New Pension Law Changes The Rules (Again!) For 401(K) And Other Defined Contribution Plans

(September 25, 2006)

President Bush signed the 907-page Pension Protection Act of 2006 into law on August 17, 2006.  While many, if not most, of its provisions deal with defined benefit pension plans, the Pension Protection Act makes some significant changes to the ERISA and Internal Revenue Code provisions applicable to 401(k) and other defined contribution plans.

2001 EGTRRA Changes Made “Permanent”

Legislation passed in 2001 (EGTRRA) substantially increased caps on retirement plan contributions and benefits.  EGTRRA also allowed a Roth IRA feature to be included in 401(k) plans.  However, the increased caps and the Roth provisions were scheduled to automatically sunset at the end of 2010.  Thanks to the Pension Protection Act, EGTRRA’s retirement plan provisions are no longer subject to the sunset provision.  In other words, the Roth provisions and the increased contribution and benefit limits have been made permanent.

Nevertheless, by making the EGTRRA changes “permanent”, the Pension Protection Act may prompt more employers to consider adding a Roth account feature to their 401(k) plans.

Automatic Enrollment and State Wage and Payroll Laws

In recent years many employers have added automatic enrollment provisions to their 401(k) plans.  In a 401(k) plan with this feature, a new participant is automatically enrolled at a fixed deferral percentage unless he or she affirmatively elects not to contribute, or to contribute a higher or lower percentage.  Automatic enrollment tends to boost rank and file participation and contribution rates, which in turn helps plans pass ADP and ACP testing.

Unfortunately, there was a concern that automatic enrollment might violate laws governing wages and payroll deductions in some states.  Many argued that ERISA would preempt those laws, but uncertainty over this issue made many employers reluctant to implement automatic enrollment.  The Pension Protection Act eliminates the uncertainty and trumps state wage and payroll laws.  Effective immediately, state wage and payroll deduction laws will not apply to a 401(k) plan’s automatic enrollment feature if:

• The 401(k) plan is subject to ERISA;

• In the absence of participant investment instructions, the 401(k) contributions are invested in accordance with default investment regulations to be issued by the DOL; and

• The plan provides an annual notice to participants explaining the automatic enrollment provisions, the participant’s right to change the contribution rate, and how the contributions will be invested in the absence of participant direction.

Companies that have automatic enrollment provisions in their 401(k) plans should review their participant communications and default investment procedures in light of the new law.  Companies should make sure enrollment materials for the upcoming plan year will satisfy the applicable notice requirements.  Also, companies should anticipate having to implement DOL regulations on default investments sometime in the first half of 2007.

Significant Changes Impacting Plan Design

Faster Vesting.  Several years ago, EGTRRA mandated faster vesting for matching contributions.  The Pension Protection Act extends the EGTRRA rule to all employer contributions under a defined contribution plan.  Plans will no longer be permitted to use four or five-year cliff or seven-year graded vesting schedules.  Starting with the first plan year that begins after December 31, 2006, employer contributions must vest no less rapidly than under a three-year cliff or a six-year graded vesting schedule.  A special effective date provision applies to certain collectively-bargained plans.

Diversification and Employer Stock.  New diversification requirements will apply to plans that invest in publicly traded employer securities.  Starting with the first plan year that begins after December 31, 2006, participants must be allowed at all times to diversify their entire account balances attributable to 401(k) deferrals and after-tax contributions.  Matching and employer contribution accounts will be subject to full diversification after the participant has completed three years of service.  Plans will have to offer at least three diversified investment options and will have to allow participants to make diversification elections at least quarterly.  Plans will also have to meet new notice requirements.  There is a special transition rule for amounts invested in stock acquired before the effective date.  Also, a special effective date provision applies to certain collectively-bargained plans.

New 401(k) Safe Harbor Category for Automatic Enrollment Plans.  For plan years beginning after December 31, 2007, companies will have a new 401(k) safe harbor design to choose from.  A 401(k) plan that satisfies the new safe harbor (referred to as an “automatic contribution arrangement”) will be deemed to satisfy the ADP and ACP tests and the top-heavy rules.  In order to qualify as an automatic contribution arrangement, a plan must provide for the following:

• A default 401(k) deferral rate of no more than 10%, and at least 3% for the first year of automatic enrollment, 4% for the second year, 5% for the third year, and 6% for subsequent years;

• For each nonhighly compensated employee eligible to participate in the arrangement, either (i) a matching contribution equal to 100% of elective deferrals on the first 1% of compensation, plus at least 50% on deferrals between 1% and 6% of compensation; or (ii) a nonelective contribution equal to 3% of compensation;

• Full vesting within 2 years for all employer contributions; and

• Annual notice to employees regarding their rights and obligations under the arrangement.

The plan must also satisfy a number of other requirements, including limitations on matching contributions for highly compensated employees and rules governing election procedures.

Under the current 401(k) plan nondiscrimination safe harbor, which continues to be available to plan sponsors, the ADP test is deemed to be satisfied if certain notice and other requirements are met and the plan provides either (i) a matching contribution equal to 100% of elective deferrals on the first 3% of compensation, plus 50% on deferrals from 3% to 5% of compensation; or (ii) a nonelective contribution equal to 3% of compensation.  The ACP test is deemed to be satisfied if the plan satisfies additional requirements.  The new safe harbor rules under the Pension Protection Act may provide a less expensive approach for compliance with ADP and ACP testing and top-heavy rules.  Plan sponsors who have adopted or are considering adopting a 401(k) safe harbor plan should compare the new and old safe harbor options to determine which approach best accomplishes their overall plan design objectives.

Hardship Distributions Expanded.  The Pension Protection Act directs the Department of Treasury to expand the regulations for hardship distributions so that a qualifying hardship will include a hardship event that occurs with respect to any designated beneficiary of the participant, even if the designated beneficiary is not the spouse or a dependent.  Companies will have the option of amending their 401(k) plans to take advantage of the new rule.

Joint and Survivor Annuity Options.  Starting with the first plan year that begins after December 31, 2006, defined contribution plans that are subject to the qualified joint and survivor annuity rules must offer a “qualified optional survivor annuity.”  If the mandatory joint and survivor annuity under the plan provides a survivor benefit of less than 75% (e.g., a joint and 50% or 66 2/3% annuity), the plan will have to offer as an option a joint and 75% survivor annuity.  If the mandatory joint and survivor annuity under the plan provides a survivor benefit of 75% or more, the plan will have to offer as an option a joint and 50% survivor annuity.  A special effective date provision applies to certain collectively-bargained plans.

Curiously, this provision requiring the addition of another annuity distribution option for one type of plan comes in the wake of IRS rules that make it easier to eliminate annuity distribution options from certain other plans.  It also comes in spite of the fact that plan participants for many years have shown an overwhelming preference for single sum payouts and direct rollovers.  Because this new provision adds to the administrative burden already inherent in providing an annuity distribution option in a defined contribution plan, sponsors of such plans will want to revisit whether they can eliminate the option.  Generally speaking, a sponsor will have this flexibility so long as the defined contribution plan is not a “money purchase pension plan” or a successor to such a plan.

Other Changes Impacting Plan Administration and Investments

Quarterly Statements.  Starting with the first plan year that begins after December 31, 2006, defined contribution plans (including 401(k) and 403(b) plans) must provide quarterly account statements to participants if the participants have the right to direct investments.  Plans that do not allow investment direction must provide annual account statements.  Benefit statements must include certain information, including an explanation of the importance of diversification and directions to the DOL website containing investment information.  A special effective date provision applies to certain collectively-bargained plans.

Distribution Notices and Consents.  Under existing law, a plan required to provide a distribution notice to a participant cannot provide the notice more than 90 days (and generally not less than 30 days) before the date of distribution.  After 2006, plans may provide such notices up to 180 days before the date of distribution.  Also, distribution notices after 2006 must explain not only the participant’s right to defer distribution but also the consequences of not deferring the distribution.

Direct Rollovers by Non-Spouse Beneficiaries.  Beginning in 2007, a non-spouse beneficiary may roll over in a direct trustee-to-trustee transfer into an IRA a distribution from any eligible retirement plan.  The IRA will be treated as an IRA inherited by the non-spouse beneficiary.

Direct Rollovers to Roth IRAs.  Individuals who are eligible under the Roth IRA conversion rules may roll over distributions from qualified plans, 403(b) plans, and 457(b) plans (but not IRAs) directly into a Roth IRA.  The rollover is included in income (except to the extent that the amount consists of after-tax contributions), but the 10% penalty on early distributions does not apply.  This provision is effective for distributions that occur after December 31, 2007.

Penalty-Free Distributions for Reservists.  The 10% early distribution penalty tax will not apply to certain distributions to members of the reserves who are called up for active duty indefinitely or for a period in excess of 179 days.  The distribution must be made before the end of active duty and must be attributable to the participant’s elective deferrals under a 401(k) or 403(b) plan.  The new law also gives the participant the right to repay the amount of the distribution (on an after-tax basis) at any time before August 17, 2008, or within two years following the end of active duty.  The exemption from the 10% penalty tax applies to distributions made after September 11, 2001, but only to participants called to active duty after September 11, 2001 and before December 31, 2007.

Return of Certain Automatic Contributions.  Companies will be able to amend their 401(k) plans to allow the return of certain contributions made pursuant to an automatic enrollment provision, beginning in 2008.  The participant must elect to receive the “erroneous” contributions within 90 days after the first such contributions were made.  The amounts returned to the participant will be taxable in the year returned, but will not be subject to the 10% early distribution penalty tax.  In addition, if a participant’s automatic contributions result in ADP or ACP testing failures the 10% early distribution penalty tax will not apply to excess contributions or excess aggregate contributions returned to the participant within 6 months after the end of the plan year.

Investment Advice.  The Pension Protection Act encourages parties in interest, such as employers and service providers, to make investment advice available to participants.  Beginning in 2007, there is a new prohibited transaction exemption for “eligible investment advice arrangements”.  To be eligible, the arrangement must satisfy a number of significant rules and conditions.  If the party providing the advice may receive fees that vary on the basis of investments that are selected, the investment advice must be provided through an unbiased computer model that has been audited and certified by an independent expert. 

Expanded 404(c) Relief.  Section 404(c) of ERISA provides fiduciaries with protection from liability for losses resulting from a participant’s exercise of control over the investment of his or her accounts so long as certain requirements are met.  The Pension Protection Act expands this relief in three areas.

• Beginning in 2007, 404(c) protection may apply to default investments for participants who fail to provide investment instructions for their accounts.  To receive this protection, the plan fiduciaries must provide an annual notice to participants explaining how they can direct their investments and informing them how the account balance will be invested in the absence of instructions.  The new law also directs the Department of Labor to issue regulations governing default investments and the requirements a fiduciary must meet to be protected from liability.

• For plan years beginning after 2007, 404(c) protection will apply during a plan blackout period that has been authorized and that is administered in accordance with ERISA.

• For plan years beginning after 2007, 404(c) protection will be available in the event a plan’s fiduciaries decide to change investment options and to “map” participant accounts from the old options to the new options, but only if the mapping arrangement meets certain notice and other requirements.

Conforming Plan Amendments

While plans must comply with the Pension Protection Act provisions from the effective date of each provision, sponsors will generally have until the end of 2009 (later for fiscal year plans) to make conforming amendments to their plans.  However, one or more different amendment deadlines may apply with respect to regulatory changes prompted by the new law.

Many plan sponsors will want to adopt interim or good faith amendments so that their plan documents can serve as a guide to compliance with the new law.

This delayed amendment deadline stated in the Pension Protection Act seems to conflict with interim amendment rules envisioned by the IRS when it created the new system of staggered remedial amendment periods under Revenue Procedure 2005-66.  Look for future guidance from the IRS on how the requirements of Revenue Procedure 2005-66 will apply to amendments required by or relating to the Pension Protection Act’s provisions.

If you have any questions regarding this alert or other Employee Benefits Law related issues, please contact one of our Employee Benefits attorneys.

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