Pension Protection Act of 2006—United States

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By Silvio Ingui | 01 October 2006

The Pension Protection Act's (PPA) expansive sweep affects nearly all employer-sponsored retirement plans. Although its most significant effects will be felt by defined benefit plans covered by U.S. funding rules (including cash balance and other hybrid plan designs), the PPA includes important provisions affecting 401(k) and other defined contribution plans.

Effective dates

The PPA does not have one general effective date that applies to all of its provisions. Instead, the law includes different effective dates, with some applying retroactively and others effective according to plan or tax years. Amendments to retirement plans generally should be made by the end of the 2009 plan year. Plans must be in operational compliance as of the effective date of the PPA's various provisions.

Funding of defined benefit pension plans

The PPA overhauls the rules on employer contributions for defined benefit plans subject to minimum funding standards. The new funding rules generally go into effect for the 2008 plan year.

The PPA will ultimately require plans to make contributions necessary to amortize unfunded benefit liabilities over seven years. The PPA prescribes key actuarial assumptions, tightens smoothing methods, and shortens amortization periods.

The new rules will force sponsors of underfunded plans to contribute substantially more than under existing law. In addition, the manner in which the PPA determines contribution requirements could lead to significant volatility from year to year in required contributions, especially for underfunded plans. Even plans that are fully funded one year may become underfunded the next, depending on changes in interest rates.

The PPA's funding requirements for single employer plans entail:

  • Minimum funding standard—basic method. The PPA tightens actuarial assumptions and methods, forcing a plan to fund toward a 100% funded level more rapidly than under previous standards. Plan sponsors must determine the minimum contribution by using the "unit credit actuarial cost" method, under which the contribution requirement for a year is equal to the actuarial present value of benefits expected to accrue during the year plus a seven-year amortization of unfunded amounts, including gains or losses.
  • Interest rate. Beginning in 2008, plans must value their pension liabilities using a simplified yield curve matching the duration of the liability with the interest rate. Use of the yield curve may mean higher liabilities and contributions than under pre-PPA law for plan sponsors in industries where the number of retirees exceeds the number of active employees, such as traditional manufacturing.
  • Mortality assumption. Pension liabilities must be valued using a prescribed mortality assumption. Because the new mortality table will take mortality improvements into account, the likely effect is an increase in liability and costs for most pension plans.
  • At-risk valuation. Similar to the pre-PPA deficit reduction contribution, the required contribution is increased for plans that are "at risk," as characterized by a significantly low funding ratio.
  • Asset valuation—smoothing. The market value of plan assets may be averaged over a 24-month period. Smoothed asset values may not be less than 90% or greater than 110% of the market value of the plan assets, narrowed from the 80% to 120% corridor prior to the PPA. If a pension plan's assets are heavily invested in securities with highly volatile market prices, this change may cause a significant increase in the volatility of the employer's required contribution.
  • Credit balances. Credit balances—the accumulation of employer contributions in excess of the minimum funding standard—must generally be subtracted from plan assets to determine a plan's funding shortfall. If a plan's funded ratio (determined with a reduction of assets by any post-PPA credit balance) is at least 80%, the plan sponsor may use a credit balance to offset any required contribution.
  • Deductibility limit. Beginning in 2008, employers may deduct amounts sufficient to fund the plan up to 150% of the "at-risk" target liability (including the value of expected future compensation increases on accrued benefits).

Benefit determinations and restrictions for plans

The PPA imposes new limitations on benefits provided, unless the plan's funded status meets certain thresholds:

  • Restrictions on distributions—If the plan's funded ratio is less than 60%, distributions to a participant are limited. Notably, a participant cannot receive a lump-sum distribution of the full value of the accrued benefit. For a bankrupt firm, the relevant threshold for the restriction on distributions is 100%.
  • Restrictions on plan amendments improving benefits—A plan may not be amended to increase benefits if its funded ratio would be less than 80% after the plan amendment, unless the employer immediately contributes the full value of the amendment to the pension fund.
  • Restriction on benefit accruals for severe funding shortfall—The accrual of new benefits under a plan is prohibited if the plan's funded status is less than 60%.

Cash balance and other hybrid pension plans

The PPA explicitly authorizes hybrid plans—such as cash balance or pension equity plans—under which the benefit is determined by reference to a hypothetical account or other balance. In particular, the law establishes that most existing hybrid plans are deemed in compliance with age nondiscrimination requirements after June 29, 2005.

The hybrid plan requirements include:

  • Three-year cliff vesting. Accrued benefits must vest completely within three years of service.
  • Wearaway safeguards. For a hybrid pension plan that is created by a conversion from a traditional pension plan, "wearaway" is prohibited. Regardless of the accrued benefit under the prior plan design, each active participant must receive an accrual under the new plan design.
  • Interest crediting rate. Hybrid plans that use a hypothetical interest rate in the determination of benefit accruals must use a rate from 0% up to a published market rate. Plans using an interest rate within the corridor could pay the hypothetical account balance as a lump-sum distribution, avoiding the "whipsaw" issue that had plagued many hybrid plans.

Provisions for defined contribution plans

The PPA includes provisions for defined contribution plans that allow for participants to direct their investments.

Investment advice

These new rules allow a "fiduciary adviser" (e.g., a brokerage firm, mutual fund family, insurance company, etc.) to advise participants about their investments if certain criteria are met.

Automatic contribution safe harbor for 401(k) plans

The PPA creates "qualified automatic contribution arrangements," which automatically defer a stated percentage of employee pay, that are exempt from the actual deferral percentage (ADP) test for 401(k) plans. This provision allows highly compensated employees to defer the maximum allowable deferral amount without worrying that some of it will be returned. If the plan design also limits matching contributions according to the PPA's requirements, the plan will automatically pass the actual contribution percentage (ACP) test.

A qualified automatic contribution arrangement must comply with the following criteria:

  • The arrangement must apply to every new employee who becomes eligible to participate in the plan following the adoption of the feature and to current employees who have not already made an election on plan participation.
  • Absent an election to do otherwise, the plan must automatically defer a stated percentage of salary into the 401(k) plan. The automatic deferral percentage must be uniform for all employees and must not exceed 10%, but must be at least 3% for the first year the employee participates in the plan, increasing up to 6% by the fourth year.
  • Each employee must be given the opportunity to elect out of the automatic contribution feature or to defer a different percentage of pay.
  • The employer must match 100% of each nonhighly compensated employee's deferral amount up to 1% of pay plus 50% of any additional deferrals up to 6% of pay for a total maximum match of 3.5% of pay, or contribute 3% of pay for each nonhighly compensated employee eligible to participate in the plan. The rate of matching contributions for highly compensated employees must not be higher than the rate for nonhighly compensated employees.
  • The employee must be 100% vested in employer contributions after two years of service.
  • Employees eligible to participate in the 401(k) plan must be given a notice that explains the automatic contribution feature and related options. Employees must be given a reasonable period to change the automatic contribution amounts or elect out of the program.

Diversification requirements

Defined contribution plans holding publicly traded employer securities must give participants the ability to diversify those investments. Exceptions apply, most notably for certain stand-alone ESOPs.

New disclosure and notice requirements for all retirement plans

The PPA establishes significant new disclosure requirements. Plan sponsors will need to provide participants more details about all retirement plans and must do so faster than under current law.

Conclusion

Virtually all retirement plans will be affected by the PPA, requiring plan sponsors to amend their plans, change communication materials, and revise administrative manuals and practices. The new funding rules for defined benefit plans, coupled with pending changes in accounting requirements, will cause many more plan sponsors to rethink how they provide and fund for retirement benefits to employees. Before taking any abrupt action, plan sponsors should carefully evaluate the options, the expected expense, their ability to meet benefit objectives, and the risk exposure of their existing plans.