Summary of Qualified Plan Limits for 2006

Pension Protection Act of 2006: A Summary
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In August, 2006, the President signed into law the Pension Protection Act of 2006 (“Act”). Much of the Act applies to the funding of defined benefit plans. This memorandum will focus on the key provisions of the Act as they relate to defined contribution (401(k)) plans and those provisions which relate to non-funding issues of defined benefit plans.

EGTRRA is Permanent. The Act is the most significant pension legislation since the Economic Growth and Tax Relief and Reconciliation Act of 2001 (“EGTRRA”). If you recall, EGTRRA brought many changes including increased 401(k) contributions, catch-up contributions, increase deduction limits, shorter vesting schedules for matching contributions, and ROTH 401(k) provisions. EGTRRA, however, was enacted as a temporary law change. Unless made permanent by another Act of Congress, EGTRRA would expire in 2011. The Act made EGTRRA permanent.

Vesting Restrictions. If you recall, EGTRRA limited the vesting schedule that could be imposed with respect to matching contributions to schedules that would satisfy the top-heavy plan requirements. In general, that means that the vesting schedule must be no worse than a 6 year graded vesting schedule (20% after 2 years and 20% for each additional year) or a 3 year cliff schedule (100% after 3 years). Under the Act, effective for contributions made in the 2007 and subsequent plan years, profit sharing contributions must vest under a top-heavy vesting schedule. Contributions made in the 2006 and previous plan years can continue to vest under the plan’s existing vesting schedule.

Non-Spousal Beneficiary Rollovers. If a participant dies leaving his or her spouse as their beneficiary, the spouse can rollover the plan distribution to their own IRA or qualified plan. If a participant dies leaving a non-spouse beneficiary, no rollover was permitted. In that case, the non-spouse beneficiary was taxed on the distribution from the plan and the plan may have placed restrictions on how quickly the amounts must be distributed. Effective for plan years beginning in 2007, a non-spouse beneficiary can rollover benefits to an ‘inherited’ IRA. Under the ‘inherited’ IRA, the non-spouse beneficiary can withdrawal over their life expectancy.

Automatic Enrollment. The Act makes significant changes to the rules regarding automatic enrollment. Automatic enrollment would enroll a participant in a 401(k) plan if the participant does not affirmatively elect whether or not to participate. The plan would state what default level of contribution the participant would make and how those funds would be invested in the plan. The participant could change those elections at any time by actually submitting an enrollment form.

ERISA Pre-emption. Effective immediately, under the Act, automatic enrollment was added to ERISA. As a result, plans are exempt from conflicting State laws which would prohibit or restrict the use of automatic enrollment. This preemption applies only if the default investment utilized for automatically enrolled participants satisfies the DOL’s default investment guidance (which is pending) and the plan provides proper advanced and annual notice to the affected employees regarding the automatic enrollment arrangement.

New 401(k) Safe Harbor. Effective in 2008, the Act creates a new 401(k) safe harbor for plans with a ‘qualified automatic enrollment’ arrangement. If the safe harbor is satisfied, the arrangement will automatically satisfy the ADP and ACP tests and the top-heavy requirements. To be a qualified automatic enrollment arrangement:

· the plan’s automatic deferral percentage must be between 3% and 10% (if less than 6%, a participant’s automatic deferral percentage must be increased by 1% each year until reaching at least 6%);

· an employer safe harbor contribution must be made for non-highly compensated employees of either: (i) an employer match of 100% of the first 1% of compensation plus 50% of the next 5% of compensation; or (ii) a 3% non-elective contribution; and

· the employer safe harbor contribution must vest upon the completion of 2 years of service and must be subject to the distribution limitations applicable to 401(k) contributions.

Corrective Distributions. If a plan includes an automatic enrollment arrangement but does not satisfy the safe harbor requirements set forth above, the plan must continue to apply the ADP and ACP test. In that case, the plan has up to six months (instead of the usual 2½ months) after the plan year end to distribute excess ADP and/or ACP amounts and avoid the 10% excise tax and those amounts are taxable in the year they are distributed. This provision is effective in 2008.

Permissible Withdrawals. A participant who is automatically enrolled in a plan may be permitted to withdrawal all deferrals and applicable earnings within the first 90 days of the date he or she was automatically enrolled. This provision is effective in 2008.

Default Investments. Section 404(c) of ERISA provides plan fiduciaries with certain protections when a participant selects investments from a range of investments offered under the plan (assuming the plan qualifies for 404(c) protection). However, section 404(c) protection applied only when a participant made a selection, it did not apply if the participant was defaulted to a specific investment option (which would occur if they enrolled in the plan but did not make an investment election, or if they were automatically enrolled in the plan). Effective for plan years beginning in 2007, the DOL will issue guidance regarding default investments that will qualify such investments for protection under section 404(c).

Investment Advice. Starting in 2007, the Act provides an exemption to the current prohibited transaction rules to allow financial institutions, broker-dealers, agents and their affiliates to provide, as plan fiduciaries, investment advice under an ‘eligible investment advice arrangement’ to the plan or plan participants and receive compensation for such advice or the sale of investments under the plan. An eligible investment advice arrangement is an arrangement that either:

· Provides that any fees, commissions or other compensation received by the fiduciary advisor for investment advice or the sale of investments to the plan will not vary depending upon the investment options selected; or

· Uses a computer model certified annually by an independent investment expert to provide unbiased investment advice.

Certain notice and disclosure requirements must be satisfied.

Employer Stock. Plans investing in employer stock must comply with additional requirements starting with the 2007 plan year. Under certain circumstances, participants must be permitted to divest out of employer stock at least quarterly. In addition, the plan must offer at least 3 other investment options which are diversified and which have materially different risk and return characteristics.

Reservists. Effective immediately, the Act waives the 10% excise tax on early distributions for certain reservists called to active duty (for at least 180 days) on or after September 11, 2001.

Cash Balance Plans. A cash balance plan is considered a ‘hybrid’ plan because it combines some of the actuarial characteristics of a defined benefit plan (required funding, higher contribution limits in some cases) with the individual account characteristics of a defined contribution plan. A cash balance plan is a defined benefit plan that provides benefits to employees by reference to a hypothetical account balance. Contributions to the hypothetical account are based on a percentage of current year compensation. In addition, the hypothetical account is credited with interest based on an ‘interest credit rate’ set forth in the plan. Thus, at least from the participant’s perspective, a cash balance plan looks and operates like a profit sharing plan. However, the cash balance has the added advantage of a benefit guarantee since it is a defined benefit plan (for example, investment return does not affect the participant’s balance).

Cash balance plans have been popular with small business in recent years because they permit the owners/key employees to accrue a much larger retirement benefit in a short period of time.

In certain litigation, the legality of cash balance plans has been brought into question mostly from a determination of whether they violate age discrimination laws. The Act makes it clear that they do not violate such laws if the benefit provided to any participant is not less than the accrued benefit of any similarly situated (employees are identical in every respect…period of service, job classification) younger employee.

The Act does impose additional requirements that apply to cash balance plans in addition to the general tax-qualification requirement:

Accelerated Vesting. Effective in the 2008 plan year, a cash balance plan must provide for full vesting after 3 years of service. This is a provision which does not apply to any other tax-qualified plan.

Whipsaw / Interest Credit Rate. Under prior law, a participant’s lump sum distribution was calculated in such a way that would increase his lump sum distribution over the value of his hypothetical account balance if the interest credit rate under the plan exceeded the 30-year Treasury rate. This was commonly referred to as a whipsaw. To avoid the whipsaw, many plans defined the interest credit rate as the 30-year Treasury rate. This way, no increase was applied to the hypothetical account balance in determining the lump sum distribution.

Effective immediately, the Act makes it clear that the amount of a participant’s lump sum distribution should be the value of his hypothetical account balance. As a result, it is no longer necessary for the interest credit rate to equal the 30-year Treasury rate to avoid the whipsaw. The interest credit rate, however, must not exceed a market rate of return.

Combined Pension and Profit Sharing Plans. Many sponsors of defined benefit plans (either traditional or cash balance plans) also sponsor a defined contribution plans (either 401(k) or profit sharing plans). In that situation, the total deductible contribution was limited to the greater of 25% of eligible participants’ compensation or the funding required under the defined benefit plan.

Under the Act, effective for the 2006 plan year, only employer contributions to the defined contribution plan (i.e., profit sharing plan) that exceed 6% of participant compensation would be subject to the limit. Thus, an employer could contribute to the pension plan and contribution 6% of compensation to a profit sharing plan without being concerned with the 25% combined plan limit.

In addition, under the Act, beginning with the 2008 plan year, the combined deduction limit would not apply to defined benefit plans that are covered by the PBGC. This would be any plan that pays the PBGC premium (generally plans or non-professional groups or professional groups with more than 25 participants).

Plan Amendments. The Act clearly states that amendments necessary to implement the terms of the Act must be made by the end of the 2009 plan year. Prior to amendment, however, all plans must be operated in accordance with the requirements of the Act. Whether interim amendments will be required in the 2007 and later plan years is still an open question.

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We are awaiting guidance regarding the application of several of these provisions. We will provide additional information as it becomes available from the Internal Revenue Service and/or Department of Labor.