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PENSION PROTECTION ACT OF 2006:
RETIREMENT PLAN PROVISIONS
~ A letter from the Tax Director at Case | Sabatini ~

Background

The Pension Protection Act of 2006 amends numerous rules related to qualified retirement plans and other similar plans. The amendments change the landscape of retirement plans. Their pervasive nature is evidenced by the fact that Congress has allowed delay of slightly over one year before most provisions take effect. Some, however, take effect immediately. While this gives plan sponsors a little time to ramp up, the complexity of the overhaul is so significant that immediate attention will be required.

Pension Plans – Current Law and Current Liability

Until the provisions of the Act take effect, present law imposes special funding rules (referred to as the "deficit reduction contribution" rules), under which an additional charge to a plan's funding standard account is generally required for a plan year if the plan's funded current liability percentage for the plan year is less than 90 percent. A plan's "funded current liability percentage" is generally the actuarial value of plan assets as a percentage of the plan's current liability. In general, a plan's current liability means all liabilities to employees and their beneficiaries under the plan, determined on a present-value basis.

Under the Pension Funding Equity Act of 2004, a special interest rate applies in determining current liability for plan years beginning in 2004 or 2005. For these years, a weighted average rate on long-term investment-grade corporate bonds is used as the benchmark. The Act extends this benchmark to plan years beginning after December 31, 2005, and before January 1, 2008.

Pension Plans - Overhaul

General. For plan years beginning after December 31, 2007, in the case of single-employer defined benefit plans, the Act repeals the present-law funding rules (including the requirement that a funding standard account be maintained) and provides a new set of rules for determining minimum required contributions. Under the new rules, the minimum required contribution to a single-employer defined benefit pension plan for a plan year generally depends on a comparison of the value of the plan's assets with the plan's funding target and target normal cost. These are new concepts.

New Rules. The minimum required contribution for a plan year generally is as follows:

· If the value of plan assets (reduced by any pre-funding balance and funding standard carryover balance) is less than the funding target, then the minimum required contribution is equal to the sum of target normal cost, any shortfall amortization charge, and any waiver amortization charge.

· On the other hand, if the value of plan assets (reduced by any pre-funding balance and funding standard carryover balance) equals or exceeds the funding target, then the minimum required contribution is equal to the target normal cost, reduced (but not below zero) by the excess of the value of plan assets (reduced by any pre-funding balance and funding standard carryover balance), over the funding target.

Definitions. A plan's funding target is the present value of all benefits accrued or earned as of the beginning of the plan year. A plan's target normal cost for a plan year is the present value of benefits expected to accrue or be earned during the plan year. A shortfall amortization charge is generally the sum of the amounts required to amortize any shortfall amortization bases for the plan year and the six preceding plan years. A shortfall amortization base is generally required to be established for a plan year if the plan has a funding shortfall for a plan year. A shortfall amortization base may be positive or negative, i.e., an offsetting amortization base is established for gains. In general, a plan has a funding shortfall if the plan's funding target for the year exceeds the value of the plan's assets (reduced by any pre-funding balance and funding standard carryover balance). A waiver amortization charge is the amount required to amortize a waived funding deficiency.

Present Value and Interest Rates. The Act specifies the interest rates that must be used in determining a plan's target normal cost and funding target. Subject to a transition rule, present value is generally determined using three interest rates ("segment" rates), each of which applies to benefit payments expected to be made from the plan during a certain period. The first segment rate applies to benefits reasonably determined to be payable during the five-year period beginning on the first day of the plan year; the second segment rate applies to benefits reasonably determined to be payable during the 15-year period following the initial five-year period; and the third segment rate applies to benefits reasonably determined to be payable the end of the 15-year period. Each segment rate is a single interest rate determined monthly by the Secretary of the Treasury (i.e., the IRS) on the basis of a corporate bond yield curve, taking into account only the portion of the yield curve based on corporate bonds maturing during the particular segment rate period.

At-Risk Plans. Of special interest to Congress are plans in jeopardy. As such, the Act applies special assumptions ("at-risk" assumptions) in determining the funding target and normal cost of a plan in at-risk status. As discussed below, these assumptions are somewhat punitive in nature.

Whether a plan is in at-risk status for a plan year depends on its funding target attainment percentage for the preceding year. A plan's funding target attainment percentage for a plan year is the ratio, expressed as a percentage, which the value of the plan's assets (reduced by any funding standard carryover balance and pre-funding balance) bears to the plan's funding target for the year.

Under the Act, a plan is in at-risk status for a year if, for the preceding year: (1) the plan's funding target attainment percentage, determined without regard to the at-risk assumptions, was less than 80 percent (subject to a transition rule), and (2) the plan's funding target attainment percentage, determined using the at-risk assumptions (without regard to whether the plan was in at-risk status for the preceding year), was less than 70 percent. Under the Act, the at-risk rules do not apply if a plan had 500 or fewer participants on each day during the preceding plan year.

If a plan is in at-risk status, the plan's funding target and normal cost are determined using significantly tighter (and participant-friendly) assumptions.

Funding Standard Carryover Balances and Pre-Funding Balances. The Act preserves credit balances that have accumulated under present law (referred to as "funding standard carryover balances"). In addition, for plan years beginning after 2007, new credit balances (referred to as "pre-funding balances") result if an employer makes contributions greater than those required under the new funding rules. In general, under the Act, employers may choose whether to count funding standard carryover balances and pre-funding balances in determining the value of plan assets or to use the balances to reduce required contributions, but not both. In this regard, the Act provides more favorable rules with respect to the use of funding standard carryover balances.

Valuation of Plan Assets. Under the Act, the value of plan assets is generally fair market value. This is another departure from present law, and tightens the reins on pension plans. Note, however, that the value of plan assets may be determined on the basis of the averaging of fair market values, but only if the methodology: (1) is “permitted” under regulations; (2) does not provide for averaging of fair market values over more than the period beginning on the last day of the 25th month preceding the month in which the plan's valuation date occurs and ending on the valuation date (or similar period in the case of a valuation date that's not the first day of a month); and (3) does not result in a determination of the value of plan assets that at any time is less than 90 percent or more than 110 percent of the fair market value of the assets at that time. Any averaging must be adjusted for contributions and distributions as provided by the IRS.

Timing Rules for Plan Contributions. As under present law, the due date for the payment of a minimum required contribution for a plan year is generally 8 ½ months after the end of the plan year. Any payment made on a date other than the valuation date for the plan year must be adjusted for interest accruing at the plan's effective interest rate for the plan year for the period between the valuation date and the payment date. Quarterly contributions must be made during a plan year if the plan had a funding shortfall for the preceding plan year (that is, if the value of the plan's assets, reduced by the funding standard carryover balance and pre-funding balance, was less than the plan's funding target for the preceding plan year). If a quarterly installment is not made, interest applies for the period of underpayment at the rate of interest otherwise applicable (i.e., the plan's effective interest rate) plus 5 percentage points.

The foregoing rules apply to single employer plans, and are generally effective for plan years beginning after December 31, 2007. The effective date is delayed for plans of certain “eligible government contractor plans.” Multiemployer plans continue to be governed by current, albeit tighter, funding rules.

Impact of At-Risk Pensions on Nonqualified Deferred Compensation Plans

Effective for transfers or other reservations of assets after August 17, 2006, if during any “restricted period,” assets are set aside or restricted for certain executives under a nonqualified deferred compensation plan or arrangement, the transfer or restriction will generally be treated as taxable income to the executive. That is, there will be no deferral of taxes under the plan. A restricted period is (1) any period in which a single-employer defined benefit pension plan of an employer is in at risk-status, (2) any period in which the employer is in bankruptcy, and (3) the period that begins six months before and ends six months after the date any defined benefit pension plan of the employer is terminated in an involuntary or distress termination.

Pension Plan Lump-Sum Distributions

Accrued benefits under a defined benefit pension plan generally must be paid in the form of an annuity for the life of the participant unless the participant consents to a distribution in another form, such as a lump-sum distribution. Statutory interest and mortality assumptions must be used in determining the minimum value of the lump sum. The applicable interest rate is the annual interest rate on 30-year Treasury securities for the month before the date of distribution or such other time as prescribed by Treasury regulations. The applicable mortality table is a mortality table based on the 1994 Group Annuity Reserving Table ("94 GAR"), projected through 2002.

Effective for plan years beginning after December 31, 2007, the Act changes the interest rate and mortality table used in calculating the lump sum. Subject to transition rules and certain adjustments, the value will be calculated using the first, second, and third segment rates as described above and applied under the funding rules. The applicable mortality table that must be used will also be revised on a gender-neutral basis (by the IRS).

Interest Rate Assumption for Applying Benefit Limitations to Lump-Sum Distributions

Annual benefits payable under a defined benefit pension plan generally may not exceed the lesser of (1) 100 percent of average compensation, or (2) $175,000 (for 2006). The dollar limit generally applies to a benefit payable in the form of a straight life annuity. If the benefit is not in the form of a straight life annuity (e.g., a lump sum), the benefit generally is adjusted to an equivalent straight life annuity. For purposes of adjusting a benefit in a form that is subject to the minimum value rules, such as a lump-sum benefit, the interest rate used generally must be not less than the greater of: (1) the rate applicable in determining minimum lump sums (i.e., the interest rate on 30-year Treasury securities); or (2) the interest rate specified in the plan. In the case of plan years beginning in 2004 or 2005, the interest rate used generally must be not less than the greater of: (1) 5.5 percent; or (2) the interest rate specified in the plan.

Effective for years beginning after December 31, 2005, the Act provides that, for purposes of adjusting a benefit in a form that is subject to the minimum value rules, such as a lump-sum benefit, the interest rate used generally must be not less than the greater of: (1) 5.5 percent; (2) the rate that provides a benefit of not more than 105 percent of the benefit that would be provided if the rate (or rates) applicable in determining minimum lump sums were used; or (3) the interest rate specified in the plan.

Missing Participants

Effective for distributions made after final regulations are prescribed, plan administrators of certain types of plans will be permitted, but not required, to elect to transfer missing participant benefits to the Pension Benefit Guaranty Corporation upon plan termination. Specifically, the provision extends the missing participant program (in accordance with regulations) to defined contribution plans, defined benefit pension plans that have no more than 25 active participants and are maintained by professional service employers, and the portion of defined benefit pension plans that provide benefits based upon the separate accounts of participants and therefore are treated as defined contribution plans under ERISA.

Benefit Statements

Generally effective for plan years beginning after December 31, 2006, the Act revises the benefit statement requirements under ERISA. The new requirements depend in part on the type of plan and the individual to whom the statement is provided. For example, a defined contribution plan is required to provide a benefit statement (1) to a participant or beneficiary who has the right to direct the investment of the assets in his or her account, at least quarterly, (2) to any other participant or other beneficiary who has his or her own account under the plan, at least annually, and (3) to other beneficiaries, upon written request, but limited to one request during any 12-month period. The benefit statement provided with respect to a defined contribution plan must include the value of each investment to which assets in the individual's account are allocated (determined as of the plan's most recent valuation date), including the value of any assets held in the form of employer securities (without regard to whether the securities were contributed by the employer or acquired at the direction of the individual). A quarterly benefit statement provided to a participant or beneficiary who has the right to direct investments must also provide: (1) an explanation of any limitations or restrictions on any right of the individual to direct an investment; (2) an explanation, written in a manner calculated to be understood by the average plan participant, of the importance, for the long-term retirement security of participants and beneficiaries, of a well-balanced and diversified investment portfolio, including a statement of the risk that holding more than 20 percent of a portfolio in the security of one entity (such as employer securities) may not be adequately diversified; and (3) a notice directing the participant or beneficiary to the Internet website of the Department of Labor for sources of information on individual investing and diversification. Other new rules apply, including rules for defined benefit plans.

Investment Advice

In the case of investment advice, caution must be exercised, as the prohibited transaction rules and related penalties may be invoked. Generally effective with respect to investment advice provided after December 31, 2006, the Act adds a new category of prohibited transaction exemption under ERISA and the Internal Revenue Code in connection with the provision of certain investment advice. Specifically, the exemption applies to investment advice provided through an "eligible investment advice arrangement" to participants and beneficiaries of a defined contribution plan who direct the investment of their accounts under the plan and to beneficiaries of IRAs. If the requirements under the provision are met, the following are exempt from prohibited transaction treatment: (1) the provision of investment advice; (2) an investment transaction (i.e., a sale, acquisition, or holding of a security or other property) pursuant to the advice; and (3) the direct or indirect receipt of fees or other compensation in connection with the provision of the advice or an investment transaction pursuant to the advice.

Investment Elections

One of the cornerstones of the new legislation is participant control over investments. Effective for plan years beginning after December 31, 2006, a participant is treated as exercising control with respect to assets invested in a default arrangement until the participant makes an affirmative election regarding investments. The Department of Labor has been directed to issue regulations that provide guidance on the designation of investments as default investments, including guidance regarding appropriate mixes of default investments and asset classes which the DOL considers consistent with long-term capital appreciation or long-term capital preservation (or both), and the designation of other default investments. The DOL is required to issue the regulations within six months of the date of enactment (August 17, 2006).

Deduction Rules

Under the Act, for taxable years beginning in 2006 and 2007, in the case of contributions to a single-employer defined benefit plan, the maximum deductible amount is not less than the excess (if any) of (1) 150 percent of the plan's current liability, over (2) the value of plan assets.

For taxable years beginning after 2007, in the case of contributions to a single-employer defined benefit pension plan, the maximum deductible amount is equal to the greater of: (1) the excess (if any) of the sum of the plan's funding target, the plan's target normal cost, and a cushion amount for a plan year, over the value of plan assets (as determined under the minimum funding rules); and (2) the minimum required contribution for the plan year. The cushion amount for a plan year is the sum of (1) 50 percent of the plan's funding target for the plan year; and (2) the amount by which the plan's funding target would increase if determined by taking into account increases in participants' compensation for future years or, if the plan does not base benefits attributable to past service on compensation, increases in benefits that are expected to occur in succeeding plans year, determined on the basis of average annual benefit increases over the previous six years.

Permanency of EGTRRA Pension and IRA Provisions

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) made many taxpayer-friendly changes to the Internal Revenue Code. It authorized catch-up contributions for older workers, increased contribution limits and benefits, made some retirement arrangements more attractive for small businesses, and expanded rollover options for taxpayers with 457 and 403(b) plans. Like most of EGTRRA's provisions, the enhanced retirement savings incentives were temporary and would have ended after December 31, 2010. However, the Pension Protection Act of 2006 repeals the sunset provision in EGTRRA that applies to retirement savings plans.

The major EGTRRA retirement provisions that are made permanent rather than sunset at the end of 2010 include:

· Permanent higher dollar amount for IRA contributions ($4,000 in 2006 and 2007, $5,000 in 2008, inflation adjusted thereafter).

· Permanent higher dollar limits on defined contribution plans ($44,000 in 2006), elective deferrals (including $15,000 in 2006 for 401(k) plan deferrals) and compensation that may be taken into account under a plan.

· Permanent catch-up contributions for older workers ($1,000 after 2005 for IRAs, $2,500 for SIMPLE plans, $5,000 for 401(k) plans).

· Permanent faster vesting of employer matching contributions.

· Elective deferrals not taken into account for purposes of deduction limits (enhancing the availability of so-called solo-401(k) plans).

· Purchase of service credit under governmental pension plans.

· Automatic rollovers of certain mandatory distributions.

Government Plans and the Purchase of Permissive Service Credit

A qualified retirement plan maintained by a State or local government employer may provide that a participant may make after-tax employee contributions in order to purchase permissive service credit, subject to certain limits. Permissive service credit means credit for a period of service recognized by the governmental plan which the participant has not received under the plan and which the employee receives only if the employee voluntarily contributes to the plan an amount (as determined by the plan) that does not exceed the amount necessary to fund the benefit attributable to the period of service and that is in addition to the regular employee contributions, if any, under the plan.

The Act modifies the definition of permissive service credit by providing that permissive service credit means service credit which relates to benefits to which the participant is not otherwise entitled under such governmental plan, rather than service credit which such participant has not received under the plan. Credit qualifies as permissive service credit if it is purchased to provide an increased benefit for a period of service already credited under the plan (e.g., if a lower level of benefit is converted to a higher benefit level otherwise offered under the same plan), as long as it relates to benefits to which the participant is not otherwise entitled. In addition, the Act allows participants to purchase credit for periods regardless of whether service is performed, subject to the limits on nonqualified service. These provisions are generally effective as if they were included in the amendments made by the Taxpayer Relief Act of 1997.

Hardship Distributions

Distributions from a 401(k) plan, a tax-shelter annuity, a Section 457 plan, or nonqualified deferred compensation plan subject to Section 409A may not be made prior to the occurrence of one or more specified events. In the case of a Section 401(k) plan or tax-sheltered annuity, one event upon which distribution is permitted is the case of a hardship. Similarly, distributions from Section 457 plans and nonqualified deferred compensation plans subject to Section 409A may be made in the case of an unforeseeable emergency. Under regulations, a hardship or unforeseeable emergency includes a hardship or unforeseeable emergency of a participant's spouse or dependent.

Effective August 17, 2006, the Act directs the Secretary of the Treasury (i.e., the IRS) to revise the rules for determining whether a participant has had a hardship or unforeseeable emergency to provide that, if an event would constitute a hardship or unforeseeable emergency under the plan if it occurred with respect to the participant's spouse or dependent, such event will, to the extent permitted under the plan, constitute a hardship or unforeseeable emergency if it occurs with respect to a beneficiary under the plan. The provision requires that the revised rules be issued within 180 days after the date of enactment (August 17, 2006).

Automatic 401(k) Enrollment

The Act strongly encourages automatic enrollment in 401(k) plans. Under the Act, a 401(k) plan that contains an automatic enrollment feature that satisfies certain requirements (a "qualified automatic enrollment feature") is deemed to meet certain nondiscrimination tests, as well as the top-heavy rules. The administration of these tests and rules is often an expensive proposition for employers.

An employer that wishes to take advantage of the new law must implement a “qualified automatic enrollment feature.” Under such a feature, the plan must provide that, unless an employee elects otherwise, the employee is treated as making an election to make elective deferrals equal to a stated percentage of compensation not in excess of 10 percent and at least equal to three percent of compensation for the first year the deemed election applies to the participant, four percent during the second year, five percent during the third year, and six percent during the fourth year and thereafter. The stated percentage must be applied uniformly to all eligible employees.

An automatic enrollment feature must also require the employer to either (1) satisfy a matching contribution requirement, or (2) make a three-percent nonelective contribution to a defined contribution plan. Any matching or other employer contributions taken into account in determining whether the requirements for a qualified automatic enrollment feature are satisfied must vest at least as rapidly as under two-year cliff vesting. That is, employees with at least two years of service must be 100 percent vested with respect to such contributions. The automatic enrollment rules are generally effective for years beginning after December 31, 2007.

Vesting

Under present law, in general, a plan is not a qualified plan unless a participant's employer-provided benefit fully vests upon the completion of five years of service or pursuant to a seven-year graded vesting schedule. Faster vesting schedules apply to employer matching contributions. Employer matching contributions are required to fully vest after three years of service or pursuant to a six-year graded vesting schedule.

Effective for contributions for plan years beginning after December 31, 2006, the Act applies the present-law vesting schedule for matching contributions to all employer contributions to defined contribution plans.

In-Service Pension Distributions

In general, a pension plan (i.e., a defined benefit plan or money purchase pension plan) may not provide for distributions before the attainment of normal retirement age (commonly age 65) to participants who have not separated from employment. Effective for distributions in plan years beginning after December 31, 2006, the Act provides that in-service distributions may be made to an employee who has attained age 62 and who is not separated from employment at the time of the distribution.

Summary

As you can see, the Pension Act made a number of important changes, several which may have an impact on the retirement plan. While the foregoing summary is intended to be an accurate account of the new law, it is not intended to be tax advice. As such, you should consult with the text of the new law, as well as its legislative history and tax counsel, for specific guidance. As always, we would be pleased to assist you before you act on any information contained in this letter.

For additional guidance, or if you would like to discuss how this will affect your tax planning, please contact our firm at (412) 881-4411. If you do not have a contact at Case | Sabatini, simply ask for Jim Dee and he'll make sure to put you in touch with the CPA whose background most closely matches your needs.

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Disclaimer: To ensure compliance with requirements imposed by the Internal Revenue Service, 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 any penalties that may be imposed, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.