August 8, 2006
The Congress has passed major pension legislation, the "Pension Protection Act of 2006" (the "Act"), which President Bush has promised to sign into law. We describe below some of the most important changes the Act makes and attach a detailed chart [PDF] summarizing many of the key benefits provisions of the Act. In addition, a Gibson Dunn update is available on certain changes affecting investment funds.
Funding of Defined Benefit Plans. The Act significantly changes the defined benefit plan funding rules, generally effective for plan years beginning in 2008. Plan sponsors may want to discuss these changes with their actuaries and consider whether additional contributions should be made before 2008. In particular, plans that are “at risk” (i.e., generally less than 80% funded) are subject to various requirements, including additional funding obligations and, in some cases, prohibitions on lump sum distributions.
Cash Balance Plan “Safe Harbors.” The Act includes “safe harbors” for cash balance plans with regard to the age discrimination and accrual rules, as well as with respect to “conversions” of “traditional” defined benefit plans. However, the safe harbors generally apply prospectively, and the Act specifically provides that no inference may be drawn with respect to events that occurred before enactment. In addition, the safe harbors impose stringent requirements that most cash balance plans do not meet (e.g., full vesting after three years of service). Finally, there is a risk that the “safe harbors” will eventually be treated by courts as the only way to satisfy the various rules.
Funding of Executive Compensation. The Act amends section 409A of the Internal Revenue Code (the "Code") to provide for accelerated income taxation of “covered” employees (as well as a 20% additional tax) if a nonqualified deferred compensation plan provides for funding (or if there actually is funding) of a rabbi trust or other vehicle when the employer (i) is in bankruptcy and sponsors a defined benefit plan, (ii) sponsors a defined benefit plan that is “at risk” under the rules noted above, or (iii) has recently effected a “distress” termination of an underfunded defined benefit plan. For this purpose, covered employees generally include the top-five officers of publicly-traded companies and former employees who were in that classification when they retired.
Employer Stock Diversification Rights. The Taxpayer Relief Act of 1997 generally prohibited employers from requiring employees to invest their own contributions in employer stock. The Act extends that rule to employer contributions once a participant completes three years of service in the plan. This rule applies to virtually all plans with publicly-traded employer stock (other than stand-alone ESOPs that do not include employee or employer matching contributions and one-participant plans) and is phased in over three years beginning in 2007.
Participant Investment Advice. The Act provides a prohibited transaction exemption to permit qualified fiduciary advisers to offer personal investment advice to participants in defined contribution plans and IRAs pursuant to an "eligible investment advice arrangement." In general, the arrangement must either provide that (i) the advice is based on computer models meeting certain criteria or (ii) the adviser’s compensation may not vary based on the investments selected. Various disclosure requirements and other conditions apply. The plan sponsor generally is protected against liability to participants in connection with such advice, provided the plan’s fiduciaries act prudently in selecting and monitoring the adviser. Employers can expect that many service providers will be calling to tout their virtues as providers of investment advice to the employer’s employees.
“Automatic Enrollment” 401(k) Plans. The Act provides various incentives to establish “automatic enrollment” 401(k) plans under which participants contribute unless they affirmatively “opt out.” These changes reduce various risks that have deterred employers from adopting automatic enrollment features, including clarifying the ERISA preemption of state wage laws and providing ERISA section 404(c)-type relief to default investment funds.
Faster Vesting of Employer Contributions. Beginning in 2007, employer non-matching contributions to defined contribution plans will be subject to the same vesting rules that have applied to employer matching contributions since 2002 (i.e., the contributions must vest at least as fast as a three-year “cliff” schedule or a six-year “graded” schedule).
Rollover Rights for Nonspouse Beneficiaries. Beginning in 2007, nonspouse beneficiaries will be permitted to “roll over” eligible rollover distributions to an IRA or another employer’s plan.
Permanency of EGTRRA. The Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") increased a number of the limits applicable to tax-qualified plans and added “Roth” IRAs. Those provisions were to sunset in 2010. The Act removes the sunset provision and makes these provisions permanent.
Changes of Rules Affecting Investment Funds. The Act relaxes the “significant" participation test for determining whether many investment funds contain plan assets. It also provides a number of prohibited transaction exemptions that will be useful to financial service providers. A separate Gibson Dunn Update that discusses these changes is available.
Gibson, Dunn & Crutcher lawyers are available to assist clients in addressing any questions they may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work, or
William J. Kilberg (202-955-8573, firstname.lastname@example.org),
Stephen W. Fackler (650-849-5385, email@example.com),
David West (213-229-7654, firstname.lastname@example.org),
David I. Schiller (214-698-3205, email@example.com),
Michael J. Collins (202-887-3551, firstname.lastname@example.org),
Sean Feller (213-229-7579, email@example.com),
Amber Busuttil Mullen (213-229-7023, firstname.lastname@example.org),
Jennifer Patel (202-887-3564, email@example.com) or
Chad Mead (214-698-3134, firstname.lastname@example.org).
IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any matters addressed herein.
© 2006 Gibson, Dunn & Crutcher LLP
The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.