PENSION REFORM AND SIMPLIFICATION

STATUS

On August 17, 2006, President Bush signed into law H.R. 4, the Pension Protection Act (PPA), after it was approved by the House of Representatives and the Senate by votes of 279-131 and 93-5, respectively.

BACKGROUND

On September 2, 1974 President Gerald R. Ford signed into law H.R. 2, the Employee Retirement Income Security Act of 1974 (ERISA), which had been overwhelmingly approved by both the House of Representatives and the Senate by margins of 376-4 and 85-0, respectively.  This law created the Pension Benefit Guaranty Corporation (PBGC) within the Department of Labor.  The PBGC was established to ensure the viability of private sector pension plans.  It also seeks to keep pension insurance premiums at a minimum.  The corporation is made up of two distinct insurance programs, a single-employer plan and a multiemployer plan.  The multiemployer plan consists of collectively-bargained plans with more than one company making contributions.  In 2005, the PBGC insured the private pensions of 44 million individuals, paying about $3.7 billion in benefits to nearly 683,000 people. 

Significantly, the PBGC is not funded by tax revenue, but rather through insurance premiums collected from employers that sponsor insured pension plans, earns money from investments, and receives funds from pension plans it takes over.  Congress sets the premium rates, which is the most significant source of revenue for the program.  Currently, the minimum annual premium charged for each participant in a single-employer plan is $19, with an additional $9 for each $1,000 of “unfunded vested benefits.”  Multiemployer plans pay a flat $2.60 annually per participant.  The PBGC is authorized to borrow up to $100 million from the U.S. Treasury, but must include their receipts and disbursements in federal budget totals.

The single-employer PBGC showed its first surplus in 1996, and peaked four years later with a surplus of $9.7 million in 2000, largely as a result of the strong performance of the equity markets in the 1990s.  However, since then, its net position has annually decreased to the point where it posted a deficit of $23.3 billion in 2004.  In 2005, the net position improved slightly by $500 million to a deficit of $22.8 billion.  While the corporation’s assets have increased by 160 percent since 2001, to a total of $56.5 billion in 2005, its liabilities grew by a far larger 470 percent to $79.3 billion.  This is due largely to the dire financial situation at some of the nation’s largest airlines, most notably United Airlines and US Airways. 

PENSION PROTECTION ACT

One of the major victories for Republicans during the 109^th Congress was completion of the PPA, the most comprehensive reform of the nation’s pension laws since the ERISA.  This new law was spurred by the default in recent years of several large, defined-benefit pension plans and the increasing deficit of PBGC.  At the beginning of his second term, George W. President Bush advanced a proposal for pension funding reform to increase the minimum funding requirements for pension plans and strengthen the pension insurance system.

The new law establishes new funding requirements for defined benefit pensions and includes reforms that will affect cash balance pension plans, defined contribution plans, and deferred compensation plans for executives and highly-compensated employees. 

Single-Employer Plans

Since the passage of ERISA, federal law has required companies to prefund the pension benefits that the plan participants earn each year.  If a plan is underfunded, the plan sponsor must pay off with interest this unfunded liability over a period of years.  The PPA establishes new rules for determining whether a defined benefit pension plan is fully funded, the contribution needed to fund the benefits, and the required contribution to the plan if previously earned benefits are not fully funded.

When the PPA is fully phased in, it will require plan funding to be equal to 100 percent of the plan’s liabilities.  Any unfunded liability will have to be paid off with interest over seven years.  Those with severely underfunded plans that are at risk of defaulting on their obligations will be required to fund their plans according to special rules that will result in higher employer contributions to the plan.  Plan sponsors will continue to be allowed to use credit balances to offset required contributions, but only if the plan is funded at 80 percent or more. 

Under this new law, a plan sponsor’s minimum required contribution will be based on the plan’s target normal cost (the present value of all benefits that plan participants will accrue during the year) and the difference between the plan’s funding target (the present value of all benefits already accrued by plan participants as of the beginning of the plan year) and the value of the plan’s assets.  If a plan’s assets are less than the funding target, the plan has an unfunded liability, which must be paid off with interest in annual installments over seven years. 

Under the PPA, pension plans that are determined to be at risk of defaulting on their liabilities will be required to use specific actuarial assumptions that will increase the required contributions.  A plan will be deemed at-risk if it is unable to pass either of two tests.  First, a plan will be deemed at-risk if it is less than 70 percent funded under the “worst-case scenario” assumption that (1) the employer is not permitted to use credit balances to reduce its cash contribution and (2) employees will retire at the earliest possible date and will choose to take the most expensive benefit.  Second, a plan will be deemed at-risk unless it is at least 80 percent funded under standard actuarial assumptions.  This test will be phased in over four years, starting at 65 percent in 2008, 70 percent in 2009, 75 percent in 2010, and 80 percent in 2011.  Plans with 500 or fewer participants in the preceding year would be exempt from the at-risk funding requirements.

Beginning in 2008, the maximum deductible employer contribution to a defined benefit plan will be (1) the plan's target normal cost plus (2) 150 percent of the funding target plus (3) an allowance for future pay or benefit increases minus (4) the value of the plan's assets.  In 2006 and 2007, the deduction limit will be to 150 percent of the plan's current liability minus the value of the plan's assets.  Contributions in excess of this limit are subject to a 10 percent excise tax.  The PPA also repeals the alternative maximum deductible contribution as determined using an interest rate of 90 percent to 105 percent of the four-year weighted average rate on 30-year Treasury bonds.

Cash Balance Plans and other Hybrids

The PPA clarifies that cash balance plans do not discriminate against older workers as long as benefits are fully vested after three years of service and interest credits do not exceed a market rate of return.  The law also provides that the age discrimination test is met if a participant's accrued benefit is not less than the accrued benefit of any other employee similarly situated in all respects except age.  The accrued benefit can be tested on the basis of an annuity payable at normal retirement age, a hypothetical account balance, or the current value of the accumulated percentage of the employee's final average pay. The law prohibits wear-away of benefits accrued before the conversion of a plan to a cash balance plan if the conversion occurred after June 29, 2005.  Earlier conversions may still be subject to legal challenge under the laws in effect at the time of the conversion.  These provisions are effective beginning in 2008.

Multiemployer Plans

Multiemployer plans are collectively bargained plans maintained by several employers, usually within the same industry, and a labor union.  Multiemployer defined benefit plans are subject to funding requirements that differ from those for single-employer plans. Most of the funding requirements for multiemployer plans that were in effect before enactment of the PPA remain in effect under the new law. The PPA establishes a new set of rules for improving the funding of multiemployer plans that the law defines as being in "endangered" or "critical" status.  These new requirements will remain in effect through 2014.

The PPA establishes new requirements for multiemployer plans that are seriously underfunded. A plan's actuaries will have 90 days after the start of the plan year to certify the funding status of the plan for that year and to project its funding status for the following six years.  If the plan is underfunded, it will have 30 days after the actuarial certification to notify participants and approximately eight months to develop a funding schedule to present to the parties of the plan's collective bargaining agreement.  The schedule must be designed to meet the statutory funding requirements before the end of the funding improvement period.  For multiemployer plans in "critical status," the law makes changes in the anti-cutback rules of ERISA to give plans the right to eliminate or reduce some benefit payment options and early retirement benefits for plan participants who have not yet retired.  The law also establishes new disclosure requirements for multiemployer plans.

The PPA requires plans to amortize over 15 years (rather than 30 years, as under prior law) any increases in plan liabilities that are due to benefit increases or to changes in the actuarial assumptions used by the plan.  Amounts already being amortized under the old amortization schedule need not be recalculated.

The PPA increases the limit on tax-deductible employer contributions to multiemployer plans to 140 percent of the plan's current liability (up from 100 percent), and it eliminates the 25 percent of compensation combined limit on contributions to defined-benefit and defined contribution plans.  These provisions went into effect in the 2006 tax year.  The law will allow the Internal Revenue Service (IRS) to permit multiemployer plans that project a funding deficiency within 10 years to extend the amortization schedule for paying off its liabilities by five years, with an additional five-year extension permissible.  It requires such plans to adopt a recovery plan and to use specific interest rates for plan funding calculations.

The PPA also establishes mandatory procedures, effective through 2014, to improve the funding of seriously underfunded multiemployer plans.  Under the PPA, a plan is considered to be endangered if it is less than 80 percent funded or if the plan is projected to have a funding deficiency within seven years.  A plan that is less than 80 percent funded and is projected to have a funding deficiency within seven years is considered to be seriously endangered. An endangered plan has one year to implement a "funding improvement plan" designed to reduce the amount of under-funding. Endangered plans have 10 years to improve their funding. They must improve their funding percentage by one-third of the difference between 100 percent funding and the plan's funded percentage from the earlier of (1) two years after the adoption of the funding improvement plan or (2) the first plan year after the expiration of collective bargaining agreements that cover at least 75 percent of the plan's active participants.

Seriously endangered plans that are less than 70 percent funded will have 15 years to improve their funding. They must improve their funding percentage by one-fifth of the difference between 100 percent funding and the plan's funded percentage from the earlier of (1) two years after the adoption of the funding improvement plan or (2) the first plan year after the expiration of collective bargaining agreements that cover at least 75 percent of the plan's active participants. A plan that is endangered or seriously endangered may not increase benefits. If the parties to the collective bargaining agreement are not able to agree on a funding improvement plan, a default funding schedule will apply. This schedule would reduce future benefit accruals. Additional contribution requirements will apply only if they are needed to achieve the funding improvement required by the law. A plan is not endangered in any plan year in which the required funding percentages are met.

A multiemployer plan is considered to be in critical status if (1) it is less than 65 percent funded and has a projected funding deficiency within five years or will be unable to pay benefits within seven years; (2) it has a projected funding deficiency within four years or will be unable to pay benefits within five years (regardless of its funded percentage); or (3) its liabilities for inactive participants are greater than its liabilities for active participants, its contributions are less than carrying costs, and a funding deficiency is projected within five years. A plan in critical status has one year to develop a rehabilitation plan designed to reduce the amount of underfunding. The plan sponsors will not be required to make "lump-sum" contributions that normally are required to meet the minimum funding standard when a plan has an accumulated funding deficiency. Employers will not be subject to an excise tax if a funding deficiency occurs as long as the plan is meeting its obligations under the rehabilitation plan and under the collective bargaining agreements negotiated to improve plan funding.

Defined-Contribution Plans

The PPA makes permanent the higher benefit limits in defined benefit plans, higher contribution limits for individual retirement accounts and defined contribution plans, and catch-up contributions for workers 50 and older that were included in the Economic Growth and Tax Relief Reconciliation Act of 2001. These provisions had been scheduled to expire on December 31, 2010.

Federal law prohibits tax-qualified retirement plans from discriminating in favor of highly-compensated employees (HCEs) with regard to coverage, amount of benefits, or availability of benefits.  A "highly compensated employee" is defined in law as any employee who owns 5 percent or more of the company or whose compensation exceeds $100,000 (indexed to inflation). An employer can elect to count as HCEs only those employees who rank in the top 20 percent of compensation in the firm, but it must include all 5 percent owners.

To be tax-qualified, a 401(k) plan must satisfy one of two tests: either the proportion of non-highly compensated employees (NHCEs) covered by the plan must be at least 70 percent greater than the proportion of highly compensated employees (HCEs) covered by the plan, or the average contribution percentage for NHCEs must be at least 70 percent of the average contribution percentage for HCEs.  Contributions to a plan cannot discriminate in favor of HCEs. Plans that have after-tax contributions or matching contributions are subject to the "actual contribution percentage" (ACP) test, which measures the contribution rate to HCE accounts relative to the contribution rate to NHCE accounts. Some 403(b) plans are subject to nondiscrimination rules; 457 plans generally are not. The actual contribution percentage of HCEs in a 401(k) plan generally cannot exceed the limits shown in the following table:

Maximum Average 401(k) Contributions for Highly Compensated Employees

Note: "Deferral and match" equals the sum of employer and employee contributions.

Any of three "safe-harbor" designs are deemed to satisfy the ACP test automatically for employer matching contributions (up to 6 percent of compensation):

1.                             The employer matches 100 percent of employee elective deferrals up to 3 percent of compensation, matches 50 percent of elective deferrals between 3 percent and 5 percent of compensation, and all employer matching contributions are fully vested.

2.                             Employer-matching contributions can follow any other matching formula that results in total matching contributions that are equal to or greater than under the first design. All employer-matching contributions vest immediately.

3.                             The employer automatically contributes an amount equal to at least 3 percent of pay for all eligible NHCEs. Employer contributions vest immediately.

All 401(k) plans must satisfy an "actual deferral percentage" (ADP) test, which measures employees' elective-deferral rates.  The same numerical limits are used as under the ACP test. Three "safe-harbor" designs, similar to the safe-harbor designs for the ACP test, are deemed to satisfy the ADP test automatically.  In addition, "cross-testing" allows defined contribution plans to satisfy the nondiscrimination tests based on projected account balances at retirement age, rather than current contribution rates. This permits bigger contributions for older workers. Because higher-paid employees receive proportionally smaller Social Security benefits relative to earnings than lower-paid workers, employers are permitted to make larger contributions on earnings in excess of the Social Security wage base ($94,200 in 2006).  Regulations limit the size of the permitted disparity in favor of workers whose earnings are above the wage base.

Automatic Enrollment "Safe Harbor"

The PPA creates a "safe harbor" from nondiscrimination testing for plans that adopt automatic enrollment, provided the plans meet certain requirements.  The requirements include notifying employees of the amount of pay to be deferred, the investments into which the deferrals will be deposited, and giving the employee the right to change the amount deferred or the investments into which the money is deferred or to opt out of the arrangement altogether.  A plan with automatic enrollment will be deemed to satisfy the nondiscrimination rules for elective deferrals and matching contributions if it provides a minimum matching contribution of 100 percent of elective deferrals up to 1 percent of compensation, plus 50 percent of elective deferrals between 1 percent and 6 percent of compensation.

The nondiscrimination safe harbor that existed prior to the PPA (described above) will continue to be available for all 401(k) plans, including those with automatic enrollment. To qualify for the automatic enrollment safe harbor, the contribution rate for automatic enrollees must be at least 3 percent during the first year of participation, 4 percent during the second year, 5 percent during the third year, and 6 percent thereafter. The plan may specify a higher contribution up to a maximum of 10 percent. The automatic enrollment arrangement will not have to apply to employees already participating in the plan. Employees must be fully vested in employer contributions after no more than two years, rather than the immediate vesting rule for other safe harbor 401(k) plans. The distribution restrictions under Internal Revenue Code 401(k)(2) also will apply to automatic-contribution plans.

An employee who is automatically enrolled will have 90 days to opt out of the plan and withdraw any contributions made on his or her behalf, plus the earnings on those contributions. These amounts will be taxed in the year the employee receives them, but they will not be subject to the 10 percent extra tax that ordinarily would apply to distributions received before age 59 1/2.  This rule also will apply to 403(b) plans and 457(b) plans that adopt automatic enrollment.

Plans that opt for automatic enrollment must choose a set of default investments for participants who have not designated their specific investment choices.  Under the PPA, an automatic enrollment plan will be granted protection from fiduciary liability under ERISA 404(c) for its default investments, provided that automatic contributions are invested in accordance with regulations to be issued by the Department of Labor and that the plan notifies employees of their right to change the investments or to opt out of the plan.  The PPA clarifies that ERISA preempts any state law that would prohibit automatic enrollment, provided that the plan notifies affected employees annually of their rights in the plan.  The automatic enrollment provisions of the PPA are effective for plan years starting in 2008, except the ERISA preemption of state law, which is effective on the date of enactment.

OUTLOOK

Senators Gordon Smith (R-OR) and Jeff Bingaman (D-NM) have introduced S. 1141, the Automatic IRA Act.  This bill would require employers that do not have pension plans to set up Automatic IRAs for their employees.  No employer contribution would be required and employees would be automatically enrolled unless they chose to “opt out.”  This legislation could have “legs” this Congress.  We will keep you informed on this issue and any developments. 

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