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Implementing pension simplification 1996.

On August 20, 1996, President Clinton signed H.R. 3448, the Small Business Job Protection Act of 1996 (P.L. 104-188), marking a historic moment for public pension simplification. Numerous provisions in that bill affect nearly every type of state and local government pension plan. These changes came about through the efforts of a number of governmental and employee organizations that sought to improve the overall administration of public-sector pension plans through amendments to the tax statutes that govern them. Public pension retirement administrators now are evaluating these changes and their potential impact on specific retirement plans.

A new publication entitled Pension Simplification 1996: An Implementation Guide for Public-Sector Employers from the Government Finance Officers Association and the National Association of Government Deferred Compensation Administrators provides an overview of issues for plan administrators to consider as they review the provisions of the Small Business Job Protection Act of 1996 (SBJPA). The book was developed and written by highly experienced plan administrators and consultants, and they discuss the many impacts the new provisions will have on plans.

The book covers all of the issues of interest to public-sector plans. The primary areas of interest are the SBJPA provisions related to Internal Revenue Code (IRC) Section 415 and IRC Section 457. Section 415 relates to limits on retirement benefits and contributions, while Section 457 relates to deferred compensation plans. The book also covers other provisions, such as minimum participation, veterans rehire provisions, and tax-sheltered annuities. While extensive review and care has been used in writing this guide, individual plans will need to work with their actuary, legal counsel, and auditor to determine the precise impact on their plan and how various provisions would be best implemented within their plan. Plan administrators also need to be aware of any subsequent changes in the law.

Changes to IRC Section 415

Section 415 limits the annual pension contribution or benefit level of both public and private employers. It was added to the IRC in 1974 as part of the Employee Retirement Income Security Act and became effective in 1976. Pension plans must comply with these limits in order to maintain their tax-qualified status.

Prior to the enactment of the SBJPA, Section 415 imposed two limits for federal tax qualification purposes on benefits paid by a state or local government defined benefit retirement system. Benefits were limited to the lesser of 100 percent of the participant's average annual compensation for the highest three years of taxable compensation or an absolute dollar cap indexed for inflation - known as the dollar limitation - of $125,000 in 1997.

While private-sector employers can amend their pension plans to meet Section 415 requirements, public-sector entities have found the amendment process difficult at best because the requirements of state and local law (particularly benefit formulas) often conflict with the federal tax code. In many state and local plans there are constitutional or statutory restrictions - often called anticutback rules - that prevent a reduction in the benefit formula once promised in a plan document. Accordingly, prior to the SBJPA, state and local government plans occasionally faced a dilemma, in the case of particular participants, between adhering to the Section 415 benefit limits to avoid the risk of federal tax disqualification of the entire qualified trust and maintaining benefit levels to comply with the anticutback restrictions.

Several provisions of the SBJPA attempt to eliminate or lessen the burden of these conflicts. Under SBJPA, state and local government plans are excluded from the 100 percent of compensation limitation within Section 415. This repeal was driven by the recognition that such a limitation risked cutting back relatively modest benefits earned by long-service, low-paid state and local workers. The Section 415 dollar limit is addressed by establishing a new qualified governmental excess benefit arrangement. A flat exemption from the Section 415 dollar limit for state and local plans proved to be politically infeasible in Congress. Instead, the qualified governmental excess benefit arrangement is designed to provide an escape valve by which a state or local government plan can adhere to the Section 415 dollar limit without having to cut back benefits in violation of anticutback restrictions. Finally, disability and survivor benefits paid to a governmental participant with less than 10 years of service are not subject to Section 415 limits.

The following is a list of the sections of the Small Business Job
Protection Act of 1996 that are discussed in the new Government
Finance Officers Association/National Association of Government
Deferred Compensation Administrators publication Pension
Simplification 1996: An Implementation Guide for Public-Sector

Topic SBJPA Section


Plan amendments to conform with Section 1465

Section 415 Changes

Repeal of the 100 percent of compensation
limit Section 1444

Excess benefit arrangements

Survivor and disability benefits removed
from benefit limits

Revocation of grandfather election

Definition of compensation Section 1434

Combined plan limit repeal Section 1452

Excise tax changes

GATT changes Section 1449

Section 457 Changes

Trust requirement Section 1448

Indexation of deferral amount Section 1447

Inactive account distributions

One-time change in distribution election

Other Pension Simplification Provisions

Minimum participation standards Section 1432

USERRA changes Section 1704(n)

Five-year averaging rule repeal Section 1401

$5,000 deduction of death benefits repeal Section 1402

Taxation of annuities Section 1403

Section 401(k) nondiscrimination rules Section 1433

Changes related to tax sheltered annuities Section 1450

Another dilemma Congress faced was how to enforce the Section 415 limits on state and local plans for plan years prior to the passage of the SBJPA. As adopted in earlier Congresses, the overall Section 415 relief legislation for state and local government pension plans would have deemed governmental plans to be in compliance with Section 415 limits for all prior years, thus providing a fresh start. The SBJPA, however, only states that nothing in the act is intended to imply that plans previously had failed to satisfy IRC Section 415. It is unclear how the Internal Revenue Service will interpret this provision.

In light of its new Section 415 provisions, SBJPA also permits options for governmental plans that had elected Section 415(b)(10) grandfather protection - an option offered in 1988 to exempt some participants from the Section 415 limits in exchange for lowering certain floors on dollar limits. The SBJPA allows plans to revoke that election and to be relieved of the lowered floors on dollar limits in future years.

Beyond the major provisions directed specifically at issues faced by state and local pension plans, SBJPA also changed the definition of compensation for Section 415 testing, repealed the combined plan limit, and made technical corrections to rules imposed by the Retirement Protection Act of 1994, which is part of the General Agreement on Tariffs and Trade (GATT).

Changes to IRC Section 457

Governmental deferred compensation plans (i.e., Section 457 plans) are voluntary, supplemental, long-term retirement programs that give state and local government employees an opportunity to defer the receipt of income until retirement or termination of employment. These plans have widespread participation.

The Small Business Job Protection Act of 1996 makes a number of changes to Section 457 plans. The changes affect what such plans must do to retain their tax-favored status and permit certain additional plan options:

* plan assets must be held for the exclusive benefit of employees in a trust, custodial account, or qualifying insurance contract;

* the maximum contribution to Section 457 plans is indexed for inflation;

* increased flexibility in the payment of account values is provided through an additional participant election on the timing of payment;

* plans are authorized to "cash out" or pay inactive accounts under $3,500 in value; and

* the definition of compensation under Section 415 is amended so that deferrals into a Section 457 plan are not taken into account in the limits on retirement benefits paid by qualified defined benefit plans.

The legislative history presented in the conference committee's report for the SBJPA also states that Section 457 plans can offer a loan option. The enactment of all of these reforms by Congress should provide increased security for the employees that participate in the plans and increased flexibility in plan administration.

Most of the changes are effective immediately. As noted below, it is generally not necessary for existing plans to take immediate action. Plans must take action, however, for their participants to receive the benefit of these changes.

Other Changes Included in SBJPA

The SBJPA included several other provisions related to pensions but not related to Section 415 or Section 457. The following additional provisions are described in Pension Simplification 1996:

* minimum participation standards,

* veteran rehire provisions related to the Uniformed Services Employment and Reemployment Rights Act of 1994,

* simplified distribution rules,

* Section 401(k) nondiscrimination rules, and

* changes to tax-sheltered annuity plans.

Plan amendments to incorporate all of the provisions of the SBJPA must be completed by the first day of the plan year beginning after December 31, 1999. This date is later than the effective date of a number of provisions in the SBJPA. In some cases, therefore, the plan will need to comply with provisions but will have some extra time to make the specific changes to the plan document.

Pension Simplification 1996 includes general descriptions of SBJPA provisions, and complex issues are presented in a question-and-answer format. Appendices provide references for the relevant sections of both the SBJPA and the IRC as well as a listing of effective and other important dates.

Pension Simplification 1996: An Implementation Guide for Public-Sector Employers can be ordered by calling GFOA at 312/977-9700. The cost is $18 for GFOA members and $24 for nonmembers.

Author JENNIFER HARRIS, director of GFOA's Pension and Benefits Project, contributed to Pension Simplification 1996.
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Author:Harris, Jennifer
Publication:Government Finance Review
Date:Feb 1, 1997
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