Plan Design Trends and Selected Compliance Issues After the Pension Protection Act of 2006

Plan Design Trendsand Selected Compliance Issues After the Pension Protection Act

of 2006

Mark L. Lofgren, Principal

Groom Law Group, Chartered

Washington, D.C.

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Overview

• Defined contribution plans– Focus on participation and increased contributions– Automatic enrollment– Employer stock diversification– Other changes related to PPA – 403(b) plan compliance update

• Defined benefit plans– Focus on benefit reductions– Cash balance/hybrid plan developments– Other changes related to PPA

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Overview

• Impact of new section 415 regulations

• Update on IRS determination letter program and related plan amendment timing rules

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DC Plans – Sponsors Move to Increase Participation and

Contributions• Move away from DB plans coordinated with new

emphasis on DC plans• Common changes to DC plans

– Increased match– New or increased employer non-elective contributions– Safe harbor designs– Automatic enrollment– Automatic employee deferral increases– Enhanced investment and planning tools– Roth 401k?

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Auto-EnrollmentWhat Is It?

• Automatic deduction from employee’s paycheck that is contributed to 401(k) savings plan– Deduction percentage may increase over time

• Employee must affirmatively elect to stop the deduction

• Employer determines where automatic contributions are to be invested, absent an affirmative election from the participant

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Auto-EnrollmentDoes It Work? (Yes!!!)

• Studies show that individuals are less likely to stop contributions once they begin

• Helps plans increase participation of non-highly compensated employees

• Deductions are not perceived as being that onerous, especially if the deductions:– Commence when employment commences– Increase when compensation increases

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Auto-EnrollmentConcerns of Employers

• Administrative hassle

• State laws prohibiting payroll deductions without an employee’s consent

• Difficulty of returning contributions to employees who don’t want to contribute

• Employer assumes fiduciary liability for investment of automatic contributions

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Auto-EnrollmentNew PPA Rules

• Encourages automatic enrollment adoption by providing administrative relief – New nondiscrimination safe harbor

• Allows limited distribution of amounts automatically contributed

• Express preemption from state laws

• DOL to develop regulations describing safe harbor default investment funds – Qualified Default Investment Alternative (QDIA)

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Auto-EnrollmentEffective Dates

• IRS issues proposed regulations 11/8/07– Effective for plan years beginning after 1/1/08– Until regulations are final, can rely on proposed

regulations

• DOL issues final regulations 10/24/07– Effective 12/24/07– Limited transition relief for default investments in

principal preservation funds made prior to effective date

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Auto-EnrollmentOverview of IRS Rules

• Two types of auto-enrollment arrangements

• Eligible Automatic Enrollment Arrangement (“EACA”) – described in IRC §414(w)

• Qualified Automatic Enrollment Arrangement (“QACA”) – described in IRC §401(k)(13)

• Not required to be either or both

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Auto-EnrollmentEligible Automatic Contribution

Arrangements (EACA)

• Plan with an EACA can allow employees to elect to receive distributions of contributions made under the EACA

• Default contribution rate must be a uniform percentage of compensation

• Notice describing the auto-enrollment arrangement must be provided

• Automatic contributions must be invested in QDIA

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Auto-EnrollmentEACA Withdrawal Rules

• Plan with an EACA can, but is not required, allow employees to elect to receive distributions of contributions made under the EACA– Plan may charge a fee for the distribution, provided the fee

is the same that applies to other distributions– Distribution is not subject to the notice and consent

requirements for other distributions

• Plan is not required to provide this to all eligible employees

• Can place requirements on the receiving distributions– Not permitted to require employee never to participate in

the plan in order to receive the distribution

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Auto-EnrollmentEACA Withdrawal Rules

• Withdrawal election must be made no later than 90 days after the first contributions would have been included in income

• Must withdraw all amounts contributed, adjusted for gains/losses

• If amounts are taxable, they will be taxed in year the distribution is made, no early distribution tax under §72(t) and distribution is reported on Form 1099-R

• Any related matching contributions must be forfeited

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Auto-EnrollmentEACA Testing Date Extended

• Distributions of contribution to pass the ADP/ACP tests can be made up to 6 months after the end of the plan year with no excise tax

• This provides more time to conduct ADP/ACP tests and to determine how to pass the tests

• It appears this additional time is available regardless of whether the plan provides for the distribution of automatically deferred amounts

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Auto-EnrollmentEACA Notice Requirement

• Must be given to each employee to whom the EACA applies

• Notice must include:– Description of distribution rights– Level of automatic contributions – Right of employee to decline or elect different

contribution percentage – Description of default investments– Description of withdrawal rights

• Can’t satisfy requirements by referring to provisions of the SPD

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Auto-Enrollment EACANotice Requirement

• Notice must be provided a reasonable time before beginning of each year

– A period of 30 days and no more than 90 days will comply

– Plans with immediate eligibility can provide notice no later than the first day the employee becomes eligible

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Auto-Enrollment EACANotice Requirement

• EACA Notice can be used to meet the QACA, QDIA and preemption notice requirements

• Notice can be in writing or delivered electronically

• IRS posted a sample notice on its website on 11/15/07

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Auto-EnrollmentQualified Automatic Contribution

Arrangement (QACA)• If a QACA, then the plan automatically meets the ADP

and ACP tests

• Plan must be amended to provide the QACA before the year in which it will be effective

• Rules are similar to the rules for the IRC §401(k)(12) safe harbor – However, no QACA exclusion for early participants

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Auto-EnrollmentQACA Contribution Requirements

• Any eligible employee who has not made an affirmative election as of the effective date of the QACA must be subject to automatic enrollment unless he or she affirmatively elects not to participate

• Minimum contribution must equal 3% of compensation

• Minimum contribution increases by 1% in each succeeding plan year up to 6% of compensation

• Maximum contribution cannot exceed 10% of compensation

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Auto-Enrollment QACA Employer Contributions

• Non-elective contribution of 3% of compensation; or

• Matching contribution of at least:– 100% of the first 1% of compensation– 50% of the contributions exceeding 1% and but not

more than 6%

• Employer contribution must be fully vested after 2 years of service

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Auto-Enrollment Other QACA Requirements

• Notice requirement – follows EACA notice requirement

• Investment of contribution – no requirement that amounts be invested in a QDIA– Given the advantages of EACA’s and the fiduciary

concerns, employers likely to invest amounts in QDIAs

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Employer Stock Diversification

• PPA added new requirement to allow participants to diversify plan accounts invested in publicly-traded employer stock

• Generally, provides full divestment rights within three years

• Enacted as partial response to Enron

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Employer Stock Diversification

• Generally effective for plan years beginning on or after 1/1/07

• Special effective date rule for employer contributions– 3-year phase in (beginning 2007) for employer

contributions– no phase in for participants age 55 and 3 years of

service before 2006

• IRS proposed regulations issued 1/3/08, to be effective 1/1/09

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Employer Stock Diversification

• Rules generally apply to any DC plan that holds publicly traded employer securities

• Exception for stand-alone ESOPs

• What is publicly traded employer security?– Readily traded on an established securities market,

foreign exchanges included if officially recognized by government and has a “ready market”

– “Employer” security determined on 50% controlled group basis

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Employer Stock Diversification

• Employee money - participants must be permitted to diversify immediately

• Employer money– participants must be permitted to diversify after three

years of service– Service measured under plan’s vesting rules, or third

anniversary of DOH• Rules extend to alternate payees and

beneficiaries• Frequency – plan must permit periodic

reasonable opportunities to diversify at least quarterly

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Employer Stock Diversification

• Generally cannot impose restrictions on investing in employer stock that do not apply to other investment options)

• Permissible trading restrictions– Policies to comply with securities law requirements– Restrictions that do not apply to stable value funds– Plan limit on participant holdings (e.g., 10% limit on

company stock allocation)– Reasonable trading fees– Restrictions to limit short-term trading

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Employer Stock Diversification

• Plans must offer at least three non-employer stock investment options with materially different risk and return characteristics

• Must provide notice of diversification rights to participant at least 30 days prior to date first eligible to diversify

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Other PPA Changes for DC Plans

• Faster vesting of employer contributions – 3 yr cliff/2-6 yr graded

• Hardship distributions can be extended for hardship of spouse or dependent

• Expanded rollover rules

• New distribution rules (limited application)– In-service distributions permitted after 62 – New qualified optional survivor annuity – New QJSA notice and consent rules

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403(b) Plan Compliance Update

• After 43 years, IRS finally issued comprehensive regulations

• Some major new requirements, generally effective 1/1/09:– Written plan containing all material terms– Financial audit requirement for large plans (100+

participants)– Restrictions on the exchange of 403(b) contracts and

distributions– New rules to determine employers under common

control– New rules for nondiscrimination testing– Clarifies contribution and funding requirements

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DB Plans – Sponsors Move to Reduce Future Obligations

• Many companies have announced move away from DB plan benefits in recent years

• Typical approaches include:– Complete freeze– Continuation of accruals only for current employees,

no new participants– Continue benefit accruals, but at reduced level– Combination of reduced accruals and restricted

participation

• Renewed interest in hybrid designs

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Cash Balance/Hybrid Plans

• What are they? Defined benefit plan with benefit expressed as a lump sum value

• Formula typically presents benefit as an account balance that grows with credits based on pay and interest

• Who has them? – Common among many large public companies– Common for smaller professional organizations

• For many years, these plans have been plagued by class action lawsuits and lack of consistent IRS guidance

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Cash Balance/Hybrid Plans

• Important recent developments are beginning to clear the air– Courts are increasingly finding that the cash

balance formula is legal– The PPA adds specific rules to govern and

legitimize these plans– IRS issued proposed regulations for PPA

requirements– IRS recently began to issue favorable

determination letters

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PPA Rules for Cash Balance/Hybrid Plans

• New age discrimination rules– Safe harbor for benefit formula– Interest credits must not exceed a market rate of return– Conversion amendments after 6-29-05 must protect against

“wear-away”

• Three-year vesting required

• Lump-sum “whipsaw” calculations no longer required

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PPA Rules for Cash Balance/Hybrid Plans

• New age discrimination safe harbor - “accrued benefit” at all times is equal to or greater than that of any similarly situated, younger employee who is or could be a participant

– For this purpose “accrued benefit” can be expressed as balance in hypo account, current value of accumulated percentage of final average pay, or annuity at NRA

– If a plan has multiple formulas, each must be tested separately

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PPA Rules for Cash Balance/Hybrid Plans

Limits on interest rates:• Interest credits must not be based on a rate

greater than a market rate of return• Principal preservation required over duration of

participation in plan• IRS has provided limited list of permissible rates,

based on T bills or bond yield• Reasonable fixed or minimum rates ok, but IRS

still considering limits• IRS considering equity-based rates

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PPA Rules for Cash Balance/Hybrid Plans

Special rules for conversions after 6/29/05:• Accrued benefit of existing participants must not

be less than “A + B” benefit (no “wear-away”) –– A = Accrued benefit under plan terms for

service prior to conversion• Must preserve value of early retirement subsidy• Must preserve optional forms of distribution

– B = Accrued benefit under plan terms for service after conversion

• Interaction of multiple formulas or plans, and employee transfers between formulas can trigger conversion rule

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PPA Rules for Cash Balance/Hybrid Plans

• 3-year vesting required for any participant covered by a hybrid benefit formula– Participant-by-participant determination– Vesting rule applies to entire benefit even if part

determined under non-hybrid formula, and for greater-of formulas

• Lump sum payments – “whipsaw” no longer required after 8/17/06– Advance participant notice may be needed to

eliminate whipsaw

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Other PPA Changes for DB Plans

• New qualified optional survivor annuity required (eff. 2008)– If plan’s QJSA has survivor percentage < 75, must

include optional 75% survivor annuity– If plan’s QJSA has survivor percentage >= 75, must

include optional 50% survivor annuity

• In-service distributions permitted after 62 (eff. 2007) - provides opportunity for “phased retirement”

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Other PPA Changes for DB Plans

• New lump sum valuation rules to be phased in over 5 years, beginning in 2008

– New interest rate – 3-segment, corporate bond yield curve

• Existing timing rules apply (“lookback month” and “stability period”)

– Mortality table – table prescribed by IRS under new funding standard rules for single employer plans

– Cut-back relief

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Overview of New Section 415 Regulations

• After many years, IRS provided complete update of the section 415 contribution and benefit limits

• New regulations generally effective for years beginning after June 2007

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Overview of New Section 415 Regulations

New rules for post-severance compensation:

• Amounts payable because of severance generally excluded – e.g., severance pay

• Certain post-severance “employee” compensation included if paid by the later of 2 ½ months after severance from service or by the end of limitation year in which severance occurred

– Required - Payments that would have occurred if employee had continued in employment, e.g., regular wages, overtime, commissions, bonuses

– Optional - Payments for accrued bona fide sick, vacation, or other leave, if employee would have been able to use the leave had employment continued

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Overview of New Section 415 Regulations

• Compensation limit of § 401(a)(17) now applies for § 415 compensation limits; grandfather rule for prior benefits

• Foreign compensation/nonresident aliens issues addressed

• Multiple annuity starting dates – new proposed regs being developed

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IRS Determination Letter and Plan Amendment Timing Rules

• New 5-year cycle determination letter program based on last digit of EIN– 1,6 – 1/31/07, 2,7 – 1/31/08, 3,8 – 1/31/09, 4,9 – 1/31/10, 5,0 1/31/11– Can use parent’s EIN for subsidiary plans if make timely election

• Timing of non-PPA-related amendments– Legally required changes by due date of tax return for the year the

change is effective– Discretionary change by end of the year in which the change is effective– Exceptions, include (a) to avoid cutback (b) add a CODA, (c) change to

safe harbor 401(k) plan, or (d) other IRS guidance

• PPA-related amendments generally not required until 2009– General cut-back relief provided, subject to IRS guidance

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Update On IRS Approval of Prototype and Other Model

Documents

• IRS has completed it review of EGTRRA model documents

• IRS will shortly (or has just) issued go ahead to begin adoption process

• Adopting employers will be given two years to execute