Your retirement plans: the impact of the Pension Protection Act of 2006.

Editor's Note: This article provides an overview of aspects of the Pension Protection Act of 2006. It will appear in two parts. This month will address the changes to defined benefit and cash balance plans. Next month, the changes to defined contribution plans will be addressed. Nonprofit organizations use all of these plan types to benefit their employees.

The Pension Protection Act of 2006 (PPA) contains many provisions that impact nonprofits. Among other things, the PPA addresses both defined benefit and defined contribution plans. The primary objectives of the Act are to strengthen the funding of defined benefit pension plans by imposing stricter funding requirements, and to encourage greater participation by employees in defined contribution plans through automatic enrollment procedures.

The PPA also resolves some long-standing controversies regarding cash balance plans, at least on a prospective basis. Another significant aspect of the PPA is that it makes permanent the retirement plan provisions that were enacted in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). Under EGTRRA, these provisions were set to expire at the end of 2010.

Single-employer defined benefit plans 

As noted above, the PPA imposes stricter funding requirements on your defined benefit plans. While this is the case for both single-employer and multi-employer plans, the changes from current law are much more significant for single-employer plans. The stricter funding requirements go into effect in 2008 (plan years beginning after December 31, 2007).

Under current law, you generally must fund your plans based on a 90 percent funding target (i.e., your plan's assets are 90 percent of its liabilities). Under the PPA, your funding target is increased to 100 percent. You are given a seven-year time period to fund the targeted amount.

If your plan is "at risk," your funding requirements are more strict. Your plan is at risk when its current funding is below a certain threshold. The funding target for an at-risk plan is greater than for plans that are not at risk, because the liability is calculated in a manner that assumes that your plan's participants will retire as early as possible, and will choose the most valuable form of benefit under the plan. Fortunately, the provisions for at-risk plans apply only if your plan had more than 500 participants on each day during the preceding plan year.

The result of the stricter funding requirements is that you may be required to contribute greater amounts of cash to your plans than in the past.

More volatility in required contributions

In addition to the greater amount of contributions, you might find that the amount of required contributions is more volatile from year-to-year, and more difficult to project, than in the past. This is brought about primarily because the PPA changes the measurement approach for your pension plan assets.

Under current law, a plan measures the market value of its assets based on a five-year average. Under the PPA, the averaging period is reduced to two years. This will result in more volatility in your funding requirements, because changes in asset values are taken into account more quickly than under current law.

The measurement of your pension liabilities also becomes more complex under the PPA. Under current law, you use a single interest rate to calculate your liability amount. Under the PPA, you will have to use three different rates, based on the projected timing of your plan's benefit payments in the future.

The first rate is applied to benefit payments that your plan will make in years one through five, the second rate is applied to payments the plan will make in years six through 20, and the third rate is appried to payments the plan will make beyond year 20.

Restrictions on plan benefits

In an effort to further strengthen pension plan funding and avoid excessive pension plan commitments by employers, the PPA imposes restrictions on plan benefits, starting in 2008. If your plan is not well funded, these restrictions will limit your ability to increase your plan's liabilities. If your plan is funded at a level of 80 percent or higher, there are no restrictions. If your plan is funded below that level, you are restricted from increasing benefits, accelerating the vesting of benefits, and paying benefits in the form of a lump-sum distribution. If your plan is significantly under funded, you must freeze the accrual of benefits completely.

Lower lump-sum distributions

The PPA requires that you use certain rates to calculate lump-sum distributions for your participants, resulting in lower lump-sum distribution amounts than under current law.

Under current law, you use the yield on 30-year U.S. Treasury bonds to calculate lump-sum distributions. Starting for plan years beginning after December 31, 2007, you must use the three rates described above for funding purposes to calculate lump-sum distributions. The interest rate that applies depends on how many years in the future the participant's annuity payment would have been made (i.e., his or her normal retirement date). Typically, a higher interest rate applies for payments made further in the future, resulting in a lower lump-sum distribution amount.

Additional changes

The PPA contains many other changes applicable to defined benefit plans, but these changes are relatively minor when compared to the changes described above. These additional changes include the following:

* A requirement that your plans offer a 75 percent survivor annuity, starting in plan years that begin after December 31, 2007

* A change in the method for calculating your Pension Benefit Guaranty Corporation (PBGC) premiums, which will result in premium increases for some plans, starting in plan years beginning after December 31, 2007

* A provision that allows you to pay pension benefits to individuals who are still working for you, as long as they are at least 62 years old, starting in plan years that begin after December 31, 2006

* A requirement that you furnish benefit statements to plan participants at least once every three years, or alternatively, by notifying each of your participants annually of the availability of a benefit statement, starting in plan years that begin after December 31, 2006

* An expansion of your ability to use excess pension assets to fund retiree health benefits, effective immediately

Multi-employer defined benefit plans

The PPA brings about limited revisions to the existing funding rules for multi-employer plans. Under current law, any new unfunded past service liabilities resulting from plan amendments that improve benefits, as well as changes in actuarial assumptions, are funded over a 30-year period. Starting in 2008, the funding period for these items is reduced to 15 years. However, in certain cases with IRS approval, the funding period may be increased to as long as 25 years.

The PPA also creates a set of temporary rules for multi-employer plans that are poorly funded. Under these rules, the plans must adopt a funding improvement plan. The degree of the pension plan's underfunding determines how quickly and how much of the under funding must be eliminated. These special rules expire at the end of 2014, but any funding improvement plan that was put in place prior to the expiration remains in force.

Cash balance plans

Cash balance plans have been the subject of a great deal of litigation, focused primarily on whether the conversion of a traditional defined benefit plan to a cash balance plan results in age discrimination. The PPA sets forth rules whereby cash balance plans will not be treated as age discriminatory. These rules apply on a prospective basis, starting on June 29, 2005.

Thus, if you converted a traditional defined benefit plan to a cash balance plan prior to this date, the PPA provides you no assurance that the conversion did not result in age discrimination. For conversions after this date, you do have this assurance, as long as your plan participants continue to accrue benefits immediately after the conversion.

In addition, if at the time of the conversion, any of your participants have met the age, years of service, and other requirements for an early retirement benefit or a retirement subsidy, then the value of these benefits must be recognized in calculating the participant's benefits under the plan. Starting with your plan year that begins after December 31, 2007, your cash balance plan must provide that your participants are at least 100 percent vested after three years of service. In addition, the interest credits you provide in the plan cannot exceed a market rate of return.

Some of the provisions we have discussed above take effect in 2007, so you need to determine whether they apply to your plans and review your situation accordingly. For example, you are required to comply with the new rules for benefit statements in 2007. In addition, you can choose to allow individuals who are at least 62 years of age to start taking retirement payments from your defined benefit plan, even though they continue to work for you. It is not too early to start considering the changes that go into effect in 2008, especially the changes that affect the funding of your plans. If you have not already done so, it is a good idea to ask your plan actuary to prepare an estimate of the cash contributions that will be required for your plan under the new rules in 2008 and beyond.

If your plan provides for lump sum distributions, you may want to start educating your employees now about the changes in 2008 that serve to lower the dollar amount of these distributions. Employees who are near their retirement age may have already obtained estimated lump-sum distribution amounts, and will be disappointed to learn that the amount will decline after 2007.

If your organization maintains 401(k), 403(b) or 457 plans, Part II of this article will discuss them next month. For more information, go to www.GrantThornton.com/ppabooklet.

Eddie Adkins is the compensation and benefits partner in Grant Thornton's national tax office practice in Washington, D.C. His email is [e-mail]. Harvey Berger is a retired tax partner with Grant Thornton and currently serves as a consultant on nonprofit tax issues. His email is [e-mail]. Greg Goller is Grant Thornton's National Partner-in-Charge of Not-for-Profit Tax Services and is based in the Washington, D.C., area office. His email is [e-mail]