What is New in the New Pension Law?

November, 2006

By Alan M. Levy, Esq.

Airlines are using bankruptcy to get rid of pension plans. Enron executives have been held liable for millions of dollars lost by the company's defined contribution plans. Huge multiemployer pension funds have reduced future benefits to cope with stock market losses and retirees outnumbering active participants. The Pension Benefit Guarantee Corporation, the federal agency which assures benefits for retirees in underfunded plans, has a deficit of $20,000,000,000.00. These billion dollar problems often end up as additional liabilities for the employers who must fund these programs and the employees - from management to entry level workers - who depend on them for their retirement. The new pension law has created both options and liabilities for employers; this summary describes some of those new rules.

On August 17, 2006, President Bush signed the 900-page Pension Protection Act of 2006, the "PPA." The core ¹ of this legislation pushes employers away from defined benefit plans and toward defined contribution plans. It will now be easier and less legally risky to administer a 401(k) plan or a cash balance plan, and even more onerous to continue a classic fixed pension program. At the same time, because the vast majority of multiemployer pension funds are defined benefit plans, more stringent funding rules for them will both discourage new employer entries and further burden those already contributing employers by making them pay for circumstances over which they had no control.

401(k) PLANS AND OTHER DEFINED BENEFIT PROGRAMS

Defined contribution plans have always been attractive because the employer only promises an amount to be contributed, not an amount to be paid out as a retirement benefit; the retiree receives only the value of the promised contributions plus any earnings or losses on them. (Interestingly, the Center for Retirement Research at Boston College reported on September 5, 2006 that from 1988 through 2004, defined benefit pension plans outperformed 401(k) plans by 1% in terms of return on investment; IRAs earned even less.) The legal problems with these plans typically arise from the failure or refusal of some lower-paid employees to enter them (thus skewing downward the possible contribution on behalf of some "highly compensated employees") and from the appropriate investment programs for which the plan fiduciary is responsible.

The PPA addresses the first issue by changing the ground rules for plan enrollment. The old law required employees to make an affirmative decision to participate in the employer's 401(k) defined contribution plan; often employees declined to participate because they did not want a consequent payroll deduction. Starting with plan years after 2007, the PPA allows an employer to require automatic enrollment in its 401(k) plan, with a subsequent right to opt out within 90 days and be reimbursed without penalty for state payroll withholding taxes for any deductions made until then.

The second major 401(k) issue is the fiduciary's duty to manage the investment of fund assets. Most employers (who typically designate members of their management as the 401(k) plan's fiduciary) minimize this obligation by using plans which establish self-directed individual participant accounts within the fund, thus moving the investment selection responsibility to the employee. However, large proportions of participants, either fearful of making bad investment decisions or unaware of their options, fail to direct their investments and cause the contributions on their behalf to go to a "default account" composed of unassigned assets; this practice may well increase as automatic enrollments bring in more participants who do not focus on their retirement benefits.

The plan fiduciary of a program with a significant "default account" (or one without self-directed individual accounts) is responsible for the prudent investment of those funds. A safe but low yielding money market or bond fund is not prudent if reasonable risk in a mutual fund, for example, would produce appreciably better returns. The PPA and the proposed regulations issued by the Department of Labor on September 28, 2006 address this issue by permitting and encouraging three alternative investment vehicles:

"Life-cycle funds" which balance risk and age with debt and equity investments, typically moving to more conservative investments as participants get older; these could be multiple funds assigned to participants by age range, or a single fund for smaller plans that determine that most of their participants are in a narrow range of ages.
A single-balance fund for all assets of all participants in the default account, which would require the fiduciary to make prudent investment selections which provide an appropriate mix of debt, equity, etc., taking into account the plan population's ages and other demographics; modify the investments as appropriate for changes in those demographics and the marketplace; and conscientiously monitor performance results to correct unintended asset fluctuations.
Individually managed accounts for each participant, which is a greater burden than broad-range vehicles in the context of required prudence, but might be more easily handled by putting each affected participant in his/her own individual life-cycle fund.

If self-directed individual accounts are used, the fiduciary will still have an obligation to provide an array of investment options which are reasonable and prudent. Thus, the fiduciary must monitor and adjust the mutual funds and other vehicles made available for self-direction to assure they meet their represented expectations, include an adequate variety of opportunities, and do not cause unreasonable risks or administrative costs. The PPA offers some relief in this regard by amending the ERISA prohibited transaction rules to allow a plan to offer participants guidance through an "eligible investment advice arrangement" which either does not charge its fees based on the particular investment options selected or only uses a computer program model which is dedicated to providing investment advice to participants. (The investment advice rule also applies to IRAs, HSAs, Archer MSAs, and Coverdall education savings accounts.) Also, the PPA now allows block trading, cross trading, and other specified investment practices, and it allows participants to sell any company-matched stocks in their accounts after completing three years of service.

A variation on the 401(k) aspects of the PPA is the new law's modifications to rules about IRAs. Rollover options have been expanded to allow tax-free distributions from the account of a deceased employee to the IRA of a beneficiary other than his/her spouse. After 2007, distribution from a qualified plan can be rolled over into a Roth IRA as if being transferred from a traditional IRA without a 10% early distribution tax penalty if the individual's adjusted gross income is less than $100,000.00. Hardship/unforeseeable emergency distributions and withdrawals to pre-age 59 V2 military reservists have been liberalized, and income limits on IRAs and Roth IRAs are indexed after 2006.

SINGLE EMPLOYER DEFINED BENEFIT PLANS

Funding issues dominate the future of defined benefit plans - those programs in which the plan sponsor (employer) must contribute whatever it takes to assure a specific benefit (e.g., monthly payments of $1,000.00, or of years of service multiplied by a factor such as 2% of final annual salary). In recent years, losses in market values and/ or in the population of active participants have reduced assets, requiring employers to contribute higher than anticipated dollar amounts to satisfy funding needs.

Funding a defined benefit plan has two basic elements: the amortized anticipated net liability as benefits become due, which is the "prefunding balance," and the adjustment of that figure to accommodate net gains and losses from investment income, administrative expenses, and unanticipated benefit payments or savings in a particular year, which is the "funding shortfall." Until now, actuaries typically "smoothed" or "leveled" gains and losses over a five year term to allow offset of "bad" and "good" years in the market. This meant that any given year's asset valuation could reflect a five year averaged result instead of an annual "snapshot" of the plan's current financial condition.

Starting in the first plan year after 2007, the PPA will require that defined benefit plans reduce the leveling periods to recognize more immediate market values of assets. Now asset values will have to be averaged over no more than a 24-month period, subject to a maximum of 105% of market value on the valuation date. This asset figure is then to be compared to the plan's "target liability," i.e., the liability for anticipated benefit accruals in the current plan year, which is the plan's "target normal cost." In turn, the plan's sponsor must make a minimum annual contribution equal to its normal cost plus the amortization of any shortfall over no more than seven years. In general, after that first year under the new rule, the shortfall amortization base will reflect gains and losses from the immediate prior year. Carryover gains and losses can only be used to adjust annual contributions in a year when the plan is at least 80% funded. In other words, the underfunded plan can no longer spread gains which are greater than the assumed investment return over five years into the future to offset any subsequent losses.

Also, the PPA defines plans as "at-risk" if their funding target attainment percentage is less than 80% without including at-risk liabilities and less than 70% including at-risk liabilities. ("At-risk liabilities" are the cost which assumes participants eligible to retire within the next ten plan years will do so at the earliest possible date, even if younger than the normal retirement age.) If the plan is "at-risk," for the current plan year plus any two of the preceding four years and has more than 500 participants, it must add 4% of the funding target and target normal cost, plus $700 per participant to its at-risk liability.

The plan's "adjusted funding target attainment percentage" is its ratio of assets (minus carryover and prefunding balances) to target liability (irrespective of at-risk status). When that figure is below 80% for the plan year, the plan cannot adopt any benefit increase and the employer can neither set aside or reserve assets in a nonqualified plan for its five highest paid executives nor deduct "gross-ups" to cover tax penalties. If it is below 60% for a plan year, the single employer plan is also prohibited from initiating a plan shutdown or accelerating benefit payments (e.g. lump sum payouts), and it must freeze benefit accruals. If between 60% and 80%, lump sum payments are limited. Special rules apply to collectively bargained plans and plans whose sponsoring employer is in bankruptcy.

Thus, annual contributions cannot be reduced by better-than-actuarially-assumed investment returns, and plans which are less than 80% funded must retain earnings, increase contributions, and limit certain benefits until they reach that point.

MULTIEMPLOYER DEFINED BENEFIT PLANS

Because most multiemployer plans are collectively bargained (and therefore unable to alter contributions funding except by periodic renegotiation of labor contracts, typically on a three-year cycle), these plans have always had their own set of funding rules. The PPA allows them to retain longer amortization periods and to use the prior process of "leveling" for gains and losses which differ from their actuarially assumed rate of return, but also imposes a new set of corrective actions for underfunding.

Originally, employers thought they had satisfied their obligations to a multiemployer fund when they paid the contributions required by their labor contracts. Then the 1980 amendments to ERISA added the withdrawal liability rules which were supposed to make an exiting employer also pay its pro rata share of the plan's unfunded liability, even if some of that liability was attributable to a different employer's employees. The PPA now adds possible new obligations to employers who are currently active and contributing to the plan (and whose liability is created by the plan's trustees, who have no duty to or direction from most of the contributing employers). If the plan is "endangered," it may require current employers to pay a five to ten percent surcharge over and above negotiated contribution rates to fill the funding gap, regardless of its cause.

In general, the PPA allows multiemployer plans to continue using the pre-PPA funding methods. However, it does limit amortization periods for benefit increases to a maximum of 15 years (instead of 30) and requires immediate full funding for short-term benefits (those payable over no more than 14 years, as a 13th check or some other "bonus.") "Endangered plans" are classified as:

"Endangered plans"
Plan's funded percentage for the plan year is less than 80%;

OR

Plan has an accumulated funding deficiency ² for the plan year or is projected to have one for any of one of the next six plan years, even under authorized extended amortization periods.
"Seriously endangered plans"
A plan which has both less than 80% funding this plan year and projects an accumulated funding deficiency in any one of the next six plan years.
"Critical Plans"
A. The Plan is less than 65% funded;

and

Its assets' market value plus the present value of reasonably anticipated contributions for the present and next six plan years is less than the present value of all nonforfeitable benefits and administrative expenses for the present and next six plan years.

OR

B. The Plan has an accumulated funding deficiency in the current plan year (without factoring in any extension of amortization periods);

or

projects one in any of next three years (four if funding is less than 65%).

OR

C. The plan's normal cost for the current year, plus interest,

exceeds

The present value of its current year's contributions; and

the present value of the current year's vested benefits for inactive participants is greater than that for active participants; and
it has or projects an accumulated funding deficiency for the current or any of the next four plan years.

OR

The plan's assets' market value, plus the present value of reasonably anticipated contributions for the current and each of the next four plan years

is less than

the present value of all benefits due in the current and each of the next four plan years.

The corrective actions for each of these situations are called "Funding Improvement Plans" (FIP). The FIPs are different for each category of "endangered plan," and must be adopted within short periods after annual funding certification.

For an Endangered Plan:

The FIP must provide the bargaining parties with proposed options to reduce benefit accruals by a combination of contribution increases and benefit changes which reduces its underfunding by one-third within a "funding improvement period" of ten years, and the Plan can have no accumulated funding deficiency during that time.
For a Seriously Endangered Plan:

The same corrective action as for Endangered Plans, except it has fifteen years to reduce its underfunding by one-fifth, and can have no accumulated funding deficiency during that time.

The Seriously Endangered Plan cannot accept any continuing bargaining unit which reduces its contribution rate, suspends contributions, or excludes younger or newly hired employees. Also, it cannot increase benefits while adopting their FIP.
For a Critical Plan:

A. The Plan must impose a 5% surcharge on contributions
during the first year of the FIP and can raise this to 10% in
succeeding years;

B. reduce or eliminate "adjustable benefits" (i.e., benefits other
than "normal retirement benefits");

C. restrict lump sum payouts;

D. revoke benefit increases adopted within the most recent five
years for those participants whose benefits are not yet in pay
status;

E. impose the same rules as for Seriously Endangered Plans
regarding continuing bargaining unit contribution rates and
memberships; and

F. adopt a "rehabilitation plan" which will move the fund out of
"critical status" within 10 years.

If the critical plan cannot be expected to accomplish all this successfully, it must pursue termination or merger.

There is a graduated phase-in of these rules, and the whole PPA funding structure is subject to a "sunset" on December 31, 2014. Also, the PPA allows a variety of extensions and delays on amortization schedules for multiemployer plans and modifies earlier ERISA reporting and disclosure rules to quickly inform participants and government agencies of any significant financial problems. Also, multiemployer plans expected to become insolvent within five years must notify interested parties annually if the value of their assets does not exceed three times the dollar amount of benefit payments that year.

WITHDRAWAL LIABILITY DEVELOPMENTS

The amount of an employer's withdrawal liability obligation is a function of the plan's funding position: the larger the Plan's unfunded vested benefit, the larger the employer's share of that figure. However, other than pressing for better funding, the PPA did very little to change these calculations. The modifications to the system are:

A withdrawn employer can defer interim payments for one year (and longer if security is posted) if it is challenging or arbitrating
the fund's claim that the withdrawal liability obligation is due to the employer's actions after December 31, 1998 and at least five
years ³ prior to its withdrawal which were taken to evade or avoid the liability.
A partial withdrawal occurs if an employer permanently ceases contributions on less than all of its participating units, but transfers its work to some other entity which it owns or controls.
The schedule for maximum assessments of an employer which has sold all its assets (ERISA § 4225) is changed, and its use is now limited to plans which use the "attributable method" for calculation of unfunded vested benefits.
The "free look" and "fresh start" exceptions for building and construction industry plans have been expanded.

OTHER "NEW RULES"

Since the PPA is 900 pages long, no brief analysis can cover every change and nuance which has been adopted. However, a few more points should be noted:

Cash balance and hybrid plans do not cause age discrimination violations if the older participant's accrued benefit is at least equal
to that of similarly-situated (service, compensation history) younger participants.
Starting in 2007, public employees in protective services will not be taxed for the first $3,000 per year of their pension benefit which is used for the purchase of retiree health or long term care insurance.
Plans with assets equal to at least 120% of their funding target can transfer two to ten years of estimated retiree health insurance
costs to a separate health account within the fund so long as that 120% funding continues thereafter.
The PPA made permanent a wide variety of EGTRRA, IRA, and similar tax savings which had been subject to sunset rules.
Government plans continue to be exempt from federal funding requirements.
The PGBC's premiums are substantially increased, and its guarantees in the event of a plan shutdown or unpredictable contingent event after July 26, 2005 are subject to a five-year phase-in.

CONCLUSION

The PPA is a massive collection of adjustments to make retirement funds more secure and transparent. The move from the old gains-and-losses leveling methods to more immediate recognition of, and responses to, funding dangers makes defined benefit plans both more protected for participants and more expensive for employers. Multiemployer funds have been given a variety of extensions and mandated corrective actions which can only cause contributing employers to pay more for the same benefits and still be at significant risk if the fund cannot accomplish a major economic turnaround under extremely difficult circumstances.

All these new costs and concerns only serve to advance defined contribution plans as less expensive, more secure, and less onerous for the sponsoring employer. Whether the result will be a major movement to 401(k) programs, a movement away from all employer-sponsored retirement programs or a reluctance to start new plans is far from certain.

What is clear is that every employer must assess its new costs, risks, and options resulting from the PPA and determine what, if any, retirement benefit it is willing to promise its employees.

*****

¹ As always in such legislation, the PPA has unrelated add-ons (here, e.g., permanently excluding qualified tuition programs ("QTPs") from taxable income, excluding $100,000 of otherwise taxable IRA distributions if donated to charity in 2006 or 2007, restricting non-cash charitable donations, such as second hand clothing, to usable items claimed at true current market value, not purchase price or hypothetically excellent condition.)

² An "accumulated funding deficiency," generally, is any excess of the total changes to the plan's funding standard account for all plan years over total credits to the funding standard account for those same years, measured at the end of the most recent plan year. Thus, the gains and losses leveling going to a deficit or negative number results in an "accumulated funding deficiency."

³ The period is two years for small employers with no more than 500 employees and a contribution obligation for no more than 250.

If you have any questions about the issues raised by this e-alert, please feel free to contact Alan M. Levy at (414) 273-3910 or by e-mail at alevy@lindner-marsack.com

Lindner & Marsack, S.C. represents management exclusively in labor, employment, and employee benefits law, including the administration of employee health and retirement programs. Established in 1908, Lindner & Marsack, S.C. is consistently rated among the top labor and employment law firms in the nation. We are located at 411 East Wisconsin Avenue, Suite 1800, Milwaukee, Wisconsin, 53202. Call us at (414) 273-3910 or visit our website, www.lindner-marsack.com, to learn more about our firm and its talented and innovative legal professionals.

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