The Pension Protection Act of 2006 - a comprehensive reform package.

EXECUTIVE SUMMARY

* The PPA '06 makes many changes that will facilitate certain plan designs and affect how plans operate.

* The PPA '06 makes permanent more than three dozen EGTRRA rules affecting IRAs and retirement plans.

* Several provisions are designed to increase funding for retiree medical costs and provide incentives for funding healthcare and LTC costs.

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The Pension Protection Act of 2006 (PPA '06) makes sweeping changes to retirement plans and other employee benefits.

This article is an overview of the PPA '06's more significant retirement plan and healthcare-related provisions.

President Bush signed the Pension Protection Act of 20061 (PPA '06) on Aug. 17, 2006. The PPA '06 will simplify and transform rules governing the funding of defined-benefit plans, accelerate employers' funding obligations, prospectively clarify the rules for cash-balance plans, make permanent revisions enacted in 2001 that were set to expire in 2010, strengthen diversification rights and investment education provisions for plan participants and encourage automatic enrollment in defined-contribution Sec. 401(k) plans. These changes will also have dramatic effects on the cashflow, reported earnings and benefit payments of businesses sponsoring plans--issues of great concern to chief executive officers, chief financial officers and human resources directors. This article provides an overview of these and other significant PPA '06 changes.

Employer's Funding Obligation

PPA '06 Section 112(a) completely replaces the prior rules governing the funding of single-employer, defined-benefit pension plans with a new standard keyed solely to the plan's funded status. The general principle is that a plan's required contribution should equal the present value of benefits earned by participants during the current year, plus the amount necessary to amortize any funding shortfall over no longer than seven years. In the case of severely underfunded (i.e., at-risk) plans, special rules increase the funding obligation. These rules are generally effective in 2008. The PPA '06 also extends--for 2006 and 2007--funding relief enacted in 2004.

Employee's View

As part of its efforts to increase the solvency of defined-benefit plans, the PPA '06 addresses the competing interests of current retirees on the one hand, and future retirees and plan sponsors on the other.

New Assumptions for Calculating Lump-Sum Distributions

PPA '06 Section 303(a) changes the assumptions for calculating lump-sum distributions from defined-benefit pension plans. If such a plan offers a lump-sum distribution as an optional benefit form, the PPA '06 requires it to convert accrued benefits to lump-sum equivalents using interest rates based on the corporate bond yield curve. Similar to the funding rules, segment rates apply to the calculation. Thus, the interest rate will depend on when the benefit would have become payable had the participant delayed distribution until the plan's normal retirement age.

Beginning in 2008, a participant's lump sum will be determined based on a mixture of the corporate bond yield curve and the 30-year Treasury rate, with full implementation of the corporate bond yield curve in 2012.

Under the PPA '06, the mortality assumptions used to value lump-sum distributions will be determined by reference to the mortality table published by Treasury for funding purposes, but very large plans will be able to request permission to use tables based on their own experience.

Limits on Benefits Based on Plan's Funded Status

PPA '06 Section 113(a)(1)(B) imposes a variety of new benefit limits on single-employer plans whose funded status falls below specific levels. Poorly funded plans may be subjected to restrictions on benefit accrual, benefit increases or accelerated payment of benefits, depending on the degree of underfunding. Exhibit 1 on p. 652 summarizes the assorted restrictions that will begin to apply at various levels of underfunding.

In addition, PPA '06 Section 116 restricts an employer's ability to set aside assets in a trust or other arrangement to fund nonqualified deferred compensation for its top five executive officers during the (1) period that the employer's defined-benefit plan is deemed at risk, (2) period that the employer is in bankruptcy and (3) 12-month period beginning six months before the termination of an underfunded plan. If amounts are set aside in violation of these rules, or subject to provisions that they will be set aside in these circumstances, the executive will owe tax on them. The tax will not apply to assets set aside before the restriction period.

Any tax gross-up payment provided by the employer to defray an individual's tax liability, under PPA '06 Section 116, is deemed deferred compensation subject to a 20% additional tax under Sec. 409A(b)(5)(A). In addition, an employer cannot deduct these gross-up amounts, under Sec. 409A(b)(3)(C)(iii). These rules apply to transfers made after Aug. 17, 2006.

Plan Design and Operation

The PPA '06 will help facilitate the adoption of certain plan designs and will affect how plans operate.

Cash-Balance and Other Hybrid Defined-Benefit Plans

PPA '06 Section 701 resolves, but only prospectively, three of the major controversies surrounding cash-balance and other hybrid pension plan designs:

* Age discrimination. It protects hybrid plans against challenges under age discrimination rules found in the Code, the Employee Retirement Income Security Act of 1974 (ERISA) and the Age Discrimination in Employment Act (ADEA), so long as their vesting schedules and interest-crediting rates meet specific standards.

* Conversion from traditional to hybrid formulas. It prohibits erosion of previously accrued benefits following the conversion of a traditional defined-benefit plan into a hybrid plan.

* Calculation of lump-sum distributions. When a participant in a hybrid plan elects a lump-sum distribution, it allows the plan to distribute just the participant's hypothetical account balance. Under prior law, as interpreted by most courts, this so-called "whipsaw" effects sometimes required a larger distribution.

The provisions on hybrid plans have varying effective dates. The whipsaw amendment is effective for distributions made after enactment. The requirements for vesting and interest credits are effective for years beginning after 2007. Plan conversions that took place after June 29, 2005 will have to comply with the new rules.

Phased Retirement

Under PPA '06 Section 905(b), defined-benefit plans can allow in-service distributions to participants age 62 or older. This will enable older workers to work part time and receive pension benefits that will maintain their earnings level. Under current law, plans cannot make in-service distributions to participants who have not reached the plan's normal retirement age (65 for most plans).

Automatic Enrollment in Sec. 401(k) Plans

PPA '06 Section 902 removes any perceived state-law impediments to automatic enrollment in Sec. 401(k) plans and includes new rules to encourage plans to adopt this technique. It explicitly protects automatic-enrollment plans against state interference, effective on the enactment date. In addition, it requires employers to provide participants, on enrollment, with a notice explaining their right to elect out of the plan or to change the rate of contribution, the timeframes for making elections and how the plan will invest contributions in the absence of any contrary instructions by the participant. Contributions made for automatic enrollees who have not elected otherwise must be invested in accordance with guidelines that will be established by Department of Labor (DOL) regulations.

The PPA '06 creates an optional nondiscrimination safe harbor, and several other provisions are intended to simplify the administration of automatic-enrollment Sec. 401(k) plans.

Diversification Requirements

Under PPA '06 Section 901, any defined-contribution plan that holds publicly traded employer securities (or nontraded tracking stock related to the performance of a subsidiary of a public company) must permit participants to diversify account balances invested in those securities. It must make available at least three materially different alternative investment options. The plan must allow all participants to diversify the investment of their elective deferrals and after-tax contributions, and permit those with three or more years of service to diversify the investment of other contributions made on their behalf.

These provisions do not apply to employee stock ownership plans (ESOPs) that have no elective deferrals, after-tax employee contributions, or matching contributions that do not form part of another qualified plan. All ESOPs remain subject to the existing, less stringent, diversification requirements.

Investment Advice to Participants

PPA '06 Section 601 creates a new prohibited-transaction exemption, permitting plan fiduciaries to be compensated for giving participants investment advice, subject to rules intended to limit the possibility of abuse. The exemption applies to both qualified plans and IRAs, with some differences.

Other Modifications to the Prohibited-Transaction Rules

PPA '06 Section 611 modifies a number of the prohibited-transaction rules. These changes affect plan participation in block trades brokered by a party in interest (Section 611(a)), transactions with parties in interest through regulated electronic communications networks (Section 611(c)), and certain cross-trading (Section 611(g)) and foreign exchange transactions (Section 611(e)).

Combined Defined-Benefit/See. 401(k) Plans for Small Employers

Under PPA '06 Section 903, companies with up to 500 employees may establish combined defined-benefit and automatic-enrollment Sec. 401(k) plans, beginning in 2010. These plans will have a single plan document and trust fund, and have to file only one Form 5500, Annual Return/Report of Employee Benefit Plan. Otherwise, they will operate as separate plans, independently subject to all ERISA and Code qualification rules. These plans will be subject to strict rules governing minimum benefit and contribution levels, vesting and uniformity of benefits, rights and features.

Permanency of Prior Law and Related Tax Incentives

PPA '06 Section 811 makes permanent more than three dozen rules affecting IRA and retirement plan sponsors and participants that were enacted as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). In the absence of new legislation, these provisions were scheduled to expire at the end of 2010. If the EGTRRA had been allowed to expire, certain contribution and benefit limits would have reverted to pre-EGTRRA levels with only, at most, adjustments for inflation.

New Design Features

PPA '06 Section 811 permanently extends a provision allowing plan participants to qualify for the favorable tax treatment of a Roth IRA feature in a Sec. 401(k) or 403(b) plan. A Roth feature allows an employee to make after-tax contributions, which, along with earnings, qualify for tax-free distribution under certain conditions.

The PPA '06 makes permanent rules that allow employers to deduct dividends paid on stock held by an ESOP, provided the plan permits participants to elect to take a distribution of the dividends or reinvest them in additional shares of employer stock. Prior to the EGTRRA, the ESOP could deduct only dividends actually distributed.

Also, the PPA '06 adds a new provision allowing Sec. 401(k) and 403(b) plans to make hardship distributions to any beneficiary of a participant, not just a spouse or dependent. Treasury is directed to issue implementing regulations within six months of enactment.

Portability

The EGTRRA significantly eased the rules on rollovers of retirement savings from one type of tax-favored retirement fund to another, by removing barriers that either prohibited specific types of rollovers or required the use of a conduit IRA to accomplish them. The PPA '06 further expands rollover opportunities, by allowing nonspouse beneficiaries to roll over distributions from qualified plans, Sec. 403(b) plans and some other retirement arrangements, beginning in 2007. In addition, it allows direct rollovers from retirement plans to Roth IRAs after 2007.

Other Extensions

PPA '06 Section 811 also permanently extends rules that:

* Allow after-tax contributions to employer retirement plans to be rolled over into IRAs;

* Grant the IRS authority to extend the 60-day rollover period when failure to comply is due to events beyond the individual's reasonable control; and

* Allow benefits accrued in Sec. 403(b) plans or eligible governmental Sec. 457 plans to be used to purchase additional service credit in governmental defined-benefit plans.

PPA '06 Section 811 also makes permanent a number of administrative simplifications introduced by the EGTRRA, and Section 1001 requires the DOL to issue regulations within one year of enactment to ease the restrictions on qualified domestic relations orders, by clarifying timing and ordering issues.

PPA '06 Section 1004 imposes a new distribution mandate. Defined-benefit and money-purchase pension plans have to offer an annuity option with a 75% survivor annuity, as well as a lesser option that at least equals the 50% survivor annuity generally already offered. This requirement is effective for plan years beginning after 2007 (later for collectively bargained plans).

Vesting Rules: Defined-Contribution Plans

PPA '06 Section 904 changes the vesting rules for employer contributions to defined-contribution plans made after 2006. Special rules apply to collectively bargained plans and certain leveraged ESOPs. Under current law, matching contributions are subject to faster vesting rules than are other employer contributions. The PPA '06 applies the matching contribution rules to all contributions; these rules are set forth in Exhibit 2 above.

Other Changes Affecting IRA Contributions

PPA '06 Section 812 extends the nonrefundable "saver's credit," which provides low-income taxpayers who contribute to retirement plans or IRAs a credit of up to $2,000. In addition, under Section 833(a), beginning in 2007, the income levels used in determining eligibility for the credit will be indexed.

PPA '06 Section 833 provides for inflation indexing of the income limits used to determine eligibility for Roth IRA contributions and deductions for contributions to traditional IRAs. Current law limits Roth IRA contribution eligibility to taxpayers with adjusted gross incomes (AGIs) below a specific level. In addition, it phases out an active plan participant's ability to deduct for traditional IRA contributions as AGI increases. The phaseout thresholds increased over the years, but have not been indexed for inflation. The PPA '06 provides for inflation adjustments for these amounts, effective in 2007. In both cases, the new inflation adjustments are in $1,000 increments.

The PPA '06 makes other changes to IRAs. For tax years after 2006, Section 830(a) allows individuals to have a portion of their tax refunds deposited directly into an IRA. In addition, it temporarily allows tax-free distributions of up to $100,000 from IRAs for charitable purposes if an individual is age 70 1/2 or older. These distributions must be made in 2006 or 2007.

Healthcare Provisions

The PPA '06 includes several provisions designed to encourage funding of retiree medical costs and otherwise provide tax benefits for funding healthcare and long-term care (LTC) COSTS.

Use of Excess Pension Plan Assets

PPA '06 Section 841(a) offers sponsors of single-employer plans the option of transferring excess pension assets to fund estimated retiree medical costs for up to 10 years. This transfer is available even in years in which the present-law one-year transfer is not available, because the asset accumulations required to qualify for the transfer are not as great as those required for the one-year transfer. Plan sponsors making this transfer will have to maintain the retirement plan's funded status at the minimum level during the transfer period (either by additional contributions or transfers back from the health accounts), and will have to maintain retiree medical benefits at a certain level for the transfer period and for four years subsequent to it.

Section 841(a) allows employers that provided retiree medical benefits under all benefit plans during their tax year ending in 2005, and whose aggregate cost of providing such benefits in that year was at least 5% of gross receipts, to make similar transfers to fund the expected medical costs of retirees covered under the terms of a collective bargaining agreement (CBA). The minimum level of plan funding needed to make any transfer is the same amount as for the qualified future transfers discussed above. A maximum transfer is a reasonable estimate of what the employer will pay for the benefits under the CBA (and consistent with generally accepted accounting principles) during the life of the beneficiaries (or such shorter time, if the CBA limits the benefits). Employers will have to maintain benefits at a level no lower than an amount specified in the CBA.

LTC Insurance

PPA '06 Section 844 provides rules on qualified LTC insurance coverage offered as part of, or as a rider to, an annuity or life insurance contract. In the case of either type of contract, a charge against the cash value for the qualified LTC portion of the coverage will not be includible in gross income. Rather, amounts paid for qualified LTC reduce the individual's investment in the annuity or life insurance contract.

Additionally, Section 844 liberalizes the rules on tax-free exchanges of insurance and annuity contracts to include combination products and exchanges of stand-alone qualified LTC insurance contracts. It also adds a reporting requirement for charges against the cash value or cash surrender value of a combined arrangement used to pay for qualified LTC coverage.

Finally, the PPA '06 clarifies the treatment of policy acquisition expenses by issuers of combination contracts. These changes generally apply to contracts issued after 1996 for tax years beginning after 2009.

Other Provisions

Relief for Airlines

PPA '06 Section 402 contains special funding rules for pension plans of commercial passenger airlines and airline catering companies. In general, these plans are exempt from the normal funding rules and can elect either to amortize their funding shortfalls over 10 years (instead of the normal seven) or, under special rules, 17 years.

Several restrictions apply to the 17-year period. In general, benefit levels must be frozen and certain benefits must be eliminated. Special participant notice, minimum coverage and deduction limits also apply. In addition, if the plan terminates, the PPA '06 increases the plan sponsor's termination premiums and restricts the Pension Benefit Guaranty Corporation's (PBGC's) benefit guarantees.

PBGC Provisions

The PPA '06 provides new rules for determining variable-rate PBGC premiums based on yield-curve segment rates, which will be phased in beginning in 2008. It retains the current method for 2006 and 2007. Also, it limits the annual variable-rate premiums owed by employers with 25 or fewer employees to $5 per participant for plan years beginning after 2006 and makes termination premiums (imposed on sponsored plans that shift liabilities to the PBGC) permanent.

PPA '06 Section 403(a) limits the PBGC'S guarantee for plant shutdowns and other unpredictable contingent-event benefits (i.e., benefits not payable on account of a participant's age, service, compensation, death or disability) occurring after July 26, 2005.

PPA '06 Section 410(a) expands the PBGC missing-participant program to include missing participants in terminating defined-contribution plans and certain other plans that the PBGC does not insure. The new program will be available after the PBGC publishes regulations. Participation will be voluntary.

Voluntary Correction Programs

The PPA '06 contains the first legislative endorsement of the Employee Plans Compliance Resolution System (EPCRS), the voluntary compliance program that has grown out of IRS programs initiated in the early 1990s. PPA '06 Section 1101 calls for continuous improvement of the EPCRS program, with an emphasis on making it better understood and more favorable to small employers, reducing the need for Service approval of plan corrections, allowing more failures to be corrected voluntarily during audit and assuring overall fairness.

Plan Amendments and Transition Rules

Plan administrators must operationally comply with the PPA '06 in accordance with the effective date of each provision. However, under PPA '06 Section 1107, plan sponsors have until the last day of the first plan year beginning on or after 2009 (2011 in the case of governmental plans) to adopt plan amendments. Amendments adopted pursuant to the PPA '06 will be exempt from the anti-cutback rules.

Improved Access to Information

PPA '06 Section 508(a) contains several provisions affecting access to plan information. For plan years beginning after 2007, it requires making certain Form 5500 information available via the Interact and on the employer's intranet (if it has one).

It also changes certain requirements regarding the provision of periodic benefit statements. For plan years beginning after 2006, it requires plan administrators to provide quarterly benefit statements to defined-contribution plan participants and beneficiaries who have the right to direct the investment of plan assets, and annual statements to participants and beneficiaries without such investment rights. The PPA '06 generally requires the providing of benefit statements to participants in defined-benefit plans at least every three years. Alternatively, a plan administrator may give annual notice of the availability of such statement.

Defined-contribution benefit statements must give an explanation of the importance of portfolio diversification, including a discussion of the inherent risk of holding more than 20% of the portfolio in a single security (such as an employer security), and a notice indicating that further information on investing and diversifying is available on the DOL's website. The PPA '06 directs the DOL to issue model benefit statements within one year of enactment.

PPA '06 Section 509 reduces the information that must be provided in some cases. It eliminates the blackout notice requirement retroactively from enactment for plans that allow for self-directed investment if the plan covers only one individual and a spouse, or only partners in a partnership, and spouses. For plan years after 2006, the PPA '06 eliminates Form 5500 reporting obligations for certain one-participant and partner-only plans with less than $25,000 in assets, and simplifies the reporting obligations of plans with fewer than 25 participants.

Employer-Owned Life Insurance

PPA '06 Section 863 amends the tax treatment of certain employer-owned life insurance. In general, life insurance proceeds are excludible from a beneficiary's gross income. In recent years, litigation has arisen over the tax or regulatory treatment of contracts covering a broad-based employee population.

Under the PPA '06, if an employer owns a life insurance policy on the life of a former employee, any proceeds in excess of the premiums (plus any other amounts the employer paid for the policy) are includible in the employer's gross income. Provided certain notice and consent requirements are met, exceptions apply to amounts paid (1) to the employee's heirs, (2) with respect to an individual who was an employee at any time within 12 months of his or her death or (3) with respect to a person who was a director or highly compensated employee or individual when the policy was issued.

The PPA '06 imposes reporting and recordkeeping requirements. Its provisions generally apply to contracts issued or materially changed after the date of enactment.

Conclusion

The PPA '06 is unlikely to be the last word on Congressional pension reforms, but it certainly marks the culmination of a reform initiative that started at the beginning of this decade. It continues the shift from corporate to individual responsibility for retirement savings that has occurred over the past few years.

For more information about this article, contact Ms. Walker at [e-mail] or Mr. LaGarde at [e-mail]

Editor's note: This article has been adapted from Deloitte Tax LLP, "Securing Retirement: An Overview of the Pension Protection Act of 2006" (8/3/06).

(1) P.L. 109-280.

Deborah Walker, CPA

Tax Partner

Deloitte Tax LLP

Washington, DC

Stephen LaGarde

Tax Senior

Deloitte Tax LLP

Washington, DC

Exhibit 1: PPA '06 plan restrictions
based on funded status

Less than 80% of        less than 60% of
benefit obligations     benefit obligations
funded                  funded

* No amendment that     * No amendment that
  increases benefits    increases benefits

* Limited accelerated   * No accelerated forms
  forms of                of distribution
  distribution
                        * No additional
                          benefit accruals

                        * No shutdown benefits

Exhibit 2: Vesting rules

                    Current law            Under the PPA '06

       Matching          Other                    All
       contributions     contributions       contributions

       3-year   6-year   5-year   7-year   3-year   6-year
Year   cliff    graded   cliff    graded   cliff    graded

1          0%       0%       0%       0%       0%       0%
2          0%      20%       0%       0%       0%      20%
3        100%      40%       0%      20%     100%      40%
4        100%      60%       0%      40%     100%      60%
5        100%      80%     100%      60%     100%      80%
6        100%     100%     100%      80%     100%     100%
7        100%     100%     100%     100%     100%     100%