicable defined benefit plan.

Under a typical cash balance plan, a percentage of compensation (a pay credit) is credited to a hypothetical account for each participant. Those amounts are then credited with interest (an interest credit) until the account is paid out, typically as a lump sum at termination of employment. The design mimics a typical defined contribution plan. However, a cash balance plan is a defined benefit plan because interest credits are determined without regard to the performance of fund assets. The employer benefits from any surplus and must make up any shortfall. Three areas of cash balance plans have been troubling: (1) age discrimination, (2) whipsaw and (3) wearaway. PPA deals with all three areas and also imposes vesting requirements.

Age Discrimination: PPA provides that a plan does not violate age discrimination rules if a participant's accrued benefit is equal to or greater than that of any similarly-situated younger person. The accrued benefit may be expressed as an annuity payable at normal retirement age, the balance of a hypothetical account or the current value of the accumulated percentage of the employee's final average compensation. These provisions are effective for periods beginning after June 29, 2005. The new rules are not to provide any inference regarding the provisions of prior law, allowing litigation to proceed. Litigation has been mixed, but a three-judge panel of the 7th U.S. Circuit Court of Appeals has ruled that IBM's cash balance plan did not discriminate against older workers.

Whipsaw: In a cash balance plan, a participant's benefit generally is thought of as the balance in his or her hypothetical account. If a participant terminates before normal retirement age and elects to take a lump sum distribution, one would assume that the plan would pay the participant the amount credited to the participant's account, just as would a defined contribution plan. However, the IRS has taken the position that the plan must project the participant's accrued benefit to normal retirement age and then discount the benefit back to the date of payment at the 30-year Treasury rate. If the plan credits interest at a higher rate than the 30-year Treasury rate, the participant would be entitled to a lump sum that is greater than the current account balance. The plan would be "whipsawed."

Effective upon enactment, PPA allows payment of the current account balance. Effective for years beginning after December 31, 2007, for plans in existence on June 29, 2005, (with a collective bargaining delay to as late as plan years beginning in 2010) and effective for periods beginning on or after June 29, 2005, for new plans, interest credits may not exceed a market rate of return and may not reduce the account below the aggregate pay credits.

Wearaway: When a traditional defined benefit plan is converted to a cash balance plan, the IRS currently allows a plan to freeze accrued benefits and then offset the frozen benefits against future accruals. This is referred to as "wearaway." Wearaway has been used in some conversions to eliminate early retirement subsidies and for other purposes. Under PPA, if, after June 29, 2005, a traditional defined benefit plan is converted to a cash balance plan, each participant's accrued benefit under the terms of the plan after the amendment must be at least the sum of (a) the participant's accrued benefit for years of service before the effective date of the amendment, determined under the terms of the plan as in effect before the amendment, plus (b) the participant's accrued benefit for years of service after the effective date of the amendment, determined under the terms of the plan as in effect after the amendment.

Vesting: Consistent with the vesting requirements PPA imposes on defined contribution plans, PPA requires that hybrid plans must provide for 100 percent vesting after three years, effective for years beginning after December 31, 2007, for plans in existence on June 29, 2005, (with a collective bargaining delay to as late as plan years beginning in 2010) and effective for periods beginning on or after June 29, 2005, for new plans.


Automatic Enrollment

PPA's new rules generally apply to 401(k) plans and 403(b) annuity contracts and are effective for plan years beginning after December 31, 2007. Some rules are generally applicable to plans with automatic enrollment features, even those that chose not to adopt "qualified automatic enrollment contribution arrangements."

Although existing law allows automatic enrollment or "negative elections" under which participant contributions are withheld by the employer unless the employee elects otherwise, the new law makes automatic enrollment more appealing under new "qualified automatic contribution arrangements." A "qualified automatic contribution arrangement" must meet requirements regarding automatic deferrals, matching or non elective contributions, and employee notice, summarized as follows:

		Automatic Deferrals: An employee who has not made a written election to participate or to opt out must be automatically enrolled and is treated as having elected to make an elective contribution of at least 3 percent of compensation the first year, increasing by 1 percent annual increments to 6 percent during the fourth and subsequent years. A plan may provide for a qualified contribution percentage of up to 10 percent. The automatic deferral election will cease if an employee makes an affirmative election to opt out or to have contributions made in an amount different from the stated percentage under the "qualified automatic contribution arrangement."
		Matching or Non Elective Contributions: An employer either must make matching contributions of 100 percent of the first 1 percent of compensation plus 50 percent of the next 5 percent of compensation (but not to exceed 6 percent of compensation), or non-elective contributions of at least 3 percent of compensation for all non-highly compensated eligible employees. Employees must be 100 percent vested after two years of service.
		Notice Requirement: An annual written notice must be given explaining an employee's election rights and how contributions under the automatic contribution arrangement will be invested in the absence of an investment election by the employee.

A plan with a "qualified automatic contribution arrangement" under PPA is treated as meeting the actual deferral percentage (ADP) test with respect to elective deferrals and the matching contribution percentage requirements (ACP) test with respect to matching contributions. PPA also exempts a plan with a "qualified automatic contribution arrangement" from the top-heavy rules.

Some employers have been reluctant to implement automatic enrollment because of state garnishment and payroll withholding laws. PPA responds to those concerns and broadly pre-empts any state law that would directly or indirectly prohibit or restrict the inclusion of an automatic contribution arrangement in a plan. This applies both to plans with "qualified automatic contribution arrangements" and to plans with other automatic enrollment features as long as certain notice and other election requirements are met. This change regarding pre-emption is effective on the date of enactment.

An employee who fails to make an election and is automatically enrolled may subsequently opt out and withdraw automatic contributions (with earnings) made during the first 90 days. Such a withdrawal is not subject to the 10 percent tax. Withdrawn contributions (and earnings) are includible in the employee's gross income in the year of distribution; any employer matching contributions are forfeited. This provision is not limited to plans with automatic enrollment features that meet the requirements for "qualified automatic contribution arrangements."

Plans with automatic enrollment features, including those with "qualified automatic contribution arrangements", now have 6 months instead of 2½ months from the end of the plan year to distribute corrective distributions without incurring excise tax.


Qualified Tuition Programs

PPA permanently extends the qualified tuition program provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001.


Funding Retiree Health Benefits

PPA provides some new opportunities to fund health benefits. Under existing law, excess assets from overfunded defined benefit plans may be transferred to an account within the plan to be used to pay retiree health benefits -- an IRC §420 transfer into an IRC §401(h) health account. The transfer is limited to assets in excess of 125 percent of the plan's current liability minus the lesser of the market or actuarial value of the assets and is further limited to the cost of the retiree health benefits for the year of the transfer.

Effective upon enactment, PPA allows the transfer of assets in excess of 120 percent of the plan's current liability. The transfer must pay for at least two years of estimated retiree medical costs and cannot pay for more than 10 years of estimated retiree costs. Two cost maintenance rules apply. First, the plan must maintain the 120 percent funding levels for all years in which estimated retiree medical costs were used to determine the transfer limits (either by contribution or by transferring the assets out of the health account). Second, the retiree health costs must be maintained for each year of transfer and for the next four years, which is similar to the existing rule that requires cost maintenance for a five-year period beginning with the year of transfer.

PPA also expands the transfer rules to apply to some multi-employer plans in taxable years beginning after December 31, 2006. Special rules apply to some multi-employer plans for multi-year transfers made pursuant to a collective bargaining agreement.


Long-Term Care Provisions

Long-term care insurance may be provided as a rider on an annuity contract or life insurance contract but still may be treated as a separate contract for certain purposes under IRC §7702, and the long-term care component of the contract may be paid for by reducing the cash value of the contract, effective in taxable years beginning after 2009 for contracts issued after 1996. In addition, long-term care contracts (including annuity contracts and life insurance contracts with long-term care riders) may qualify for tax-free exchanges, effective for exchanges after 2009.


Corporate-Owned Life Insurance and Taxation Changes

PPA is not all good news for employers. Effective for contracts issued after enactment, PPA imposes an income tax on proceeds from corporate owned life insurance unless the insured was an employee within 12 months of death, a director, a more-than-5 percent owner or one of the top 35 percent of employees ranked by pay at the time of purchase or the proceeds were used to buy back from the insured's family or beneficiary an equity interest owned by the insured at the time of death.

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For more information about the issues covered in this report, please contact David S. Foster in our San Francisco office at 415-369-7020 or at dsfoster@thelen.com or contact your Thelen attorney. For more information about Thelen's Construction and Government Contracts Department, click here.





©2006 Thelen LLP