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Pension Protection Act Signals a New Era for the Private Pension System

By Chip Hunt and Chip Hardy, PrimeTRUST Advisors. PrimeTRUST Advisors is a pension consulting and investment advisory firm. They are committed to advancing awareness of fiduciary standards of care through presentations, fiduciary training programs and in practice application with their clients. Email chunt AT primetrustadvisors.com for questions or comments regarding this article..

In August, with the signature of President Bush, the Pension Protection Act of 2006 (PPA) quietly became the most comprehensive pension reform package since ERISA was passed in 1974.

Its significance cannot be overstated!

First, consider the remarkable contrast of policy in Washington towards the private pension system when compared to the prevailing policies of the past twenty years. Since 1986, pension policy reforms have been driven by fiscal policy. This resulted in reductions in tax deductions, contributions and benefits. At the same time, restrictive non-discrimination and top-heavy rules and reporting responsibilities burdened plan sponsors. Then in 2001 with the passage of the Economic Growth Tax Relief Reconciliation Act (EGTRRA), a sudden reversal in policy resulted in increased: benefits limits, contribution and funding amounts, tax deductions and plan portability provisions. In addition, catch-up contributions were introduced allowing individuals age 50 and above to accelerate their retirement funding. Unfortunately, the restored incentives were only temporary. In general, Congress applied an expiration date of 2010 for many of the favorable provisions. PPA made the EGTRRA provisions permanent, which is dramatic given the legislative history surrounding pension policy.

In effect, PPA offers positive support for the private pension system by continuing and extending what EGTRRA began. This Act provides the foundation and momentum for new plan design options, funding considerations and investment strategies, which likely will foster much follow-up guidance and legislation. PPA is the tipping of the first domino.

Make no mistake about it… this means for advisers and consultants to employers who sponsor retirement plans, there will be significant planning opportunities ahead as the dust continues to settle. This Act is chocked-full of provisions pertaining to retirement and tax planning issues, which affect individual taxpayers and employers alike.

Events Influencing the Act

Clearly the earlier events of the new millennium… 9-11, a slowing economy, falling stock markets, failing airlines, corporate and accounting scandals, rocketing casualty rates for pension plans and mounting pension liabilities for the Pension Benefit Guaranty Corporation all have shaken the foundation of the American private pension system. This has had a stinging effect on the American worker and corporate retirement plan sponsors. The nineties never looked so good.

PPA is a determined response. It seeks to restore confidence and incentives through:

  • simplifying and overhauling funding rules for defined benefit pension plans,
  • getting tough on under-funded plans,
  • breathing new life into cash balance pension plans,
  • providing for participant investment diversification rights,
  • advocating much needed help for plan participants by effectively broadening access to investment advice providers,
  • encouraging tax deferred retirement savings programs by providing new rules for automatic participant enrollments, more generous vesting, enhanced portability rules, and
  • extending and liberalizing the rules governing plan benefits and contributions.

EGTRRA 2001 Permanency

Valuable retirement savings incentives originally enacted as part of the EGTRRA are made permanent by PPA. Those provisions include:

  • Increased amounts individuals could contribute to tax-favored IRAs, SIMPLE plans, 401k, 403b and 457 retirement plans,
  • Other increased contribution limits, covered compensation amounts and pension benefits.
  • Catch-up contributions to IRAs and employer sponsored plans for individuals age 50 and older.
  • Roth contributions to 401k plans and 403b plans.
  • Enhanced portability of retirement benefits by expanding rollover options.

Defined Benefit Pension Plan Reforms

New funding rules apply

Under the new law, prior funding methods are replaced with a single funding methodology directly tied to the plan's funded status. Generally, the new funding rules are a "pay as you go" system where employers are annually required to fund the amount of benefits accrued for any given year, plus make a "short-fall contribution" equal to the funding short-fall (plan liabilities in excess of assets) amortized over seven years.

When measuring plan liabilities against plan assets, there are new rules which should generally lower the present value of plan liabilities… automatically improving a plan's funded status. How? The newly prescribed interest rates used to calculate the present value of plan liabilities will be indexed to tiered corporate bond rates of varying maturities, which are generally higher that the Treasury rates used under the current law.

For newly defined "at-risk" pension plans, there are stricter funding rules which will accelerate funding requirements by requiring the plan to fund based upon the assumption that it is likely to be terminated and therefore must fund to the most valuable forms of benefit that the plan could provide. Smaller plans, with fewer than 500 employees are afforded some relief since they are exempt from the "at-risk" rules.

Additionally, there are other benefit restrictions for under-funded plans (no small plan exemption here) which apply to plans less than 80% funded; including curtailing of lump-sum distributions, benefit accruals and a small hand-full of other restrictive benefit rules.

More generous deduction limits to apply

The new law significantly increases the tax-deductible limits for contributions to defined benefit pension plans. Generally, in an effort to encourage a funding cushion, employers are allowed to fund up to 150% of the plan's unfunded liability! For employers offering both a defined contribution (DC) and a defined benefit (DB) plan, the combined deduction limit for contributions is eliminated after 2007 for plans covered by PBGC insurance. Favorable transition rules apply for 2006 and 2007.

The New Life of Cash Balance Pension Plans

In the mid to late nineties, cash balance plans were widely thought to be the future for traditional DB plans. However, unfavorable court decisions relating to age discrimination issues and an IRS moratorium on issuing determination letters abruptly halted conversions of traditional defined benefit pension plans to the cash balance design. PPA clarified this issue… cash balance plans are not inherently age discriminatory so long as:

  • Interest credits to account balances do not exceed a market rate of return,
  • Plans must be fully vested after three years of service, and
  • Any participant's accrued benefit is not less than any "similarly situated" younger employee's accrued benefit.

It is not much of a stretch to suggest that these plan arrangements, once again, may well be the way of the future for pension plans.

Automatic Enrollment 401k Plans

Under current IRS rules, participants may be automatically enrolled into a 401k plan. Yet, some states' payroll withholding laws, have created enough uncertainty for these arrangements that employers have been reluctant to adopt these provisions. PPA addresses these concerns by specifically affirming that ERISA preempts state laws with respect to employee benefit issues.

According to the Act, plan sponsors wishing to automatically enroll participants must:

  • Provide notice to participants explaining the right to elect out of the plan, or
  • To change the rate of contribution,
  • Define the time periods for making elections, and
  • Explain how contributions will be invested in the absence of any other such election by the participant.

One noteworthy question of particular interest surrounding such arrangements is the issue of which "automatic" investment option is appropriate. The Department of Labor is charged with the responsibility of establishing guidelines within six months of the date of enactment for automatic investment provisions. It is suggested by those closely monitoring the situation, that the "automatic" option will likely emphasize diversified portfolio options similar to "life-style" funds, "target-year" retirement funds and balanced fund type arrangements.

New Safe-Harbor Rules for "Automatic Enrollment" Plans

From a plan design standpoint, an optional safe harbor has been created by the Act to satisfy the non-discrimination rules. In general, those plans complying with the following design elements will be exempt from the complexities associated with performing the non-discrimination tests.

  • A plan qualifies for the auto-enrollment safe harbor if the contribution rate for auto-enrollees is at least:
    1. 3% in the first year of participation,
    2. 4% in the second,
    3. 5% in the third, and
    4. 6% thereafter.
  • The Plan provides for a minimum employer match of 100% of employees' elective deferrals up to 1% of compensation, plus
  • 50% of elective deferrals between 1% and 6% of compensation, or
  • The Plan provides a 3% non-elective employer contribution.

Given the demise of traditional pension plans and the increased dependence upon 401k arrangements as the primary source of retirement income, it only stands to reason that more emphasis will be placed on the use of automatic provisions. This would not only encourage plan participation, but also increase levels of contributions through automatic annual escalators and improve investment performance using professionally managed "automatic" investment options.

A provision of the Act that is sure to please accountants, employers and employees alike, deals with corrective refunds of excess contributions returned to Highly Compensated Employees for plans failing the non-discrimination tests. Automatic enrollment plan refunds will be allowed within six months after the end of the plan year (the 2 ½ month rule remains in effect for plans without automatic enrollment). Also, the refunds will be taxed in the year of distribution. Additionally, the Act eliminates the need to distribute "gap period" earnings on refunds for all 401k plans.

Investment Advice to Participants

PPA creates a new Prohibited Transaction Exemption that permits fiduciaries to be compensated for providing investment advice to plan participants with respect to its own proprietary investment options. Prior to the Act, this was considered a conflict of interest. The "Fiduciary Adviser" (FA) must satisfy certain rules: either the associated fees do not vary among the participant's investment choices or, the FA's advice is based upon an unbiased computer model certified by an independent third party.

In essence, this allows 401k service providers (mutual fund companies, banks, insurance companies and brokerage firms) to give investment advice to participants with respect to their own products and be compensated without triggering a Prohibited Transaction… provided they acknowledge in writing their status as a plan fiduciary.

Note: the plan sponsor still has the fiduciary duty to prudently select and monitor the "advice provider" according to the normal fiduciary standards of care, although they do not have to monitor the specific advice given to participants.

DB(k) Plans

For employers with fewer than 500 employees, beginning in 2010, employers can sponsor a plan with the combined features of a defined benefit pension plan and an automatically enrolled 401k plan arrangement. Plans following specific design requirements would be exempt from the non-discrimination and top-heavy rules.


PPA begins a new era for the private pension system. While there are varied opinions being expressed in regards to this Act, there should be no doubt that, while this legislation is not perfect, it is indeed a much needed pension policy turn-about, strongly favoring the pension system.


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