January 2007 Vol. X, No. 1
ERISA, EMPLOYEE BENEFITS AND EXECUTIVE COMPENSATION NEWSLETTER
These past several months have been busy indeed with respect to tax and ERISA law changes affecting most types of tax-qualified, executive compensation and welfare benefit arrangements. This Newsletter highlights the salient issues of which you should be aware, including the new Pension Protection Act of 2006, Massachusetts health care law, and statutory as well as case law developments affecting cash balance plans. We also direct your attention to a piece by Al Lurie on cash balance plans in Section VI, which will acquaint you with interesting developments relating to such plans, as well as our thoughts thereafter as to why that type of plan may warrant your serious consideration.
Since our last Newsletter, The Wagner Law Group continues to grow. We are pleased to welcome to our legal team Alvin D. Lurie, Former Assistant Commissioner of the Internal Revenue Service, as of counsel, specializing in all aspects of ERISA and employee benefits; Barry M. Newman, as senior associate, specializing in welfare benefit issues; Dennis T. Blair, as senior associate, specializing in all aspects of tax-qualified and non-qualified plans as well as the SEC rules governing pension arrangements; and Stephanie Vaughn Rosseau and Sholom M. Fine, as associates. To learn more about our team and practice, please visit our website at www.erisa-lawyers.com.
We are truly pleased and proud to announce that Jon C. Schultze has been promoted, and as of January 1, is a partner of the firm.
Marcia S. Wagner continues to work and lecture extensively having recently authored, among other things, a BNA Tax Management Portfolio entitled "ERISA Litigation, Procedure, Preemption and Other Title I Issues," as well as a chapter for West Publishing's Advising Small Business series entitled "Qualified Retirement Plans." Barry M. Newman recently authored, for Aspen Publishers, Quick Reference to ERISA Compliance.
Marcia S. Wagner has also recently been named by Boston Magazine as one of the Top 50 Women Lawyers and Top 100 Lawyers in Massachusetts. Marcia Wagner, and John Keegan have been honored as Massachusetts Super Lawyers for 2006. Marcia, and John were selected for this honor as among the top 5% of Massachusetts attorneys after an extensive peer review and evaluation process conducted by Law & Politics. Their findings were published in the Massachusetts Super Lawyers magazine (a publication distributed exclusively to lawyers) as well as in Boston Magazine.
In the event you desire legal advice or consultation, please feel free to contact any member of The
Wagner Law Group.
TABLE OF CONTENTS
I. COST OF LIVING ADJUSTMENTS
II PENSION PROTECTION ACT
A. FUNDING RULES FOR DEFINED BENEFIT PLANS
B. BENEFIT RESTRICTIONS
C. REPORTING AND DISCLOSURE REQUIREMENTS
D. PLAN DESIGN CHANGES
E. DEDUCTION LIMITS
F. BENEFIT CALCULATIONS
G. PBGC PREMIUMS AND RELATED PROVISIONS
H. NEW RULES AFFECTING PLAN DISTRIBUTIONS
I. ROLLOVER CHANGES
J. NEW RULES FOR INDIVIDUAL RETIREMENT ACCOUNTS
K. AUTOMATIC ENROLLMENT PROVISIONS
L. ACCELERATED VESTING
M. DIVERSIFICATION OF EMPLOYER SECURITIES
N. INVESTMENT ADVICE
O. FIDUCIARY RESPONSIBILITY
P. HEALTH AND WELFARE PLANS
Q. PROVISIONS DIRECTLY AFFECTING TAX-EXEMPT AND GOVERNMENTAL PLANS
R. EGTRRA PROVISIONS MADE PERMANENT
III. EXTENSION OF TRANSITION PERIOD UNDER CODE SECTION 409A
IV. MASSACHUSETTS HEALTH CARE LAW
B. EMPLOYER OBLIGATIONS
C. INDIVIDUAL OBLIGATIONS
V. CASH BALANCE LITIGATION
VI. COMMENTARY ON CASH BALANCE PLANS
VII. CONCLUDING THOUGHTS ON CASH BALANCE PLANS
I. COST OF LIVING ADJUSTMENTS
| Maximum annual payout from a defined benefit plan
at or after age 62 (Plan Year ending in stated Plan Year)
|Maximum annual contribution to an individual's defined contribution account (Plan Year beginning in stated year)||$44,000 **||$45,000 **|
|Maximum Section 401(k), 403(b) and 457(b) elective deferrals||$15,000 ***||$15,500 ***|
|Section 401(k) and Section 403(b) catch-up limit for individuals aged 50 and older||$5,000***||$5,000***|
| Maximum amount of annual compensation that can be taken into account
for determining benefits or contributions under
a qualified plan
| Test to identify highly compensated employees, based on
compensation in preceding year
|Wage Base: For Social Security Tax||$94,200||$97,500|
|For Medicare||No Limit||No Limit|
|Amount of compensation to be a key employee||$140,000||
|Maximum Social Security Benefit at Social Security Normal Retirement Age||$2,053/Month||$2,116/Month|
|Earnings Test - Early Retirement (Age 62) (Amounts that Can Be Earned before Benefits Are Cut)||$12,480/Year||$12,960/Year|
|PBGC maximum gurantee||$3,971.59/Month||$4125/Month|
* There are late-retirement adjustments for benefits starting after age 65.
** Plus "catch-up" contributions.
*** These are calendar year limitations.
II. PENSION PROTECTION ACT
On August 17, 2006, President Bush signed the Pension Protection Act of 2006 ("PPA"), a comprehensive bill that will have a significant impact on many, if not most, employee benefit programs. Plan sponsors should carefully consider how the PPA affects their plans.
As indicated in this Newsletter, many of the changes enacted in the PPA have delayed effective dates, although some are effective immediately. The PPA generally gives plans until the end of the 2009 plan year to be amended to comply with such changes. In the interim, plans must comply with the new provisions in operation.
Highlights of the PPA and certain additional developments are described below.
A. Funding Rules for Defined Benefit Plans
Minimum Funding Standards. Currently, the funding target for a single employer defined benefit pension plan is 90% of the plan's current liability. Failure to attain the target generally requires that an additional contribution be made to the plan.
For plan years beginning after 2007, the PPA requires plans to shift to a new target, namely the present value of all benefits accrued or earned as of the beginning of the plan year. Thus, the target funding percentage is increased to 100%. The new target funding percentage is phased in over four years (92% in 2008, 94% in 2009, 96% in 2010 and 100% thereafter). The phase-in is not available to new plans or certain plans subject to the deficit reduction contribution rules.
The minimum required contribution for a year generally includes a plan's target normal cost for the year. However, if the plan has not met its phased-in funding target, as described above, the minimum required contribution is the sum of the target normal cost and a funding shortfall amortization charge. The shortfall amortization charge is the annual installment necessary to amortize the difference between the value of a plan's assets (subject to certain reductions for positive credit balances resulting from contributions in excess of minimum funding in prior years) and its funding target over a seven-year period. This contrasts with the funding rules in effect prior to the PPA under which charges to the funding standard account for unfunded past service liability or unfunded liability resulting from a plan amendment were amortized over 30 years.
Plans that have a funding shortfall in the prior year are required to make the minimum required contribution for the current year in equal quarterly installments that will be due on April 15, July 15, October 15 and January 15 of the following year.
"At-risk" plans will have accelerated funding requirements as a result of the requirement that the target normal cost and the shortfall amortization be determined using worst case assumptions in which participants are assumed to elect the most expensive benefits at the earliest possible age and, if a plan has been at-risk for at least two of the four preceding years, by adding variously determined loading factors to the target normal cost and the shortfall amortization charge.
A plan would be considered at-risk if for the preceding plan year it is less than:
· 80% funded using standard assumptions (the percentage starts at 65% in 2008 and increases 5% a year until fully phased-in in 2011), and
· 70% funded using worst case assumptions in which participants are assumed to take the most expensive benefits at the earliest possible age.
Comment: Defined benefit plan sponsors should consult with their actuaries and review the funding level of their plans to determine whether the new rules will result in increased costs. Based on the results of this review, they may desire to develop new strategies to contain costs.
Interest Rate and Mortality Assumptions. For 2006 and 2007, the interest rate used to determine the present value of plan liabilities will continue to be based on investment grade long-term corporate bonds. These interest rates will be higher compared to the 30-year Treasury bond rates previously used for this purpose, thereby generally resulting in lower plan liabilities.
Beginning in 2008, the interest rate will be based on a modified yield curve of investment grade corporate bonds incorporating three different interest rates determined by the actual duration of the plan's liabilities. Rates for each of the three segments will be published monthly by the Treasury Department based on bonds maturing during the applicable duration periods. Thus, the rate for bonds maturing: (i) within five years will be matched to plan liabilities payable within the same period; (ii) in five to 20 years will be matched to plan liabilities payable within that period; and (iii) in more than 20 years will be matched to plan liabilities in excess of 20 years. The use of the modified yield curve is phased in over three years beginning in 2008. Plan sponsors will have the opportunity to decline the phase-in and will also be able to make a one-time election to use the full yield curve rather than using the three separate segments. It is anticipated that in many cases interest rates based on the yield curve will result in somewhat lower plan liabilities.
Comment: Interest rates as determined under the PPA should produce a more realistic rate for purposes of measuring plan liabilities, eliminating the artificially high liabilities experienced by some plans under prior law and resulting in a lower current liability.
The Treasury Department will prescribe mortality tables based on the actual and projected experience of pension plans. Large plan sponsors may request to use a substitute mortality table if the number of participants is large enough and the plan has existed long enough to have creditable information.
Credit Balances. Under prior law, contributions exceeding annual required minimum contributions gave rise to a credit balance that could be credited against future required contributions. The PPA restricts the extent to which plans that are less than 80% funded can use credit balances and limits the interest added to a credit balance to the plan's actual rate of return on its assets. These changes will prevent employers from taking advantage of flush years by prefunding the plan and subsequently taking a credit against future contribution obligations when the plan is "at-risk."
B. Benefit Restrictions
Restrictions Relating to Defined Benefit Plans. The PPA adds provisions to ERISA and the Internal Revenue Code that, for plan years beginning after 2007, impose limitations on (i) benefit increases, (ii) benefit payments, (iii) benefit accruals, and (iv) shutdown benefits in situations where a defined benefit plan is not fully funded. The PPA established several specified funding percentages that, if not met, will trigger one or more of the new limitations. The plan administrator must provide written or electronic notice to participants and beneficiaries within 30 days of the date that restrictions on benefit payments or accruals become applicable.
The PPA prohibits amendments to a defined benefit pension plan that would increase benefits or accelerate the vesting or accrual of benefits if the plan's funding percentage is less than 80% or would be less than 80% taking into account the amendment. The restriction does not apply if the plan sponsor makes contributions or provides security to the plan to pay for the increase. Moreover, this restriction does not apply to new plans for the first five years of plan existence.
Another new restriction prohibits a defined benefit plan that is less than 60% funded from paying benefits in a form other than a single life annuity. In this event, lump sums as well as unpredictable contingent event benefits, such as plant shutdown benefits, would not be permitted. The restriction on nonannuity forms of payment also applies to plans with less than 100% funding whose sponsor is in bankruptcy.
If a plan's funding percentage is between 60% and 80%, the amount of a lump sum distribution is limited to the lesser of 50% of the amount otherwise payable or the present value of the participant's maximum PBGC guaranteed benefit. The new restrictions on the form of payment would not apply to a plan that was frozen as of September 1, 2005.
Plans that have been in existence for at least five years and that are less than 60% funded must freeze all benefit accruals as of the valuation date for the plan year. Benefit accruals may resume when the plan is no longer subject to this restriction.
Comment: The restrictions on benefit increases are clearly an attempt to improve funding by precluding plan sponsors from promising benefits that the plan may not be able to afford.
Restrictions on Executive Deferred Compensation. The PPA amends Section 409A of the Internal Revenue Code (the "Code") to prohibit an employer maintaining a nonqualified deferred compensation plan from making contributions to a rabbi trust while any qualified defined benefit plan is in "at-risk" status. Funding of a nonqualified plan is also prohibited when the defined benefit plan sponsor is in bankruptcy and during the period beginning six months before and ending six months after the termination of an underfunded defined benefit plan. This funding restriction also applies to members of a controlled group of which the qualified plan sponsor is a member. Violation of the new rule will result in immediate taxation of the nonqualified plan benefit plus a 20% penalty on nonqualified plan participants who are the plan sponsor's CEO, one of its top four other most highly compensated officers, or individuals subject to the reporting and short-swing profit requirements under Section 16(a) of the Securities Exchange Act of 1934.
For purposes of determining whether the new funding restriction applies, a defined benefit plan is determined to be "at-risk" by applying the new funding rules discussed above. This has led many observers to conclude that the funding restriction applies if the plan's funding target attainment percentage for the preceding year was less than 80%. However, the Technical Explanation of the Joint Committee on Taxation states that the relevant threshold is 60%, although there does not appear to be statutory justification for its statement. Enactment of a technical corrections bill may be necessary to achieve this result.
The amendment to Section 409A applies to "transfers or other reservation of assets after the date of the enactment" of the PPA, which was August 17, 2006. However, the at-risk rules do not come into effect until 2008. Accordingly, Treasury and IRS officials have indicated that the prohibition on the funding of nonqualified deferred compensation arrangements arising from inadequately funded defined benefit plans will not apply until 2008.
Comment: In the future, employers will be required to determine the funding status of their defined benefit plans before making contributions to nonqualified plans benefiting the CEO, the next four most highly compensated employees, and employees subject to the short-swing profit rules. If there is a risk of becoming subject to the new funding restrictions, an employer should consider prefunding its nonqualified plan before the 2008 effective date.
C. Reporting and Disclosure Requirements
Funding Status. Beginning in 2008, plan administrators of defined benefit plans will be required to send annual notices to participants, beneficiaries, the PBGC, and unions providing detailed information on plan funding. The notice must disclose the value of the plan's assets as compared to liabilities for the current year and the two preceding plan years, its funding status, its funding policy and allocation of investments, a summary of the rules governing termination, and a description of those benefits guaranteed by the PBGC. This requirement is similar to the current rule for multiemployer pension plans which will be required to provide additional information as to whether the plan is in endangered or in critical status.
The notice must be provided within 120 days after the end of the plan year to which it relates, although plans with fewer than 100 participants will not have to provide it until the Form 5500 annual report for the year is due. The Department of Labor will publish a model notice within one year of the enactment of the PPA (i.e., by August 17, 2007).
Comment: Employers should review the funding status of their defined benefit plans under the new rules and determine how this information will affect their employees. In some cases, it will be important to educate employees about their plans before the notice is issued in order to ensure that they understand the information being provided and do not become unnecessarily alarmed.
Notice to PBGC of Underfunding. Beginning in 2008, the plan sponsor of a plan that is less than 80% funded for the preceding plan year under the rules described above must file additional funding information with the PBGC.
Repeal of Certain Notice Requirements. Beginning in 2008, defined benefit plans subject to Title IV of ERISA will no longer be required to furnish a summary annual report ("SAR") to participants. Effective as of 2007, the PPA also repeals Section 4011 of ERISA, a provision which requires certain underfunded plans to provide a funding notice to participants and beneficiaries.
Quarterly Benefit Statements by Defined Contribution and 403(b) Plans. Beginning with the 2007 plan year, the PPA requires administrators of defined contribution plans (other than one-participant plans) and tax deferred annuities (403(b) plans) to provide a benefit statement to each participant at least quarterly if the participant has the right to direct the investment of assets in his or her account. Other participants must receive a benefit statement at least annually. In addition, a participant can make a written request for a benefit statement (limited to one request per year). The benefit statement must include the following information:
· The total value of benefits accrued;
· The value of each investment to which assets in the participant's account are allocated (including the value of investments in employer securities);
· The participant's vested accrued benefit or the earliest date on which the accrued benefit will become vested;
· Where relevant, an explanation of any permitted disparity or floor-offset arrangement that may apply in determining accrued benefits under the plan;
· An explanation of any limits or restrictions on the participant's right to direct investments;
· An explanation of the importance of a well-balanced, diversified portfolio;
· A statement of the risk of holding more than 20% of a portfolio in the securities of a single entity; and
· A notice directing the participant to the Department of Labor's website for information on investing and diversification.
Defined Benefit Plan Statements. For plan years after December 31, 2006, defined benefit plans are required to furnish benefit statements once every three years. Alternatively, the plan could furnish an annual notice of the availability of statements to vested participants or provide benefit statements on written request (limited to one request per year). Defined benefit plan statements must include information regarding accrued and vested benefits, and the earliest date on which any nonvested benefits will become vested. The statements must also include explanations of any permitted disparity as well as the effect of any floor-offset arrangement.
Form 5500 Changes. For plan years beginning on or after January 1, 2007, the PPA eliminates the Form 5500 reporting requirement for one-person plans with fewer than $250,000 in assets. It also requires the Departments of Labor and Treasury to implement simplified reporting for plans with fewer than 25 participants.
In July 2006, the Department of Labor together with the IRS and the PBGC proposed significant changes to the Form 5500 and its related schedules. These proposals were supplemented by additional proposed regulations issued on December 11, 2006, designed to incorporate PPA requirements. The combined proposals include the following changes:
· A new short Form 5500 filing that would be available to plans covering fewer than 100 participants that are invested exclusively in easy-to-value investments, such as mutual funds. The December proposal indicates that this Form is to serve as the simplified report required by the PPA for plans with fewer than 25 participants;
· All service providers receiving fees in excess of $5,000 would be required to be listed, rather than only the 40 receiving the most compensation;
· Plan service providers receiving compensation from third parties in excess of $1,000 in connection with plan services would be required to indicate that fact. This would apparently require disclosure of the amount of such compensation received by service providers who receive 12b-1 and other fees with respect to plan investments; and
· Schedule B, relating to actuarial information, would be replaced by separate forms for single employer and multiemployer plans. The new schedules will include actuarial worksheets designed to allow the government agencies to evaluate a plan's compliance with the PPA's funding requirements. The new rules are proposed to be effective for 2008 plan year filings.
Electronic Display of Form 5500. For plan years beginning after 2007, the PPA requires the Form 5500 annual report to be filed electronically, thereby allowing the Department of Labor to comply with a new mandate to post the Form on its website. If a plan sponsor or administrator maintains an intranet website, it must post the Form on its intranet.
D. Plan Design Changes
The PPA validates the basic design of cash balance and other hybrid-pension plans and provides special rules for plans that are converted from a traditional defined benefit plan to a hybrid plan. The hybrid-pension provisions are generally effective for periods beginning on or after June 29, 2005, and thus will not protect conversions before that date.
Comment: The June 29, 2005 effective date for the new rules was a disappointment to the sponsors of many existing hybrid plans which remain subject to legal uncertainty created by various court decisions considering whether the design of such plans discriminates on the basis of age.
It has been argued that cash balance plans are inherently discriminatory, since the ultimate value of an annual accrual for a younger employee is usually larger than the ultimate value of an annual accrual for a similarly-situated older employee due to the way in which interest is credited. The PPA clarifies that cash balance and other hybrid plans are not age discriminatory as long as the annual credit itself does not discriminate on the basis of age.
Comment: Please refer to Sections V and VI of this Newsletter for an explanation of the litigation surrounding this issue.
Under the PPA, the lump sum value of a participant's benefit can be equal to the value of his or her account. This provision is effective for distributions made after August 17, 2006. The interest rate credited on the account may not exceed a market rate, thereby eliminating a problem faced by those plans that credited interest at rates other than a statutorily prescribed rate for calculating the value of lump sum distributions. The market rate requirement is met if interest is credited at a minimum guaranteed rate that is equal to the greater of a fixed rate or a variable rate that is linked to an index, such as the one-year Treasury bill rate. However, provided that the rate of return may not be less than zero, it appears that this may not be the only way to satisfy the market rate requirement. The Treasury is directed to define the "market rate" of return and to prescribe methods of crediting interest. This provision is effective in 2008 for plans that were in effect on June 29, 2005 but will be effective immediately for plans established after that date.
When a traditional defined benefit plan is converted to a cash balance plan, a participant's benefit after the conversion must equal the value of the benefit prior to the conversion plus the benefit earned after the conversion, thus prohibiting the so-called "wear- away" approach to calculating benefits following a conversion pursuant to which a participant might accrue no additional benefit for a number of years.
The PPA also introduces a new minimum vesting requirement that applies to cash balance and hybrid plans. Under the new vesting standard, an employee with at least three years of service must be fully vested in his or her plan benefit. With respect to plans in existence on June 29, 2005, the vesting requirement does not apply until plan years beginning in 2008. For later established plans, the change is effective as of the date the plan is established. According to Treasury officials, the faster vesting requirement only applies to the cash balance portion of a plan, not to traditional benefits that are grandfathered or benefits for participants in the plan who only have traditional benefits.
Comment: Plan sponsors facing a significant cost increase due to changes in the funding requirements applicable to traditional defined benefit plans may now want to consider converting the traditional plan into a hybrid plan (e.g., a cash balance plan).
Combined Defined Benefit / 401(k) Arrangements. Currently, a 401(k) arrangement may not be combined with a defined benefit plan in one plan document. However, for plan years beginning after 2009, the PPA will allow an employer with 500 or fewer employees to provide a new type of hybrid plan which combines defined benefit and 401(k) features.
The defined benefit portion of the plan must provide a minimum benefit of 1% of final average compensation per year of service up to 20 years, without regard to whether the participant makes a contribution under the 401(k) portion of the plan. These benefits must be fully vested within 3 years. The defined benefit portion of the plan will not be subject to the top-heavy rules.
The 401(k) portion of the plan must provide for automatic enrollment at a rate of at least 4% of compensation and a fully vested matching contribution equal to at least 50% of the employee's contribution up to 4% of compensation. The 401(k) nondiscrimination rules will be automatically satisfied for these amounts.
Additional matching or after-tax contributions to the 401(k) portion of the plan and defined benefit accruals higher than the required minimums will be permitted, but they will be subject to nondiscrimination testing.
E. Deduction Limits
The PPA raises the limit on deductions for contributions to single-employer defined benefit plans. For 2006 and 2007, the deduction limit is increased to 150% of the plan's current liability less the value of the plan's assets.
For 2008 and thereafter, the limit for at-risk plans will be the excess of the sum of (i) the plan's target normal cost (one year cost), (ii) 100% of the plan's funding target (overall cost), and (iii) a cushion amount minus (iv) the value of the plan's assets. The cushion amount equals 50% of the plan's funding target plus additional amounts reflecting projections for salary increases.
Comment: Plan sponsors of underfunded defined benefit plans should consider increasing their contributions in 2006 and 2007 to avoid stricter funding rules that will apply in 2008.
For taxable years beginning after 2005, the PPA relaxes the combined plan deduction limit for employers that maintain both a defined benefit and a defined contribution plan by applying the limit only to the extent that contributions to defined contribution plans exceed 6% of the compensation of plan participants.
For years beginning after December 31, 2007, single-employer defined benefit plans that are covered by the PBGC insurance program are not taken into account in determining combined plan deduction limits.
Comment: These two relaxed deduction limitations will enable employers to provide significantly richer retirement benefits, if so desired.
F. Benefit Calculations
Minimum Value for Lump Sum Distributions. Generally, the value of a lump sum distribution is determined by using an interest rate equal to the 30-year Treasury bond rate and mortality based on the 1994 Group Annuity Reserving Table. The PPA provides that the interest rate is to be based on the three-segment, modified yield curve interest rate, discussed above, that will be used to determine plan liabilities. In contrast to the rate used to determine plan liability for funding purposes, however, the rate used to determine lump sums will be based on the rate for the month preceding the date of distribution without the use of the funding yield curve's 24-month average. The use of the new interest rate will be phased in over five years beginning in 2008. Plans will also be required to use new mortality tables to be prescribed by the Treasury.
Comment: Use of the higher corporate bond interest rate instead of the lower Treasury bond rate
previously used will result in smaller lump sum payments. However, because the change is phased in
gradually, people who retire next year will see little effect on the amount of their payment.
Converting Lump Sums to Straight Life Annuities. In applying the maximum dollar limit imposed on the annual benefit payable under a defined benefit plan by Code Section 415(b) for 2004 and 2005, the interest rate used to convert a lump sum to a straight life annuity must not be less than the greater of (i) 5_%, or (ii) the plan's interest rate. Without the PPA, the interest rate for many plans would have reverted to 5% in 2006.
However, the PPA provides that for plan years beginning after December 31, 2005, the rate must not be less than the greater of (i) 5_%, (ii) the plan's interest rate, or (iii) a rate that produces a benefit of not more than 105% of the benefit that would be provided if the interest rate (or rates) applicable in determining minimum lump sums were used.
Comment: This change has an immediate and significant effect on plan participants who have accrued the statutory limit on an annual pension of $175,000 in 2006. The increased interest rate which is used to convert this limitation to a lump sum effectively lowers the lump sum payout by as much as 15% in some cases. Since the change is retroactive to January 1, 2006, the payment of an excess lump sum earlier in 2006 before the enactment of the PPA must be corrected.
In Notice 2007-7, issued on January 11, 2007, the IRS implicitly acknowledged the hardship this would involve and relaxed the correction procedure for excess distributions that were made before September 1, 2006. In this situation, the excess amount is not required to be returned to the plan, provided that the plan which made the excess distribution issues two Forms 1009-R to the recipient by March 15, 2007. The first Form 1099-R should include only the amount that would have been distributed had the correct interest rate been used for the conversion. The second Form 1099-R should include only the excess amount that was distributed and should be completed with code "E" in Box 7 to identify the amount as an excess distribution. The participant should be notified that the excess amount reported on the second Form 1099-R is not eligible for a rollover distribution.
If the correction described above is not completed by March 15, 2007, or if the distribution was made after August 31, 2006, the plan may use the self-correction procedures of the Employee Plans Compliance Resolution System ("EPCRS") by, among other things, taking reasonable steps to have the excess amount returned by the recipient, even if the plan would not otherwise qualify for self-correction, provided that the correction is completed by December 31, 2007. A plan that meets all of the EPCRS requirements for remedial action will be allowed to correct excess distributions even after December 31, 2007.
G. PBGC Premiums and Related Provisions
PBGC Premiums. Generally, an underfunded plan must pay both an annual flat-rate premium of $30 per participant and an annual variable rate premium of $9 per $1,000 of unfunded vested benefits to the PBGC. However, plans at the "full funding limit," are not required to pay variable rate premiums. Effective for plan years beginning in 2008, the PPA repeals the "full-funding limit" exception.
Unfunded vested benefits are currently valued using an interest rate equal to 85% of the long-term corporate bond rate determined on a spot-rate basis. The PPA extends this methodology to 2006 and 2007. Beginning in 2008, the interest rate will be the same one used to determine plan liabilities (i.e., the three-segment yield curve rate) except that it will be based on a spot rate rather than a 24-month average.
Limit on Benefits Guaranteed by PBGC. The PBGC guarantees benefits payable under a defined benefit plan up to a specified amount ($4,125.00 per month for 2007). When a plan amendment increases benefits, the PBGC guarantee of the increase is phased in over five years from the amendment's effective date. Under the PPA, the PBGC guarantee of plant shutdown or other unpredictable contingent event benefits is phased in over five years from the date the shutdown or unpredictable event occurred. The provision applies with respect to plant shutdowns or other similar events occurring after July 26, 2005.
The amount of the PBGC guaranteed benefit is generally determined as of the date of plan termination. Under the PPA, however, if a bankrupt plan sponsor terminates the plan while in bankruptcy, the amount of guaranteed benefits is frozen as of the date the plan sponsor enters bankruptcy or a similar proceeding. This provision is effective 30 days after enactment, i.e., September 17, 2006.
H. New Rules Affecting Plan Distributions
Joint and Survivor Annuity Requirements. To comply with ERISA's joint and survivor annuity requirement applicable to defined benefit and money purchase pension plans, retirement plans frequently provide a joint and 50% survivor annuity as the automatic form of distribution. For plan years beginning after 2007, the PPA requires such a plan to offer more than one form of joint and survivor annuity. For plans where the automatic distribution form is a joint survivor annuity under which continuing payments to the survivor are at least 50% but less than 75% of the participant's periodic benefit amount, a minimum 75% survivor annuity must be offered as an alternative. Similarly, if the automatic form is a joint and survivor annuity under which continuing survivor payments are 75% to 100% of the participant's benefit, a 50% survivor annuity must be offered as an alternative.
Notice and Consent Period Regarding Distributions. Under prior law, an election of a form of distribution other than a joint and survivor annuity must be made no more than 90 days before the annuity starting date. For plan years beginning after December 31, 2006, the PPA increases the consent period from 90 days to 180 days.
Hardship Distributions. Current rules for 401(k), 403(b) and 457(b) plans, as well as nonqualified deferred compensation plans, permit hardship distributions based on the circumstances of a participant, or the spouse or dependents of the participant. The PPA provides that a plan may be amended to take into account the circumstances of any person named as a beneficiary, even if the beneficiary is not a spouse or dependent. The PPA directs the Secretary of the Treasury to issue regulations implementing this change by February 16, 2007. The broader rule will facilitate distributions with respect to relatives who are not dependents, as well as life-time "partners" without regard to gender.
Phased Retirement Distributions. The PPA allows a defined benefit plan or money purchase plan to pay a participant a portion of his or her benefit while still employed if he or she is 62 years of age or older. In contrast to proposed phased retirement regulations, which would have conditioned in-service distributions on a 20% reduction in an employee's work schedule, the new statutory provision merely requires the participant to be at least age 62.
Comment: This permissive provision, which is effective for distributions in plan years beginning after 2006, could be an effective strategy to help older workers transition into retirement by easing their financial concerns.
Early Distributions to Active Duty Reservists. Payments before age 59_ from an IRA, qualified plan or 403(b) contract are generally subject to a 10% penalty for early withdrawal. The PPA provides an exemption from the penalty for reservists who have been called to active duty for at least 180 days or for an indefinite period. In addition, the reservist may pay back all or a portion of the distribution to an IRA by the later of (a) two years after the period of active duty, or (b) August 16, 2008. The new exception is applicable to a distribution made after September 11, 2006, provided that it is made during an active duty period.
I. Rollover Changes
Rollover of After-Tax Contributions. Under prior law, rollovers of after-tax contributions are permitted from a qualified plan to a defined contribution plan (but not a 403(b) plan), provided that the receiving plan provides for separate accounting of the after-tax amounts. Rollovers of after-tax amounts are permitted from a 403(b) plan to another 403(b) plan but not to a qualified plan.
For tax years beginning on or after January 1, 2007, the PPA permits the rollover of after-tax amounts from a qualified plan to a 403(b) plan, so long as the rollover is implemented by means of a trustee-to-trustee transfer and the receiving plan provides the requisite separate accounting for the after-tax amounts.
Comment: It is not entirely clear whether rollover of after-tax contributions from a 403(b) plan to a qualified plan would be allowed.
Direct Rollovers to Roth IRAs. Currently, distributions from qualified plans, 403(b) plans or governmental 457 plans may be rolled over into a traditional IRA but not a Roth IRA. Individuals with adjusted gross income ("AGI") of less than $100,000 may make a subsequent rollover of such amounts into a Roth IRA. Effective for distributions made after December 31, 2007, individuals with AGI of less than $100,000 can roll over amounts from qualified plans, 403(b) plans and 457(b) plans directly into a Roth IRA. The rollover, less any after-tax amounts, is included in income, and the 10% penalty tax for early withdrawal does not apply.
Rollovers by Non-Spouse Beneficiaries. Generally speaking, the spouse of a deceased participant in a qualified plan, tax-deferred annuity or 457 plan may roll over the participant's benefit to an IRA. Effective for distributions after December 31, 2006, the PPA extends this treatment to non-spouse beneficiaries of participants in a qualified retirement plan, 457(b) plan or 403(b) plan. The IRA is then treated as an inherited IRA for purposes of satisfying the minimum distribution rules.
J. New Rules for Individual Retirement Accounts
Increased Income Limits. The income limits for deductible and nondeductible contributions to traditional IRAs and for contributions to Roth IRAs will be indexed for inflation (rounded to the nearest multiple of $1,000), effective for taxable years beginning after 2006.
Direct Deposit of Tax Refunds. The PPA directs the Secretary of the Treasury to develop a tax form or to modify existing forms to allow a taxpayer to direct that all or a portion of the taxpayer's tax refund be deposited into the taxpayer's IRA for taxable years beginning after December 31, 2006.
IRA Charitable Rollover. For 2006 and 2007 only, persons age 70_ and older may exclude from taxable income up to $100,000 per year in otherwise taxable distributions from a traditional or Roth IRA. To qualify for the exclusion, a distribution must take the form of a Qualified Charitable Distribution ("QCD"). A QCD is a distribution made directly by the IRA administrator to a charitable organization (not including private foundations) that would have been taxable if distributed directly to the plan participant.
It should be noted that the exclusion does not apply to distributions from 401(k) plans, 403(b) annuity plans, Keogh plans, defined benefit or defined contribution plans, Simplified Employee Pension plans, Simple Retirement Accounts, or any other type of qualified retirement plan other than a traditional or Roth IRA.
The individual whose IRA account is distributed must have reached age 70_ at the time of the distribution, a rule contrasting with the required distribution date in the case of minimum distributions which requires distributions to begin in the same year that the participant attains age 70_. However QCDs count toward the minimum distribution requirements of traditional IRAs, thereby doing double duty by reducing the need to take otherwise taxable distributions as well as providing that the distributions will be tax free.
Distributions of non-deductible contributions from a traditional IRA are not includible in income and are not eligible for treatment as a QCD. For QCD purposes, a special ordering rule applies pursuant to which a distribution is treated first as income up to the amount that would have otherwise been included in gross income if the aggregate balance of all IRAs owned by the individual were distributed during the same year. In contrast to the usual rule under which a proportionate amount of each IRA distribution is treated as nontaxable, this has the effect of maximizing the amount of the QCD and preserving the nontaxable part of the IRA.
Comment: The exclusion will primarily benefit donors who have maximized their ability to claim income tax deductions on a current year basis due to the 50% contribution base limitation, since QCDs operate independently of the percentage limitation rules. High income donors may also benefit by avoiding cutbacks of as much as 2% on itemized deductions, and non-itemizers will benefit by receiving the equivalent of a deduction if they make gifts directly from their IRAs to qualified charities. However, owners of Roth IRAs will find the new provision to be of limited utility, since most Roth IRA distributions are non-taxable.
K. Automatic Enrollment Provisions
New ADP/ACP Safe Harbor. 401(k) plan sponsors may satisfy the ADP and ACP tests by adopting a "qualified automatic contribution arrangement." To qualify, a plan must provide that all eligible employees are treated as making a deferral contribution election equal to a fixed percentage of compensation determined by the plan sponsor (not to exceed 10%) unless the employee affirmatively elects either not to have a contribution made or to make a lower or higher elective contribution. The default contribution rate must be equal to at least 3% of compensation during the first year in which the deemed election applies to the participant; 4% of compensation for the second plan year; 5% of compensation for the third plan year; and 6% of compensation for any plan year thereafter. An automatic election will cease if an employee makes an affirmative election. The automatic election is not required for employees who were eligible to participate in the plan immediately before the date on which the plan became a qualified automatic contribution arrangement and who had in effect an election either to participate or not to participate in the plan on that date.
To qualify for the new safe harbor, the employer must also make a matching contribution equal to 100% of each nonhighly compensated employee's elective contributions up to 1% of compensation plus 50% of the employee's elective contributions from 1% to 6% of compensation. In other words, 3_ % of compensation would be the maximum match. Alternatively, the employer could provide a required minimum contribution equal to 3% of compensation for all eligible employees.
If matching contributions are made, the plan automatically satisfies the ACP test if (i) the matching contributions do not exceed 6% of compensation, (ii) the rate of match does not increase as the rate of an employee's elective deferrals increases, and (iii) the rate of match for highly compensated employees is no greater than the rate of match for nonhighly compensated employees.
The safe harbor requires that participants be 100% vested in employer matching or nonelective contributions after completing two years of service. A safe-harbor plan must also comply with other requirements relating to notice and election procedures similar to those described below in connection with the reversal of automatic contributions. The participant must be given a reasonable amount of time after receipt of notice, and before the automatic elective contributions begin, to make an affirmative election with respect to contributions and investments.
The automatic enrollment safe harbor applies to plan years beginning on or after December 31, 2007.
Comment: Plan sponsors wishing to increase plan participation should consider adopting the new automatic enrollment safe harbor. This step would have the additional advantage of reducing administrative costs, since passage of the ADP/ACP tests would be guaranteed. Moreover, the top-heavy rules would not apply to such plans. The new safe harbor differs from the existing 401(k) and (m) safe harbors which require immediate vesting of employer matching and nonelective contributions and under which matching contributions must equal at least 100% of the first 3% of compensation and 50% of the next 2% of compensation (for a maximum contribution of 4% of compensation).
Reversing Automatic Contributions. Effective in 2008, the PPA codifies existing administrative law by permitting 401(k) plans, tax deferred annuities and governmental 457(b) plans to be amended to allow an employee to withdraw automatic contributions within 90 days of the first automatic contribution made for the employee. A plan that adopts such a provision must comply with an annual notice requirement designed to apprise the employee of his rights and obligations in an accurate and comprehensive manner. The notice, which must be furnished within a reasonable period before each plan year, must include an explanation of the employee's right not to have elective contributions made (or to elect to have such contributions made at a different percentage). The notice must also explain how contributions made under the automatic contribution arrangement will be invested in the absence of any investment election by the employee. For the notice to be effective, the employee must have a reasonable time after its receipt and before the first automatic contribution is made to reverse or change the automatic contribution.
Any amounts an employee elects to have returned (including earnings) are includible in income in the year in which they are returned. The 10% early withdrawal penalty and various withdrawal restrictions generally do not apply. If matching contributions have been made, they will be forfeited. The returned amount may include earnings derived from a default investment of the automatic contribution made by the employer pursuant to regulations issued by the Department of Labor; for more information on these regulations, please see the discussion of default investments under the heading Fiduciary Responsibility, below.
Returned contributions are not taken into account for purposes of applying the nondiscrimination rules or limits on elective deferrals. Further, if the rules for reversing automatic contributions are followed, the period for returning excess aggregate contributions to a 401(k) is extended from 2_ months to six months after the close of the plan year.
L. Accelerated Vesting
Currently, employer matching contributions made to a defined contribution plan or a top-heavy plan must be 100% vested after three years (three-year cliff vesting) or vest at a rate of 20% a year starting with year two (two-to-six-year phased vesting). The PPA extends these faster vesting schedules to all employer contributions made under defined contribution plans, not just employer matching contributions. The PPA continues to apply a five-year cliff or three-to-seven-year phased vesting schedule to an employee's accrued benefit derived from employer contributions in a defined benefit plan.
The faster vesting schedules are generally applicable to contributions made for plan years beginning after 2006. However, please see the discussion above for the implementation dates for the new three-year vesting schedule applicable to hybrid plans. In addition, for ESOPs that had an outstanding loan on September 26, 2005, incurred to acquire qualifying employer securities, the new vesting rules will not apply to any plan year beginning before the earlier of the date in which the loan: (i) is fully repaid, or (ii) was scheduled to be repaid, determined as of September 26, 2005. The effective date for collectively bargained plans will be the earlier of (i) the later of the date on which the last of the collective bargaining agreements terminates or January 1, 2007, or (ii) January 1, 2009.
Comment: Many plans already apply these faster vesting schedules to all employer contributions or benefits. However, for those plans that do not apply the accelerated vesting schedules, plan sponsors must determine which vesting schedule to apply. Plan sponsors should note that the more rapid vesting schedules will reduce forfeitures, thereby generally increasing employer costs.
M. Diversification of Employer Securities
The PPA requires plans in which participants may invest in employer stock or receive employer contributions in the form of employer stock to permit participants to diversify their plan assets by directing their accounts holding such stock into other investment options. The new requirements only apply to plans holding publicly traded employer securities. Although most such plans permit diversification of salary deferral and after-tax employee contributions, some plans limit alternative investments for matching contributions and other employer contributions. These plans (except for certain ESOPs) will have to be modified to comply with the new rules which are generally effective for plan years beginning after December 31, 2006.
In 2007, the diversification requirement will apply immediately to all investments in employer securities that are attributable to salary deferral or after-tax employee contributions. All other amounts, such as employer profit sharing and matching contributions, are subject to the diversification rules only if the participant has at least three years of service or has died. For employer contributions invested in employer stock before the plan year beginning in 2007, the diversification rules phase in ratably over three years, but only for those participants who have not attained age 55 with three years of service before the first plan year beginning after December 31, 2005.
The diversification rules require that a plan provide a choice of at least three investment options other than employer securities. The investment options must each have materially different risk and return characteristics, and they must each be diversified. Except as provided in regulations, and as required by the securities laws, a plan may not impose restrictions or conditions on investments in employer securities that are not imposed on other plan assets.
The plan administrator must provide each participant with a notice explaining the right to diversify and its importance at least 30 days before the first date on which the participant has a right to diversify with respect to any type of contribution. The IRS has issued a model notice for use by plan administrators.
Comment: It appears to have been intended that investment options generally offered under a plan must also be offered with respect to employer securities. Although the plan can limit diversification opportunities to quarterly election periods, it is also intended that individuals with employer stock in their plan accounts be given the same investment election opportunities that apply to other investment changes under the plan. Thus, if participants enjoy the right to change their investments on a daily basis, it will generally be required that they be allowed to divest employer stock on a daily basis.
N. Investment Advice
Investment Advice. The PPA encourages plan sponsors to provide investment advice to participants by allowing a "fiduciary advisor" to provide investment advice (including advice with respect to the fiduciary advisor's own investment products) to participants in plans with participant-directed accounts without violating prohibited transaction rules, provided that certain conditions are met. These conditions include the following safeguards:
· The investment advice must either be based on a computer model that is certified by an "eligible investment expert" or the fiduciary advisor's fees cannot vary based on the investment options selected;
· Before the initial provision of investment advice and annually thereafter, the fiduciary advisor must provide the participant with information on the investment advice program, including fees, historical rates of return, and the role of other parties with a material role in developing the program;
· Transactions may occur only at the participant's direction;
· The fiduciary advisor's compensation must be reasonable and all transactions must be at least as favorable to the plan as "arm's length" transactions;
· The investment advice program must be authorized by a fiduciary other than the fiduciary providing the advice or any person providing investment options under the plan;
· The investment advice program must be subject to an independent annual audit regarding compliance with these new standards for which a written report is prepared; and
· The fiduciary advisor must retain compliance records for at least six years.
A fiduciary advisor is broadly defined to include banks, insurance companies, broker dealers and registered investment advisors, as well as their affiliates, employees, representatives and agents.
The plan sponsor must use prudence in selecting and monitoring a fiduciary advisor, and is required to periodically monitor its performance, but does not have the responsibility of monitoring the specific investment advice provided to any particular participants.
These investment advice rules are effective for advice provided after December 31, 2006.
Comment: Plan sponsors wishing to take advantage of the new investment advice rules should establish procedures to ensure that fiduciaries comply with ERISA's fiduciary prudence requirements with respect to the selection and periodic review of the fiduciary advisor. The plan sponsor should be able to demonstrate compliance with ERISA standards in the event of a DOL audit.
O. Fiduciary Responsibility
Default Investments. Currently, plan sponsors are not responsible for the specific investment decisions made by participants if certain requirements are met (i.e., the plan complies with ERISA Section 404(c)). The PPA extends this protection to situations where the participants do not make an investment choice, and the plan fiduciary makes a default investment consistent with regulations which the PPA authorizes the Department of Labor to issue. On September 27, 2006, the Department issued proposed regulations that stipulated the conditions for such relief.
Comment: The Wagner Law Group submitted two significant comments to the Department of Labor regarding its proposed regulations, which may substantively affect the final regulation.
The regulations relieve fiduciaries of liability for loss or an ERISA fiduciary breach that is the direct and necessary result of investing part or all of a participant's account in a "qualified default investment alternative" ("QDIA"), although the fiduciaries would remain responsible under Section 404(a) of ERISA for the prudent selection and monitoring of a QDIA. To qualify, the plan must make available the "broad range" of investments applicable to Section 404(c) plans even if the plan does not intend to take advantage of the Section 404(c) safe harbor.
The assets invested on behalf of a participant must be in one of the following three types of investment products:
· An investment fund product or model portfolio designed to provide varying degrees of long-term capital appreciation and capital preservation through a mix of equity and fixed income exposures based on the participant's age, target retirement date, or life expectancy (e.g., a life-cycle or target retirement approach);
· An investment fund product or model portfolio designed to provide long-term capital appreciation and capital preservation through a mix of equity and fixed income exposures consistent with a target level of risk appropriate to participants in the plan as a whole (e.g., a balanced fund approach); and
· An investment management service in which the investment manager allocates the assets of a participant's individual account to achieve long-term capital appreciation and capital preservation through a mix of equity and fixed income exposures offered through investment alternatives based on the participant's age, target retirement date, or life expectancy (e.g., an aged-based managed account approach).
There is an express contemplation that, under the first and third alternatives, the asset allocations and risk levels of a QDIA will change over time, becoming more conservative as a participant ages.
For the default investment fiduciary protections to apply, the proposed regulations require that a notice must be provided to participants at least 30 days in advance of the first default investment, and at least 30 days in advance of each subsequent year describing how, among other things, contributions will be invested in the absence of any investment election by the participant. Thus, new participants' default elections should not be implemented until the first payroll period after an employee has been a participant for 30 days. Further, the plan, by its terms, must provide that any material provided to the plan and relating to a QDIA (e.g., a prospectus, proxy voting materials or account statements) is provided to the participant. In addition, any participant or beneficiary on whose behalf assets are invested in a QDIA must be afforded the opportunity to transfer those assets, in whole or in part, to any other investment alternative available under the plan without financial penalty.
The default election provision applies to plan years beginning after 2006. The PPA requires the proposed regulation to be finalized by February 17, 2007.
Comment: It should be noted that the proposed regulation does not authorize the use of money market, stable value or similar products as a stand-alone QDIA, although these types of products may well be included in the investment mix under a QDIA, and it is conceivable that they may qualify as a QDIA for certain participants (e.g., participants with advanced ages for whom a near risk-free investment is appropriate). Plans may continue to use these products as default options in accordance with pre-PPA law, but they will not ensure the fiduciary relief provided by the new law. Employers wishing to take advantage of the protection for default investments need to select qualifying investment products and amend their plans to require appropriate disclosure to participants.
Mapping Allowed. The PPA addresses the long-standing concern of fiduciary responsibility when a plan changes investment providers and a participant's investment in a mutual fund or other investment fund offered by the replaced provider is automatically transferred or "mapped" into a corresponding fund offered by the new provider. The Department of Labor has long warned that fiduciaries may not have any protection under Section 404(c) of ERISA for losses experienced in the new fund. The PPA makes Section 404(c) relief available as long as the fund into which the account is "mapped" has characteristics that are reasonably similar to the fund previously selected by the participant, and the participant does not instruct the plan fiduciary not to proceed with the mapping transaction. This relief, which will apply to plan years beginning after December 31, 2007, is conditioned on providing notice of the change at least 30 days and no more than 60 days before its effective date.
Blackout Notice to One Person Plans. The Sarbanes-Oxley Act added a blackout notice requirement when participants are not allowed to direct plan investments, obtain plan loans, or receive distributions from a plan for a period of time. Effective retroactively to the date the blackout notice rules first took effect, the PPA provides that the blackout notice requirement does not apply to one-person and partner-only plans.
Plan Asset Rules. The PPA modifies the Department of Labor's plan asset regulation which provides that, if a plan covered by ERISA or Code Section 4975 acquires an equity interest that is not publicly traded in an investment fund other than a registered mutual fund, the fund's underlying assets are treated as plan assets subject to the fiduciary provisions of ERISA and/or Code Section 4975 unless "benefit plan investors" hold less than 25% of each class of equity interest in the entity. The PPA provides that plans not subject to ERISA (e.g., governmental plans, foreign plans and non-electing church plans) are not to be treated as "benefit plan investors" and are not to count toward the 25% limitation.
The PPA also provides that an entity that is treated as holding plan assets is deemed to do so only in proportion to the equity held by the benefit plan investors. For example, if the underlying assets of Fund A are treated as plan assets because 30% of its equity is held by benefit plan investors, and Fund A acquires $1,000,000 of an equity class of securities in Fund B, only $300,000 of the equity securities held by Fund A is treated as being held by benefit plan investors and counted toward the 25% limitation in determining whether Fund B's underlying assets are treated as plan assets.
The changes to the plan asset rules are effective on August 17, 2006.
Comment: It is anticipated that the changes to the plan asset rules will allow non-publicly traded investment funds to accept more ERISA plan money.
New Prohibited Transaction Exemptions. Effective for transactions occurring after August 17, 2006, the PPA creates new statutory prohibited transaction exemptions to permit certain recurring transactions, such as block trading, cross trading, foreign exchange transactions and the purchase or sale of securities by means of an electronic communications network. Transactions between a plan and a service provider who has no discretionary authority or control regarding plan investments are also permitted as a statutory exemption, provided that certain notice requirements are met. An additional statutory exemption would apply to securities and commodities transactions that are otherwise prohibited if the transaction is corrected promptly following discovery that it is a prohibited transaction.
Annuities in Defined Contribution Plans. The PPA directs the Department of Labor to issue final regulations by August 17, 2007, clarifying that the selection of an annuity contract as an optional form of distribution from an individual account plan is not subject to the "safest available annuity" standard stated in an earlier Department release. The selection of an annuity is to be governed by applicable fiduciary standards, such as prudence.
P. Health and Welfare Plans
Retiree Health. Prior to the PPA, excess pension assets could be transferred once each year from an ongoing defined benefit plan to a Code Section 401(h) health account (within the defined benefit plan) to be used for the current year's retiree health costs. In general, excess assets were defined as the excess over the greater of the accrued liability or 125% of current liability under the plan.
The PPA allows a pension plan with assets of at least 120% of the plan's current liability to transfer, after August 17, 2006, two or more years of estimated retiree medical costs to a health account under the plan. The maximum amount that could be transferred is the lesser of 10 years of estimated retiree medical costs or assets in excess of 120% of the plan's current liability. For all years for which such a transfer has been made, the employer must make contributions sufficient to maintain the plan's 120% funding level (or transfer assets back from the health account to the pension account). In addition, the average annual cost for retiree medical benefits must be maintained at certain levels throughout the transfer period and four years thereafter. For employers meeting certain criteria, the cost maintenance requirement for multi-year transfers made pursuant to a collective bargaining agreement may be modified through the collective bargaining agreement.
Comment: Employers that sponsor an overfunded pension plan may wish to consider funding retiree health benefits through the plan. In this way, the employer may provide retiree health benefits using excess plan assets without having the corresponding liability appear on its books.
Association Health Plans. For plan years beginning after 2007, the PPA provides for a deduction under Code Section 419A to fund a reserve for medical benefits (other than retiree medical benefits) for future years that are provided through a bona fide association as defined in the Public Health Service Act. These organizations are generally trade associations that establish self-funded plans that benefit members' employees without regard to health status. The applicable Section 419A account limit is 35% of the sum of (1) qualified direct costs for the tax year, and (2) the change in claims incurred but not paid for the tax year with respect to medical benefits other than post-retirement medical benefits. This contrasts with current law, which limits the ability of plan sponsors to deduct contributions to welfare plans to fund medical benefits for future years.
Long-Term Care Insurance. The PPA changes the rules with respect to long-term care insurance to allow long-term care riders on annuity contracts and to provide that charges against the cash value of an annuity or life insurance contract to pay for the long-term care insurance rider will not be includable in income, but, rather, will reduce the investment in the contract (but not below zero). The new law also expands the rules for tax-free exchanges of certain insurance contracts to include exchanges of life insurance contracts, endowment contracts, annuity contracts, or qualified long-term care contracts for long-term care contracts, as well as contracts with long-term care insurance riders. These changes apply for taxable years beginning after December 31, 2009.
Final HSA Regulations. On July 31, 2006, the Treasury Department issued final regulations on the requirement that employer contributions to eligible employees' health savings accounts ("HSAs") satisfy a comparability test. Failure to satisfy the test subjects the employer to an excise tax.
The final regulations require that employers electing to contribute to their employees' HSAs make comparable contributions for all employees who (1) are eligible individuals enrolled in a high deductible health plan ("HDHP"), (2) are in the same category of employment (i.e., current full-time employees, current part-time employees or former employees) and have the same category of coverage (i.e., self-only coverage, and family coverages of self plus one, self plus two, or self plus three or more).
To be considered comparable, an employer's contributions to an HSA must be the same dollar amount or the same percentage of the HDHP deductible as for other eligible employees in the same category of employment and same category of coverage. Contributions for the self plus two category may not be less than contributions for the self plus one category, and contributions to the self plus three or more category cannot be less than contributions for the self plus two category. However, since self-only and family are different categories, an employer could contribute only for employees with self-only coverage and not for employees with any type of family coverage.
The final rules also provide that collectively-bargained employees need not be treated as comparable participating employees if health benefits for those employees were the subject of collective bargaining.
An employer is not obligated to contribute for an employee who is an eligible individual but has not yet established an HSA at the time the employer funds the HSAs. However, the employer is required to make up any missed contributions once the employee does set up an HSA. Further, the employer must contribute an amount to make up for lost interest on such contributions.
The comparability rules do not apply to contributions made through a cafeteria plan. To qualify for this exemption, the employee must have the right to elect to receive cash or taxable benefits instead of a contribution to the HSA.
Q. Provisions Directly Affecting Tax-Exempt and Governmental Plans
Health and Long Term Care Premiums for Public Safety Officers. Effective for distributions beginning after December 31, 2006, the Code provides that an eligible retired public safety officer may, after separation from service as a result of disability or attainment of normal retirement age, elect to have amounts from a governmental qualified retirement or annuity 457(b), 401(k) or 403(b) plan distributed directly to an insurer to pay for qualifying health care or long term care coverage. If such an election is made, up to $3,000 annually of the amount distributed is excludable from taxable income to the extent used to purchase the requisite coverage. Public safety officers who may make the election include law enforcement officers, firefighters, and certain emergency medical personnel.
Waiver of 10% Penalty for Defined Benefit Plan Distributions to Public Safety Officers. Effective August 17, 2006, the 10% early withdrawal penalty under Code Section 72(t)(10), does not apply to distributions from a governmental defined benefit plan made to a public safety employee who separates from service after age 50. Public safety employees include law enforcement officers, firefighters and certain emergency medical personnel.
The penalty waiver will particularly benefit public safety officers who terminate employment between the ages of 50 and 55 and take lump sum distributions from a Deferred Retirement Option Plan ("DROP") account, other than a DROP account over which the participant has the power to direct investments.
Purchase of Permissive Service Credit. Generally, participants in state and local government defined benefit plans may be credited with "permissive service credit" (i.e., service not otherwise credited under the plan) if the participant voluntarily contributes an amount necessary to purchase the credit. Amounts contributed by means of tax-free trustee-to-trustee transfers from 457(b), 401(a) or 403(b) plans may be used to purchase permissive service credit.
The PPA clarifies the meaning of "permissive service credit" to include credit for periods in which there has been no performance of service, and allows enhanced benefits for a period of service already credited under the plan.
In determining whether a trustee-to trustee transfer is for the purchase of "permissive service credit" (and is thus excludable from income), the limitations on nonqualified service credit under Code Section 415(n)(3)(B) will not apply. Further, the ability to purchase permissive service credit is extended from active employees to all participants.
Required Minimum Distributions. Final required minimum distribution regulations under
Code Section 401(a)(9) were issued in 2002, although until 2006, plans were only required to show that
they had exercised good faith in complying with a reasonable interpretation of the rules. The PPA directs
the Treasury to issue regulations under which a governmental plan will, for all years to which the
Code Section 401(a)(9) rules apply, be treated as satisfying the rules if the plan complies with a
reasonable, good faith interpretation of the rules.
R. EGTRRA Provisions Made Permanent
The Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") contained numerous provisions relating to qualified plans and IRAs, all of which were set to expire after 2010 under a "sunset provision." For example, under EGTRRA, the dollar limit on annual defined benefit plan payments was increased to $160,000, to be adjusted for changes in the cost of living (as noted above, $180,000 in 2007). Similarly, the dollar limit on annual additions to a defined contribution plan was increased to $40,000 ($45,000 in 2007). Another change was that individuals over age 50 can make additional catch-up contributions, i.e., elective deferrals in excess of otherwise applicable plan limits. If the sunset provision had remained in effect, the old Code and ERISA limitations, which were significantly lower, would have been applied to tax, plan and limitation years beginning after December 31, 2010, as if the changes made by EGTRRA had never been enacted. This would have been at best problematic and at worst disastrous for the retirement system. Fortunately, under the PPA, the sunset provision no longer applies to certain EGTRRA provisions such as those described above.
III. EXTENSION OF TRANSITION PERIOD UNDER CODE SECTION 409A
On October 4, 2006, the IRS issued Notice 2006-79 to extend most of the 2006 transition relief for deferred compensation arrangements governed by Code Section 409A. In late November, Notice 2006-100, also provided interim guidance on reporting and withholding rules applicable to amounts includible in income by reason of Section 409A for both 2005 and 2006.
As reported in our last Newsletter (Vol. IX, No. 1), Section 409A became effective on January 1, 2005, with the purpose of providing comprehensive rules for the taxation of nonqualified deferred compensation. Deferred compensation arrangements that violate the Section 409A requirements result in the imposition of a 20% additional tax on the individual benefiting from the arrangement, as well as regular income tax liability and a possible assessment of interest. The IRS issued proposed regulations in the fall of 2005, with a proposed effective date of January 1, 2007. However, bowing to the inevitable, the new Notice acknowledged that the IRS would not be able to issue final regulations in time for taxpayers to comply by the December 31, 2006 deadline (which it did not). Key features of the two notices are as follows:
Extension of Good Faith Compliance Period. Plans adopted on or before December 31, 2007, will not be considered to violate Section 409A, provided that (a) they are operated in "reasonable, good faith compliance" with the statute and applicable interim guidance that is effective before January 1, 2008, and (b) they are amended to conform with the statute and the final regulations before January 1, 2008.
New Payment Elections. A plan may provide or may be amended to provide for revised payment elections as to the time or form of payment without violating Section 409A, provided the new elections are made no later than December 31, 2007, and the timing or form of the election complies with Section 409A. The notice continues the approach taken in the preamble to the proposed regulations that a new payment election made in 2006 may not accelerate into 2006 amounts not otherwise payable in 2006 and may not defer amounts otherwise payable in 2006 into years after 2006. Similarly, a new payment election made in 2007 may not accelerate amounts into 2007 or defer payments otherwise due in 2007 beyond that year.
Payments Linked to Qualified Plans. The notice continues through December 31, 2007, the prior relief permitting nonqualified plan payment elections to be linked to elections under qualified plans even though the qualified plan elections do not comply with Section 409A. It also extends that relief to elections under Section 403(b) plans, Section 457(b) plans and certain broad-based foreign plans. Nevertheless, it is anticipated that the final regulations will require that nonqualified plan distributions be decoupled from distributions under qualified plans for periods after 2007.
Stock Option Issues. Prior guidance as to remedial action for discounted stock options and stock appreciation rights ("SARs") is continued. Thus, a discounted option or SAR may be reformed to add fixed payment terms consistent with Section 409A if the amendment and any payment election are made before January 1, 2008. Similarly, discounted options or SARs may be re-priced to eliminate the discount if this is done before 2008, and the transaction does not result in the receipt of cash or vested property in 2007.
Notwithstanding the ability to correct options and SARs described above, public companies that have been identified in stock option backdating investigations and, as a result, must report an incremental financial expense related to the discount, had a deadline of December 31, 2006, to correct discounted options or SARs issued to directors or executives subject to Section 16(a) of the Securities Exchange Act.
Collectively Bargained Plans. A nonqualified deferred compensation plan maintained pursuant to one or more collective bargaining agreements ("CBAs") which were in effect on October 3, 2004 is not required to comply with Section 409A until the earlier of (a) the date on which the last CBA expires or (b) December 31, 2009. For this purpose, any extension of the CBA after October 3, 2004, will be disregarded.
Reporting and Withholding. As reported in our last Newsletter, the IRS previously suspended reporting and withholding under Section 409A for 2005. The suspension came with a warning that a retrospective correction might be required at a later time. That time is upon us. Notice 2006-100 imposes reporting for amounts includible in income in 2005 or 2006 by reason of a violation of Section 409A. The obligation to withhold applies to such amounts that are includible in 2006 but not to amounts includible in 2005. However, the suspension of the requirement that amounts deferred be reported on either Form W-2 or 1099-MISC continues with respect to amounts deferred in 2005 and 2006.
Employers will generally have until January 31, 2007, to withhold and report on a Form W-2 amounts that were includible in income in 2006 because of a failure to comply with Section 409A but that were not actually or constructively received by the employee. The amount is reported in Box 1 of the employee's Form W-2 and is also entered in Box 12 of the Form using the code "Z". If the income recognition event resulting from noncompliance with Section 409A was in 2005, the taxable amount must be reported on a 2005 Form W-2 by the same deadlines that apply to 2006 amounts. However, as noted above, wage withholding does not apply to 2005 amounts.
The reporting obligation also applies to amounts includible in the income of non-employee service providers by virtue of a violation of Section 409A. Thus, amounts includible in income for 2005 and 2006 must be reported on Form 1099-MISC in Box 7 and Box 15b. Separate Forms are required for each year.
If an employer or payer paid no wages or income to the employee or service provider in 2005, other than amounts taxable under Section 409A, the employer or payer should prepare an original Form W-2 or Form 1099-MISC. If other wages or income were paid, a corrected payee statement (Form W-2c or corrected Form 1099-MISC) will be required.
For reporting and withholding purposes, the taxable amount for 2006 is determined as of December 31, 2006. Thus, for an account balance plan, the taxable amount would be the vested account balance as of December 31, 2006. For stock options and stock appreciation rights, the taxable amount is to be measured by assuming a December 31, 2006 exercise of the stock right. However, we reemphasize that such amounts would not include amounts that have been either actually or constructively received, without regard to the application of Section 409A, during 2006, since these amounts are considered to be the payment of wages or non-employee compensation at the time of receipt by the employee or service provider for purposes of reporting and withholding.
Final Regulations. Final regulations are expected to be issued early in 2007 and will be effective January 1, 2008. Deferred compensation plans and arrangements must be formally amended to comply with the final rules by December 31, 2007.
IV. MASSACHUSETTS HEALTH CARE LAW
In April 2006, Massachusetts enacted legislation requiring most state residents to carry health insurance either through their employers or individually. Employers that fail to provide health insurance to their employees may be subject to a surcharge of $295 annually per employee plus additional penalties. The new law imposes several obligations on employers, even if they are already offering health insurance coverage to their employees.
This legislation, which is administered by the Division of Health Care Finance and Policy (the "Division"), imposes multiple requirements on employers. The five most significant obligations are:
· Adopting and maintaining a premium conversion plan;
· Filing Employer Health Insurance Responsibility Disclosure ("Employer HIRD") Forms with the Division;
· Collecting Employee Health Insurance Responsibility Disclosure ("Employee HIRD") Forms;
· Demonstrating the employer's Fair Share Contribution; and
· Providing Certificates of Creditable Coverage.
B. Employer Obligations
Premium Conversion Plan. By July 1, 2007, all employers doing business in Massachusetts must adopt and maintain a premium conversion (also known as a Code Section 125 or cafeteria) plan that allows employees to pay their share of health care premiums with pre-tax dollars. Such premium conversion plans must also allow employees who obtain health care through the Commonwealth's newly-created Health Insurance Connector Plan (the "Connector") to pay their Connector premiums with pre-tax contributions. Employers will be required to file a copy of their premium conversion plans with the Commonwealth when regulations are issued.
Comment: Most premium conversion plans will need to be amended to comply with the Connector requirement to allow employees to pay their Connector premiums with pre-tax dollars. The Wagner Law Group would be happy to assist in this regard.
Employer HIRD Forms. Effective July, 1, 2007, employers with more than 10 employees doing business in Massachusetts will be required to file information about the health coverage they provide to their employees on an Employer HIRD Form to be made available by the Division. Emergency regulations implementing this requirement were issued on January 1, 2007 and have since been repealed due to changes in the law. New proposed regulations should be issued shortly. The emergency regulations described below, however, do provide insight regarding the information employers may be required to file. The emergency regulations would have required employers to file the following information each year:
· Employer's legal name, employer's d/b/a name, federal employer identification number and Division of Unemployment Assistance account number;
· Number of full-time employees (includes seasonal and temporary employees, but not independent contractors);
· Number of part-time employees (includes seasonal and temporary employees, but not independent contractors);
· Whether the employer offers subsidized health insurance to full-time employees;
· Whether the employer offers subsidized health insurance to part-time employees; and
· Whether the employer has filed its premium conversion plan with the Commonwealth.
Employers should consider taking steps to determine how to capture required information. Furthermore, employers should consider designating a responsible individual authorized to verify and certify the accuracy of the information submitted in the Employer HIRD Form.
The Division will conduct data matches with the Division of Unemployment Assistance and the Department of Revenue to verify the accuracy of the information filed on Employer HIRD Forms. Emergency regulations would have imposed a penalty of not less than $1,000 and not more than $5,000 on employers that knowingly falsify or fail to file required information.
New employers may be required to register with the Division when they register with the Division of Unemployment Assistance.
The emergency regulations stated that an employer has more than 10 employees if the sum of the total payroll hours for all employees for the period October 1 through September 30 divided by 1,820 is greater than 10. Payroll hours included regular hours, vacation, sick, FMLA leave, short-term disability, long-term disability, overtime and holiday hours. As a result, employers may not be able to simply count the number of employees to determine if they exceed the 10-employee threshold.
Employee HIRD Forms. Emergency regulations also would have required each Massachusetts employer who files an Employer HIRD Form to also collect a signed Employee HIRD Form from each employee who declines:
· employer-sponsored health coverage;
· employer-arranged health coverage (i.e., through the Connector plan with pre-tax dollars); or
· participation in the employer's premium conversion plan.
Employers would have been required to obtain signed Employee HIRD Forms within 15 days after the close of the open enrollment period for the employer's health insurance, or if earlier, July 1 of the reporting year. New hires would have been required to sign the Employee HIRD Form within 15 days of their date of hire. If an employee failed to return the signed Form, the employer would have needed to document diligent efforts to obtain the signed Employee HIRD Form and maintain the documentation for three years.
Employers would have been required to maintain signed Employee HIRD Forms for at least three years and make them available to the Division upon request. Employers that knowingly falsify required information would have been subject to a penalty of not less than $1,000 and not more than $5,000.
Employer's Fair Share Contribution. Massachusetts employers with more than 10 employees that fail to make a "fair and reasonable" contribution toward the cost of health coverage must pay an annual "Fair Share Contribution" not to exceed $295 per employee. To be exempt from the requirement to pay a Fair Share Contribution, the employer must pass one of the following two tests:
· 25% Test. The employer must cover under its health insurance plan at least 25% of its employees employed at Massachusetts locations who work at least 35 hours per week, whether or not they are Massachusetts residents for the period from October 1 through September 30 of each year.
· 33% Test. An employer that fails the 25% test must pay at least 33% of the premium cost for all of its Massachusetts employees who are regularly scheduled to work at least 35 hours per week and who work at least 90 days during the period October 1, 2006 through September 30, 2007.
Comment: It appears that the 33% test only applies for the year ending September 30, 2007. Therefore, all employers may be required to demonstrate compliance with the 25% test for years ending after that date. Employers who pass using the 33% test as of September 30, 2007, may need to modify their programs to ensure compliance with the 25% test for later years.
In accordance with the final regulations, each employer will have to file or make available information that will enable the Division to calculate the Fair Share Contribution. The Fair Share determination rules are effective October 1, 2006, and the initial reporting obligation is for the period ending on September 30, 2007.
Free Rider Surcharge. Effective July 1, 2007, in addition to the Fair Share Contribution, an employer with more than 10 employees that does not provide the required health care, or does not conform to the premium conversion plan rules, can be assessed a "free rider surcharge" if five or more of its employees or their dependents use free health care during a year or if one employee or his or her dependents uses state-funded care more than three times in a year. Final regulations, issued on December 22, 2006, have recently been repealed due to changes in the law. However, the repealed regulations do provide some insight regarding how the Division will implement the Free Rider Surcharge. In accordance with the repealed regulations, the surcharge ranged from 10% to 55% of the Commonwealth's costs for these services. However, the first $50,000 of health care provided to the employer's employees would have been exempt from the surcharge. The surcharge would have been based on services provided after June 30, 2007.
In accordance with the repealed regulations, each employer would have been required to file or make available information required by the Division to calculate and collect the surcharge. If an employer failed to provide information within two weeks after receiving written notice or falsified information, the employer would have been subject to a civil penalty of not more than $5,000 for each week on which such violation occurs or continues.
Creditable Coverage Certificates. Effective January 1, 2008, employers (and insurers) must issue certificates of creditable coverage similar to those required by the portability provisions of the federal Health Insurance Portability and Accountability Act of 1996 ("HIPAA"). Failure to provide the certificates could result in penalties of $50 per individual up to $50,000 per year.
C. Individual Obligations
The law requires all residents of the Commonwealth to have health insurance, either acquired through their employer or purchased on their own, by July 1, 2007. Those individuals who do not obtain insurance through their employer may purchase it through the Connector, which will have the task of connecting individuals and small groups with insurers. These individuals and groups may be combined by the Connector in an effort to reduce costs.
Individuals may receive a subsidy for heath insurance coverage. Those who are under the federal poverty level will receive health coverage at no cost, while those who earn up to 300% of the poverty level will have subsidized coverage. For 2007, 300% of the federal poverty rate is approximately $29,400 for an individual and $60,000 for a family of four.
On their 2007 state income tax returns, individuals will have to affirm that they have health insurance coverage. Those that do not have health insurance can lose their state personal income tax exemption. If uninsured in subsequent years, penalties will be assessed based on the cost of individual coverage.
D. Insurers' Obligations
Nondiscrimination Rule. Effective July 1, 2007, a group health insurance policy or contract (including HMOs but excluding stand-alone dental plan arrangements) cannot be issued in Massachusetts if the employer contributes a smaller percentage of the insurance premium for one employee than for another employee who receives an equal or greater salary. To date, Massachusetts has not issued any regulations or guidance on how this provision should be interpreted. This nondiscrimination rule does not apply to self-insured group health plans.
Comment: It is important to remember that this provision is directed at the insurance companies, and it is the insurers, and not employers, that are responsible for compliance. In fact, ERISA is likely to preempt (invalidate) any attempt to apply this rule directly to employers.
Dependent Coverage. Effective January 1, 2007, group health insurance policies and contracts (but not self-insured plans) are required to cover dependent children for the first two years after they can no longer be claimed as dependents for federal income tax purposes or until they reach the age of 26, whichever occurs first. Presumably, for purposes of the first rule, the two-year period will begin on the first day of the calendar year following the last year that the employee claims the child as a dependent on IRS Form 1040. There does not appear to be any requirement that the employer continue to make contributions for dependents who are no longer covered under the plan. Thus, the former dependent child may have to pay the entire cost of coverage. The new Massachusetts dependent coverage requirement is in addition to and independent of the COBRA continuation coverage requirement.
The new health care law was written in an effort to extend health coverage to the majority of Massachusetts residents. There are many questions that remain to be answered. The law imposes several new obligations on employers. It also imposes penalties on individuals who, while having incomes above the poverty level, simply do not have the means to pay for mandatory insurance.
Another issue yet to be determined is whether and to what degree the Massachusetts law will be preempted by ERISA. In general terms, ERISA "preempts" (that is, negates) any state law that "relates to" or "has a connection with or reference to" an ERISA-covered plan. Some employers have argued that the Massachusetts law, in practice, forces employers to create an ERISA-covered plan; dictates, to a certain extent, the level of employer contributions that are required for the plan; and, through the cafeteria plan requirements, interferes with the administration of an ERISA-covered plan. Therefore, they argue, ERISA preempts the Massachusetts law.
The ERISA preemption issue must ultimately be resolved in the courts, likely the U.S. Supreme Court. However, many, if not all, of the new law's provisions are likely to be in effect before it can be tested in the courts. Consequently, employers should be prepared to comply with the Massachusetts law's provisions, at least for the next few years, and possibly on a permanent basis.
V. CASH BALANCE LITIGATION
On August 7, 2006, a three-judge panel of the United States Court of Appeals for the Seventh Circuit ruled that IBM's cash balance plan did not violate the age discrimination provisions of ERISA. The decision reversed the district court's ruling in Cooper v. The IBM Personal Pension Plan which had held that IBM's plan was age discriminatory because younger participants had more years to accumulate interest credits in their cash balance plan accounts before reaching normal retirement age than older participants.
Value under the IBM plan was based on pay credits (5% of compensation) and interest credits (1% above the interest rate for one-year Treasury bills) credited to each participant's hypothetical account. The plaintiffs argued that the rate of accrual under this formula discriminated against older participants who were nearing retirement, because they had fewer years to build up their benefit and would receive a smaller annuity at age 65 than younger employees who received the same pay and interest credits.
The relevant statutory language states that "a defined benefit plan shall be treated as not satisfying the requirements [of ERISA] if under the plan, an employee's benefit accrual is ceased, or the rate of an employee's benefit accrual is reduced, because of the attainment of any age." (Emphasis added) The Seventh Circuit held that the district court had erred by substituting the phrase "accrued benefit" (i.e., an amount "expressed in the form of an annual benefit commencing at normal retirement age") for the undefined phrase "benefit accrual." According to the court, the phrase "benefit accrual" refers, not to an amount taken out at retirement, but to an employer's contribution without the effect of the time-value of money. Because every participant received the same pay credit and the same interest every year, the Seventh Circuit found that the terms of the IBM plan were age-neutral, thus rejecting the lower court's analysis under which virtually all cash balance plans would have violated the age discrimination provisions of ERISA.
The IBM plaintiffs requested the full appeals court to reconsider the three-judge panel's ruling. However, the full Seventh Circuit Court of Appeals declined the rehearing request in September, and the plaintiffs appealed the decision to the U. S. Supreme Court, which, on January 16, announced it would not review the case. Thus, the Seventh Circuit's decision constitutes the best legal authority to date on the issue of age discrimination and cash balance plans.
As discussed in our commentary below, the IBM decision indicates a more viable future for cash balance plans. Nevertheless, the decision has not been universally accepted, and three subsequent district court decisions have taken a contrary view. On October 30, 2006, the district court for the Southern District of New York, in In Re J.P. Morgan Chase Cash Balance Litigation, denied the plan's motion to dismiss an age-discrimination claim, and, in so doing, specifically rejected the Seventh Circuit's analysis in the IBM case.
Similarly, in Richards v. FleetBoston Financial Corp., the district court for the District of Connecticut denied the plan sponsor's motion for reconsideration of the court's earlier denial of a motion to dismiss an age-discrimination claim, finding that cash balance plans clearly violate ERISA's age-discrimination rule. The district court also denied the employer's request for an interlocutory appeal, that is, a review of the age-discrimination issue by a higher court while the case is still pending before the district court.
Neither the J.P Morgan nor the Richards decisions is a final judgment, but the analysis of the two courts indicates that the final result will likely be a finding that cash balance plans are age-discriminatory. This was also the holding in In Re Citigroup Pension Plan ERISA Litigation, where summary judgment for the plaintiffs was granted in the Southern District of New York on December 12, 2006. This creates a split in the Second Circuit where, earlier in 2006, two other district courts had held that cash balance plans are not age-discriminatory. And so it goes.
VI. COMMENTARY ON CASH BALANCE PLANS
The Wagner Law Group is proud to present the views of Al Lurie, the eminent practitioner and wise pension philosopher who midwifed the birth of ERISA and whose steady gaze discerns the essential impact of recent developments.
PPA 2006 IN GENERAL AND CASH BALANCE PROVISIONS IN PARTICULAR
by Alvin D. Lurie
President, Alvin D. Lurie. P.C., New York; Of Counsel, Wagner Law Group, Boston
Is the PPA good or bad? How does one encapsulate one's view of 900 pages of legislation in a few lines? In brief, I'd say Congress spoke with forked tongue: in ostensibly trying simultaneously to strengthen the private pension scheme, to protect workers' pensions, and to salvage the governmental pension insurance program, it has succeeded in none of its goals. Defined benefit plans, which were the bedrock of the nation's retirement security system when pensions flourished mid-20th century, have been in steady decline since ERISA's enactment 32 years ago, and have by now been overwhelmed by a combination of successive layers of overregulation and growing attraction of the 401(k) design.
PPA (Public Law 109-280) has now administered the coup de grace, by imposing stringent new funding minimums on DB plans, interest rate restrictions, accelerated remediation of funding shortfalls and anti-smoothing devices, plus greatly increased PBGC premiums, that will substantially elevate the ongoing costs. The consequence will inevitably increase exponentially the already pronounced rush to terminate existing plans, even the great numbers of them that have just been frozen (but not terminated) in recent years. The consequence will be many more plans tossed into the laps of PBGC (even, it can be predicted, those of the airlines, that have been the principal beneficiaries of Congress' largesse in the new law, but will doubtless be again parlaying bankruptcy threats and lobbying actions in not too many years).
Add to that the imminent FASB proposals requiring unfunded DB liabilities to be posted on the balance sheets starting this very year. [Please see attached article by Al Lurie published in Barron's for further information regarding FASB.] If more is needed to spell the end of defined benefit plans as we know them, that will do it.
Even the self-help defined benefit plans constructed by ingenious pension designers for their Fortune
1000 clients in the past 10 to 15 years -- the cash balance plan design -- which have generally been
recognized as the only viable way to save the defined benefit scheme from extinction, did not get
adequate help from this 109th Congress. While the new law provides prospective relief from the principal
legal threats that have surfaced, it does nothing to alleviate the legal vulnerability to which existing
plans (those already in court, and those that are potential targets) are now exposed. The powerful
decision published August 7 by the 7th Circuit Court of Appeals in the IBM case will go far
to fill the gap left by the legislation, but it is not the law of the land, just the law in that circuit.
However, it does augur a new age for the much beleaguered cash balance plan.
There is much to be said about the present state of cash balance plans, but I will just recount in this venue the interesting and improbable series of events by which we got to where we are. The fortnight between July 28 and August 7 loomed inauspiciously like any other lazy summer time period. But in the ensuing nine days the small cash balance universe completely turned over for the second time in the 20-odd years since it first showed up on the pension screens, and promises once again to fulfill the destiny originally predicted for it by the cognoscenti, as savior of the defined benefit model of retirement benefit, after the near fatal blow struck at it by a federal district judge in Illinois three years ago.
That was, of course, in the high-profile IBM cash balance case, where the trial court ruled
the plan to be age discriminatory because younger participants' interest credits in any given year
would extend more years than those of their older colleagues due to the simple fact of the greater
number of years remaining to their respective retirements than that of any participants who were older
in that same year. Because of the way wage and interest credits hypothetically accrue under the typical
cash balance formula -- by projecting interest credits attributable to the wage credit earned in any
service year to normal retirement date, provided the benefit is not paid before then -- those
interest credits for any given plan year of service must, as a matter of simple math, always add up
to more credits for the younger participant than will accrue to any older participant for that same
That is not age discrimination. It is simply a function of the benefit payment for the younger participant being presumed to be deferred for a longer number of years exactly corresponding to the number of years of difference in ages between a younger and older participant; and, under time-value-of-money principles, the raw wage credit, without such an interest supplement, would be worth less to the younger participant by the same amount as that interest credit if the discount rate of deferral is the equivalent of the interest credit rate. No one questions that the value of $1 paid at once is greater than the present value of $1 paid x years in the future. Hence, the true function of the interest add-on, far from advantaging the younger participant, is simply an equitable equalizer.
It is also important to remember the underscored words above that the participant will only receive the full amount of interest credits projected to retirement if payment of his or her benefit is actually deferred until then; so the projected benefit is not accrued in the sense of representing the amount the participant will actually receive, but is rather a snapshot of the benefit to which the participant would be entitled at retirement for services completed at a prior point in time, but only if the benefit is not paid before then.
Failure to recognize this led the trial judge in IBM to view that forward projection of interest as an immediate enhancement of younger workers' benefits, hence actually fully accrued at that very time. But the fact is that all the participant would receive were he or she to separate from employment and receive an immediate pension before retirement would be the amount then credited to the participant's notional account balance. By conflating the accrued benefit and the account balance at the same point in time, and compounding that error by interpreting the key measuring rod in the statue for identifying discrimination, "rate of accrual", as if it read "accrued benefit", the judge was misled by plaintiffs' counsel into reading the age discrimination provision of ERISA as foreclosing the cash balance formula generally, not just the particular formula in the IBM plan.
Until recently, when some surprising decisions were handed down by two district court judges in the
Southern District of New York, every district court case but one that was decided after IBM rejected
it; and the one exception was not a final decision, rather a ruling on an interlocutory motion to
dismiss. Nevertheless, the IBM ruling continued to dominate the landscape, and essentially
halted in its tracks all further cash balance developments, save for the uncounted numbers of plan
sponsors that froze or terminated their plans.
The overarching effect of the IBM decision prompted Rep. John Boehner, in the summer of 2005 then chairman of the House Committee on Education and the Workforce and later to become House Majority Leader to hold a hearing with the specific object of achieving "permanent legislative solutions to preserve cash balance plans as a viable retirement security option," unequivocally calling the IBM opinion "flawed" and "economically unsound". That started a series of legislative initiatives to largely the same end in the several different committees of the House and Senate, which also became the vehicle for a mixed bag of other pension reform proposals that had been gathering steam in recent years to increase funding and financial strength of defined benefit and defined contribution plans generally.
And so was born the grand pension reform efforts that summer and fall, leading in November and December to a unified bill in each of the Houses, but with large differences in policy and detail between the two bills, necessitating the creation of the conference committee, that labored for five months to compose the differences. When it seemed the effort was about to produce a bill, H.R. 2830, that accommodated the pension goals of the conferees, that bill became the magnet for totally unrelated objectives of the Republicans and Democrats, estate tax repeal in case of the former, increased minimum wage in case of the latter, which seemed destined to sink the entire legislative program, when neither side was prepared to give up its opposition to the other's aims, even to the point of sacrificing their shared pension reform goals. (Even a cloture motion to thwart a threatened filibuster in the Senate went down to defeat.)
That brings us to the fateful fortnight noted during the beginning of this essay, when, on July 28, with the House's August recess about to begin that day, a masterful maneuver was crafted by the House leadership, by stripping the pension reform components of the conference bill out of the rest of it, and voting for pension reform (now designated H.R. 4) and minimum wage increases as two separate bills, neither carrying the conference imprimatur as such. The cash balance legislation, as a prominent part of H.R. 4 (labeled the Pension Reform Act of 2006), was now a step nearer to becoming reality, but with still a large step to be taken, namely verbatim, i.e., word-for-word, approval by the Senate, if the bill was not to once again be returned to conference.
The Senate was still in session with 6 days remaining before its August recess. After the recess, with the November elections looming, any serious attention to major legislation could not be expected; so the general sense was that if the bill were not to pass the Senate in the ensuing 6 days, its further consideration and ultimate enactment could be a long way off. On the other hand, given the contentious disagreements that had transpired over five months of deliberations in the conference, and heavy last-minute lobbying from various quarters with keen interests in various aspects of the legislation, it was highly unlikely that the Senate would adopt in toto H.R. 4 on such a short time frame.
Nevertheless, the improbable occurred. The Senate passed H.R. 4 on August 3, its last day in session. Rumblings from the White House at various times during the long conference proceedings that the President would veto any bill that fell short of certain stringent markers left the possibility that we weren't through yet with pension reform legislation. But these proved without substance (as one would have supposed), and the President signed the bill with much fanfare two weeks later in his first official Rose Garden ceremony on returning from summer vacation.
There was still a catch. Despite the promises of Rep. Boehner last summer to make the cash balance legislation retroactive, thus overturning the IBM decision albeit not for the benefit of IBM itself, on whose plan the trial judge had fastened the discrimination label neither the by-passed H.R. 2830 nor the passed H.R. 4 provided retroactive relief; so the thousands of cash balance plans in operation before the June 29, 2005 effective date of the cash balance provisions were not safeguarded from the threat of attack, neither those already in litigation nor the many more not yet the object of lawsuits. To make the cheese more binding H.R. 4 states explicitly that "no inference" as to retroactive effect is to be drawn from enactment of the forward-looking rules of the statute.
Parenthetically, it is noteworthy that the act can in fact provide abbreviated retroactive protection inasmuch as its age discrimination provisions apply after June 28, 2005, provided the plan satisfies conditions relating to interest credits and, in case of plans converted from traditional defined benefit plans, anti-wearaway requirements now in the law.
By a startling coincidence, only four days after the Senate acted on the Pension Protection Act, the 7th Circuit Court of Appeals, on August 7, released its long-awaited decision in the IBM appeal, clearly repudiating the rationale and result of the troublesome lower court decision, thus on the face of it restoring the cash balance plan to its status quo ante. But, as noted above, technically the decision is only the law within the jurisdictional bounds of the 7th Circuit. However, can anyone doubt save perhaps the plaintiffs' lawyers who are waging lawsuits against other cash balance plan sponsors or are contemplating doing so that the case will cast a long shadow extending to the farthest reaches of the U.S.?
It is therefore clear to this observer that we are on the cusp of a new rebirth of the cash balance plan, thus once again providing an attractive defined benefit alternative to the 401(k) and other defined contribution models that have increasingly replaced the traditional defined benefit design. Although cash balance plans and their cousin, the pension equity plan, are called generically hybrid plans, because of their androgynous characteristics, part defined benefit and part defined contribution a resemblance that largely figured in Judge Easterbrook's opinion for the 7th Circuit in IBM their essential attributes are founded on the defined benefit model.
That is, these hybrid plans provide a specific, promised pension spelled out in the plan that is not dependent on the employer's contributions to the pension fund, or on the amount of assets in the participant's account. Indeed, there is no "account" as such, only a so-called notional account -- more a bookkeeping entry that reflects the pension accumulated to current date under the benefit formula and the participant's service credits. Unlike a true defined contribution plan, the ultimate pension is not affected by the effects of market performance or earnings on the participant's account, since the employer is obligated to provide the specific plan benefit, with all market risk falling on the employer. Moreover, any shortfall in the employer's fulfillment of its obligation is made up by the government pension insurer, PBGC, in exactly the same way and to the same extent as under the traditional defined benefit plan.
Furthermore, unlike the 401(k) plan, contributions to a cash balance plan are typically made exclusively by the employer; and the contributions are not specified in the plan, rather being governed by the actuary's assumptions, and the funding limitations of ERISA, as now to be further circumscribed when the new constraints of the PPA take effect principally in 2008. Thus, in every essential aspect, they operate exactly like a defined benefit plan, with the single exception that the benefit formula is modeled on the typical contribution formula in the DC format, i.e., a stated percent of wages for each year of participation, called a pay credit, as bolstered by an interest credit that takes the place of the earnings that accrue to each participant's benefit every year in a DC plan. In addition, the cash balance design typically provides for a lump-sum distribution on separation from service, whether or not at retirement.
Hence, the cash balance plan provides the security of a defined benefit, but the transparency and ready portability that characterizes a DC plan the best of both worlds, one might say. After a long, hard voyage through choppy waters, this most happy benefit design seems now prepared for clear sailing.
VII. CONCLUDING THOUGHTS ON CASH BALANCE PLANS
When this firm began its existence in 1996, ERISA, the massive pension reform law that was designed to make pensions safe for participants, was over 20 years old. Though designed to last well into the 21st Century, it had been amended in almost every year following its enactment, more to serve the Nation's demands for revenue than for a sound retirement system. The result has been an increasing body of restrictions on the defined benefit design that had been the chief underpinning for pensions, and a corresponding disenchantment with that form of pension among many employers who sponsored them.
It was against this background that the 401(k) plan a so-called defined contribution design that put more of the responsibility for providing for one's retirement on each worker increasingly took hold. Then, a few years later the so-called perfect storm descended on America, when the combination of a punishing bear market and historically low interest rates devastated the values of the assets in almost all plans, with accompanying needs for enormous infusions of employer contributions. The result was a predictable mass flight from the defined benefit pension structure, often with substitution of a 401(k), but, often too, complete elimination of the company pension benefit.
In its entire existence, our firm, entirely dedicated to the employee benefit practice -- alone among the major firms in this country -- has been attuned to these developments and has helped our clients work their way through them. That brings us to the year 2007 now, our 10th anniversary, when the most thoroughgoing overhaul of the pension rules has been enacted since ERISA itself, necessitating wholesale reconsideration of pension planning by every prudent employer. Chief among the reasons for this exercise is the emergence of what is called a "cash balance plan", a design that captures the attractions of the defined contribution plan for employees and employers within the security of the defined benefit design, but at the same time insulating employers from the funding risks and often intolerable benefit liabilities that ensued during the "perfect storm" years.
In the 2006 legislation, Congress for the first time freed cash balance plans from some unfavorable case law that has held back many employers from adopting such plans, but at the same time imposed new, stiffer funding requirements and other burdens on defined benefit plans and also defined contribution plans. Now is the time when many employers will be rethinking their pension and benefit programs. You owe it to yourself to consider whether the cash balance plan is right for your company and, just as important, right for your employees, whether in replacement of or as a supplement to your existing benefit plan.
Our firm is well positioned to help you in this effort. Our strong corps of professionals has recently been bolstered by Alvin Lurie, who has joined us as of counsel to the firm. Al, who, since the time when he was the Assistant Commissioner of Internal Revenue in charge of employee plans immediately after enactment of ERISA, has been among the preeminent pension practitioners in the Nation, and has written extensively on the litigation and legislation that has had such an important impact on cash balance planning in recent years. A copy of his most recent commentary is above.
If you would like to talk to us about this subject, please let us know when that would best suit you. The next 10 years are likely to become the most momentous in the history of benefit planning, as employers cope with the growing financial needs of their companies and their employees' need for a secure retirement. We will be at the cutting edge of these developments, as we have been during the first 10 years of our existence, and are anxious to help you.