New Pension Protection Act Offers Planning Opportunities

By Jeff Belfiglio, Stuart Harris, Sarah L. Bhagwandin, Greg K. Hitchcock and Jason T. Froggatt
[September 2006]

On Aug. 17, 2006, President Bush signed the Pension Protection Act of 2006 (the “Act”). The Act mostly focuses on funding and disclosure rules for defined benefit pension plans—plans that have become increasingly expensive and disfavored over the last several years, but which are still prevalent among large employers and unionized workforces. With much less fanfare, the Act also changes some rules applicable to the more common defined contribution plan, including 401(k) plans. This article highlights the Act’s changes to defined contributions plans, outlines steps to take advantage of new opportunities and offers a 2006 year-end checklist.

IN THIS ADVISORY:

• New Rules for Providing Investment Advice to Participants;
  Protection for Plan Fiduciaries in Picking “Default” Investments
  
  
• Liberalized Rules for Leaving Retirement Funds to Heirs, Accessing Hardship Distributions or Giving to Charity
  
  
• Further Validation of Automatic Enrollment 401(k) Plans
  
  
• Faster Vesting for Employer Contributions
  
  
• The Sun May Never Set on Certain EGTRRA Changes
  
  
• Expanded Employer Stock Diversification Rights
  
  
• 2006 Year-End Compliance Checklist

New Rules for Providing Investment Advice to Participants;
Protection for Plan Fiduciaries in Picking “Default” Investments

Many employees direct the investment of their retirement plan accounts (particularly with 401(k) plans). Although these employees could use sound investment advice, many employers are reluctant to facilitate more than basic “investment education,” fearing liability if the investment advice is wrong. The Act offers protection to employers and also changes how employers choose default funds for participants who fail to direct their investments.

Investment Advice. The Act provides a prohibited transaction exemption for investment advice given by a “fiduciary advisor” (including banks, insurance companies, broker-dealers, registered investment advisors, and their affiliates) under an “eligible investment advice arrangement.” The fiduciary advisor must acknowledge to both the employer and participants that it is a fiduciary under ERISA. The fiduciary advisor need not be independent, but to avoid conflicts of interest must either (a) make advisory fees uniform, regardless of the investment options selected, or (b) base investment advice on a computer model, certified by an independent investment expert, which model uses participant-specific information to allocate investments among all the options offered by the plan. (The latter route seems tailor-made for advisors who have teamed up with computerized advice providers like Financial Engines.) Participants can request individual advice that deviates from the model, provided the advisor cannot “solicit” such requests.

In addition, the arrangement with the investment advisor must provide the following:

• Along with investment advice the participant receives full disclosure (in writing) of all fees and affiliation with other parties in interest to the plan.
  
  
• The participant receives information about the past performance and method of selecting the investment options under the plan.
  
  
• The participant receives a notice of the ability to obtain independent investment advice on his or her own.
  
  
• The advisor must obtain an annual audit from an independent auditor, certifying that the advisor complies with the exemption.

The Act protects employers (and other plan fiduciaries) from potential liability associated with the advisor’s investment advice if the investment advisor has entered into an “eligible investment advice arrangement” that satisfies the above requirements. Thus, employers need not monitor the substance of the advice participants receive, or how they invest. However, employers must still prudently select and monitor the fiduciary advisor. Presumably employers will insist on a copy of the annual audit certifying the advisor’s compliance with the new exemption. The fiduciary advisor’s fees must be reasonable and can be paid from plan assets. This provision is effective for investment advice given after Dec. 31, 2006.

Default Funds. Many employers seek protection from investment-related liability by having an ERISA “404(c) plan” that offers participants a choice of investments and the opportunity to control their own investments. One problem with this approach is that some participants never make a choice, leaving the employers responsible for selecting a “default” fund. Participant inactivity is also an obstacle for automatic enrollment plans, which are more likely to have passive participants. Over the years, employers have been advised to use money market accounts, balanced funds, or target date funds as the default fund.

The Act directs the DOL to issue regulations on the appropriateness of different investments as a default fund. (The DOL has reportedly already begun drafting regulations.) Employers will presumably be able to choose between various classes of funds -- ranging from conservative to long-term growth -- and still be considered prudent. But employers will also have to give a notice, before each plan year, explaining how a participant’s account will be invested in the absence of instructions, so that the participant has at least an annual reminder of the opportunity to direct his or her investments. Curiously, notice is not required at initial enrollment, when the default selection would first be made.

The default investment provision ties into the automatic enrollment provisions of the new law, which also require annual notice of the amounts that will be deferred unless the participant elects otherwise. (See below for a summary of that part of the Act.) A plan need not use automatic enrollment to benefit from the upcoming default option regulations.

Next Steps for Employers

Liberalized Rules for Leaving Retirement Funds to Heirs, Accessing Hardship Distributions or Giving to Charity

The Act addresses two benefit distribution issues that have bothered estate planners and plan participants for years. The Act permanently fixes one problem, but only temporarily patches the other.

Rollovers for Non-Spouse Beneficiaries. Upon the death of a plan participant, beneficiaries are often able to stretch out payments over their life expectancies. This applies whether the beneficiary is the participant’s spouse or is a non-spouse. However, this strategy only works if the plan (which can be a qualified plan, a 403(b) plan or an IRA) offers installment or other long-term payment opportunities. If the plan only allows lump sum distributions, as is the case with many plans, a spousal beneficiary could roll the distribution over to an IRA, and then out of his or her IRA stretch out distributions over a period of time. On the other hand, historically a non-spouse beneficiary could not roll the distribution over to an IRA, and therefore could not avoid immediate taxation.

The Act allows non-spouse beneficiaries to roll over a distribution from a qualified plan, 403(b) plan, or government 457(b) plan to an IRA, effective for distributions after 2006. It must be a direct, trust to trust rollover. This “inherited IRA” will be subject to the minimum distribution rules requiring payments to begin by December 31 of the year following the year of death, but stretched out over the beneficiary’s life expectancy. Note that unlike prior law, this provision effectively gives a domestic partner, when named as the beneficiary, rollover rights similar to those of a spouse.

Liberalized Hardship Rules. In addition to changing the rollover rules for a non-spouse beneficiary, the Act also directs the IRS to issue regulations that liberalize hardship distributions from a 401(k) plan. Currently, a participant in a 401(k) plan may take a hardship distribution in connection with certain events (such as the occurrence of medical expenses) that apply to the participant, a spouse or dependents. New regulations would provide that a hardship distribution would be eligible if such an event were to occur with respect to the participant’s designated beneficiary under the plan, regardless of whether the designated beneficiary was a spouse or dependent. This change would extend hardship distribution benefits to a participant with a domestic partner, provided the participant named the domestic partner as his or her beneficiary under the plan.

Charitable Gifts from IRAs. Persons wanting to make significant charitable gifts while still alive have long wanted to make them out of qualified plans or IRAs, which would otherwise be taxed as ordinary income. Previously this could only be done by taking a taxable distribution, then making the gift and claiming a deduction that might not offset all the income. The Katrina Emergency Tax Relief Act opened a temporary window to charitable gifts from an IRA by eliminating the deduction limit, which assured that the deduction would offset the income from the funds distributed from the IRA or qualified plan. However, this relief expired Dec. 31, 2005.

The Act takes a more direct approach by allowing non-taxable charitable gifts directly from an individual IRA or Roth IRA, including a rollover IRA, but not a SIMPLE IRA, SEP, or qualified plan. (Of course, if eligible an individual could roll over from a qualified plan to an IRA first, then make the gift.) The distribution is limited to $100,000 per taxpayer per year and is only available to IRA owners who are at least age 70½. The distribution to charity counts against the owner’s required minimum distribution for the year. The owner will be deemed to have elected out of withholding.

This change is available only in 2006 and 2007, so prompt action is needed by those planning to make such a gift, especially if they are interested in using the maximum amount available in each year.

Next Steps for Employers

Further Validation of Automatic Enrollment 401(k) Plans

“Automatic enrollment” 401(k) plans received IRS approval several years ago, but a couple of unresolved issues left some employers skittish about the concept. As most readers will know, an “automatic enrollment” 401(k) plan automatically enters a fixed salary deferral contribution for all eligible employees. In this way, new employees who first satisfy plan eligibility requirements (for example, as age 21 and one year of service) will automatically, without further action, have a fixed amount (such as 2% of pay) withheld from their paycheck. Employees can revoke the deferral at any time, even before it becomes implemented, but if an employee does nothing, the fixed rate of deferral automatically applies.

The perceived problem with automatic enrollment plans was that they potentially violate state wage withholding laws that prohibit withholding from an employee’s paycheck without written consent. Also, for plans that allow employees to choose their investments, some automatically enrolled participants would never make the choice, leaving the employee with the burden of designating a “default” investment. This result was often directly contrary to the employer’s intent of shifting all investment responsibility to the participants.

ERISA Preemption of State Wage Law. The Act expressly preempts state wage laws that would prohibit or restrict an automatic enrollment arrangement. The preemption is effective immediately upon enactment of the Act, but arguably requires compliance with the DOL rules on default investment funds, which are not out yet.

Employer Protection for Choosing Default Fund. As described above, the Act directs the DOL to issue guidelines for steps an employer can take in choosing a default fund for employees who fail to choose an investment option.

Annual Notice. All automatic enrollment plans must give an annual notice of the automatic enrollment feature and the default investment to remind participants that they have the opportunity to change their elections and direct their own investments.

Additional Automatic Enrollment Provisions. The Act also added a few new tweaks to automatic enrollment plans. Generally effective for plan years beginning after December 31, 2007, the changes include the following:

• A plan may permit a participant to withdraw contributions (and related earnings) made during the first payroll period during which automatic deferrals are applied to the participant’s paycheck, up to 90 days after the first payroll period. This acts as a grace period for employees who procrastinate telling their employer not to enroll them automatically into the 401(k) plan.
  
  
• For 401(k) plans that must satisfy the nondiscrimination tests (the ADP and ACP tests), they may make corrective distributions up to six months after the end of the plan year without incurring the normal employer excise tax. In addition, the plans can include the distributed amount in the participant’s income in the year of distribution. This is in contrast to current law, which requires that corrective distributions be within two and one-half months following the close of the plan year to avoid an excise tax, and requires income reporting in the year of the deferral or contribution, not the year of the distribution. (Note that 401(k) plans that do not use automatic enrollment still need to comply with the older rule).

Safe Harbor Automatic Enrollment Plans. For years beginning after Dec. 31, 2007, the Act provides a new “safe harbor” from the ADP and ACP tests (as well as the top heavy test). The safe harbor is available for plans that utilize a “qualified automatic contribution arrangement,” which includes:

• Each eligible employee is treated unless the employee elects otherwise as having elected to make a deferral at a stated percentage, which percentage cannot exceed 10 percent of compensation.
  
  
• Percentage must also satisfy the following minimums: 3 percent of compensation for the first year, 4 percent for the second year, 5 percent for the third year and 6 percent thereafter.
  
  
• The escalating automatic deferrals cease if the employee opts out or chooses another deferral percentage.
  
  
• Matching contributions on behalf of each non-highly compensated employee, as follows—dollar for dollar match on deferrals up to 1 percent of compensation, with a 50 cent match for each dollar deferred over 1 percent but less than 6 percent of compensation. Alternatively, the plan can provide a non-elective contribution equal to at least 3 percent of each eligible non-highly compensated employee’s compensation.
  
  
• The employer safe harbor contribution (match or non-elective) must be fully vested at the end of two years of service (rather than fully vested under the existing safe harbor rules).
  
  
• Before each plan year, each employee eligible to participate in the 401(k) plan for that year must receive written notice of his or her rights and obligations under the plan.

Next Steps for Employers

Faster Vesting for Employer Contributions  

The Act changed the vesting requirements that apply to employer contributions made to a wide variety of qualified retirement plans:

Defined Contribution Plans. Employer contributions made in plan years that begin after December 31, 2006 must vest more quickly:

• Employer contributions must vest according to a 3-year cliff schedule (100 percent vested after 3 years of service), a 6-year graded schedule (20 percent after two years of service, and 20 percent each year thereafter), or any schedule that is more accelerated. (Remember, the new rules apply to contributions for plan years beginning after Dec. 31, 2006.)
  
  
• Prior to the Act, the 3-year cliff and 6-year graded vesting schedules only applied to employer matching contributions.
  
  
• Employer contributions for plan years prior to 2007 may continue to be governed by the older vesting schedule. There is also an exception for collectively bargained plans and ESOPs with outstanding acquisition loans.

Defined Benefit Plans. No change for defined benefit plans:

• Employer contributions continue to be required to vest according to either a 5-year cliff schedule (100 percent vested after 5 years of service) or a 7-year graded schedule (20 percent after 3 years, and 20 percent each year thereafter).

Safe Harbor Automatic Enrollment Plans. As described above, a new safe-harbor automatic enrollment plan requires a two year vesting schedule.

Next Steps for Employers

The Sun May Never Set on Certain EGTRRA Changes

In 2001, the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) implemented numerous (and generally very popular) retirement plan changes. Because the changes resulted in lower taxes, they were scheduled to expire (or “sunset”) in 2010. The Act repeals EGTRRA’s sunset date. The EGTRRA changes made permanent by the Act include:

• Higher limits on contributions to defined contribution plans ($44,000 in 2006), elective deferrals (including $15,000 in 2006 for 401(k) plan deferrals), 457 plan deferrals ($15,000 in 2006), and compensation that may be taken into account under a plan.
  
  
• Catch-up contributions for participants 50-years old and older ($5,000 in 2006 for 401(k) plans).
  
  
• Repeal of the coordination requirements for limits of 457 plan deferrals so that the limit on contributions on behalf of an employee to a 457 plan is not reduced by the amount of any employee contributions to a 401(k) or 403(b) plan.
  
  
• Availability of Roth 401(k) and Roth 403(b) plans.
  
  
• Simplification of the top-heavy nondiscrimination and coverage rules.
  
  
• Repeal of the multiple use test for 401(k) plan deferrals and contributions subject to Code section 401(m).
  
  
• Repeal of the same desk rule.
  
  
• Repeal of the compensation limit for multiemployer plans.
  
  
• Modified deductions for employer contributions to qualified plans, including the exclusion of 401(k) plan deferrals.
  
  
• Ability to reinvest ESOP dividends without the loss of dividend deductions.
  
  
• Expansion of rollover opportunities, including for after-tax contributions.
  
  
• Automatic rollovers of certain small account distributions.
  
  
• Start-up tax credit for new small employer-sponsored plans (maximum $500 per year for each of first three years).

Next Step for Employers

Expanded Employer Stock Diversification Rights

Since Enron’s collapse and similar scandals, Congress has focused on the extent to which plan participants might be “trapped” with an investment in employer stock. The Act reflects those concerns, and extends diversification rights to participants, but only with respect to the retirement plans of publicly traded employers.

What Plans Must Offer Diversification?

• Qualified retirement plans that provide for investment in employer stock, but only if the employer’s stock is publicly traded.
  
  
• Special rules apply to control groups, where one of the companies has publicly traded stock and others do not.
  
  
• The Act’s new diversification requirements generally do not apply to ”plain” ESOPs, since the Code already imposes special ESOP diversification rules; however, the new rules do apply to ESOPs operated with 401(k) plans (often called “KSOPs”) or in situations where employer stock contributions are used to satisfy non-discrimination tests applicable to a 401(k).

What Plan Accounts are Subject to Diversification?

• Employee contributions, whether pre-tax salary deferral contributions under a 401(k) plan or after-tax contributions, are always available for diversification by all employees.
  
  
• Accounts attributable to matching contributions and other employer contributions are available for diversification with respect to employees who have at least three years of service.

What Diversification Rights Must be Offered?

• When eligible for diversification, an employee must be able to redirect employer stock investments into a menu of at least three diversified options that present varying levels of risk (e.g., mutual funds of varying risk/return expectations).
  
  
• Eligible employees must have an opportunity to complete a diversification transaction at reasonable intervals, at least quarterly.
  
  
• Employees must receive notice of their right to diversify at least 30 days before an applicable account becomes eligible.

What is the Effective Date?

• The new diversification rule becomes effective for plan years starting in 2007, but the rule is phased in over three years. One third of the effective accounts are subject to diversification in the first year, another third in the second year, and the remainder in the third year.
  
  
• A special rule applies for employees who were age 55 with at least three years of service before the 2006 plan year. They are able to elect full diversification beginning in 2007.
  
  
• Salary deferral contributions under a 401(k) plan occurring during or after 2007 are subject to complete diversification as the investments are made.
  
  
• Plans for union employees have a later effective date, depending on the collective bargaining agreement.

Next Steps for Employers

2006 Year-End Compliance Checklist

This checklist is designed to help plans operate in compliance with new rules that apply in 2007 until the plan is amended. The choices made on this checklist will be incorporated in plan documents and should be announced to participants by a Summary of Material Modifications (SMM) or a revised Summary Plan Description (SPD). Please share this information with your third party administrator and anyone else who is responsible for the day-to-day administration of your plan.

Click here to view the compliance checklist.

For more information, please contact:

	Jeff Belfiglio Bellevue, Washington (425) 646-6128 jeffbelfiglio@dwt.com		Stuart Harris Portland, Oregon (503) 778-5428 stuartharris@dwt.com
	Sarah L. Bhagwandin Seattle, Washington (206) 903-3959 sarahbhagwandin@dwt.com		Greg K. Hitchcock Portland, Oregon (503) 778- 5327 greghitchcock@dwt.com
	Jason T. Froggatt Seattle, Washington (206) 628-7629 jasonfroggatt@dwt.com

This Advisory is a publication of the Employer Services Department of Davis Wright Tremaine LLP. Our purpose in publishing this Advisory is to inform our clients and friends of recent developments in employment law. It is not intended, nor should it be used, as a substitute for specific legal advice as legal counsel may be given only in response to inquiries regarding particular situations.

Copyright © 2006, Davis Wright Tremaine LLP.

return to Advisory Bulletins main page