The Pension Protection Act of 2006
Congress recently passed, and the President has signed into law, the Pension Protection Act of 2006 (the Act) a comprehensive tax law that amends several sections of the Internal Revenue Code (the Code) and the Employee Retirement Income Security Act of 1974 (ERISA). The Act affects many retirement plans and programs currently sponsored by employers for their employees.
This is the first in a series of alerts from Holland & Knight that will summarize those provisions of the Act that will have the greatest impact on employer/sponsors of retirement plans, both with regard to new compliance requirements affecting their current retirement plan documents, as well as changes affecting the ongoing administration and operation of their plans.
Described below are key provisions of Title IX of the Act that apply specifically to defined contribution retirement plans.
Automatic Enrollment Rules
The Act adds new sections to the Code, effective generally for plan years beginning after December 31, 2007, which, for the first time, formally provide that Section 401(k) plans, Section 403(b) plans, and governmental Section 457(b) plans may automatically enroll participants in “qualified automatic contribution arrangements.” Under the provisions of the Act, plans that constitute qualified automatic contribution arrangements will automatically satisfy the Code’s nondiscrimination tests if certain notice, withdrawal and contribution requirements set forth in the Act are met.
A “qualified automatic contribution arrangement” is a plan under which (i) a participant may elect to have the employer make payments as contributions under the plan on behalf of the participant or to the participant directly in cash; (ii) the participant is treated as having elected to have the employer make such contributions in an amount equal to a uniform percentage of compensation, until the participant specifically elects not to have such contributions made or specifically elects to have such contributions made at a different percentage; (iii) in the absence of an investment election by the participant, contributions are invested in accordance with Section 404(c) of ERISA; and (iv) the notice requirements set forth below are met.
A qualified automatic contribution arrangement must provide that each employee eligible to participate in the plan will be treated as having made an elective deferral under the plan in an amount equal to a “qualified percentage of compensation.” The qualified percentage of compensation must be uniformly applied, may not exceed 10 percent, and must be at least 3 percent for the first plan year, 4 percent for the following year, 5 percent for the year after that and 6 percent for all subsequent years. Employees must be permitted to affirmatively elect out of the contribution or to elect a different percentage for the deferral. The automatic deferral feature need not apply to current employees who already have elections in effect on the date on which the plan becomes a “qualified automatic contribution arrangement.”
A qualified automatic contribution arrangement must also provide for either (i) a minimum matching contribution for nonhighly compensated employees of 100 percent of the participant’s elective contribution up to 1 percent of compensation, plus 50 percent of the compensation that exceeds 1 percent (generally up to 6 percent of compensation); or (ii) a nonelective contribution on behalf of each nonhighly compensated employee who is eligible to participate in the plan, in the minimum amount of at least 3 percent of such employee’s compensation (regardless of whether the employee makes an elective contribution or an employee contribution to the plan). In addition, a qualified automatic contribution arrangement must provide for 100 percent vesting of employer matching contributions for employees who have completed at least two years of service.
Under the notice requirement, a qualified automatic contribution arrangement must also provide, within a reasonable period before each plan year, a written notice to employees containing a sufficiently accurate and comprehensive description of their rights and obligations under the plan, written in a manner calculated to be understood by the average employee eligible to participate in the plan. The notice must (i) explain the employee’s right to elect not to have the elective contribution made in his/her behalf (or to elect a different percentage); (ii) in the case of a plan having two or more investment options, provide an explanation of how the contributions will be invested on behalf of the employee in the absence of an investment election from the employee; and (iii) ensure that the employee has a reasonable period of time after receipt of the notice and before the first elective contribution is made to make his/her election. The definition of “top-heavy plan” excludes plans which consist solely of a qualified automatic contribution arrangement.
The Act also adds a new Section 414(w) to the Code that contains special rules for the treatment of certain withdrawals of contributions under automatic contribution arrangements during the 90-day period commencing with the date of the employee’s first elective contribution under the plan. Permissible withdrawals elected by a participant under a qualified automatic contribution arrangement within the 90-day window are not subject to the 10 percent penalty on early distributions and, further, the plan is not treated as violating any other restrictions under the applicable section solely by reason of permitting the withdrawal. Permissible withdrawals are those comprised solely of a participant’s elective contributions (and any earnings attributable thereto) made pursuant to the participant’s timely election to withdraw as a result of “opting out” of the plan. Permissible withdrawals are not taken into account for purposes of participation and discrimination requirements.
In the case of any distribution under a qualified automatic contribution arrangement by reason of a permissible withdrawal of an elective contribution, any employer matching contributions applicable to such contribution shall be forfeited “or subject to such other treatment as the Secretary [of the Treasury] may prescribe.”
The corrective distribution period for excess contributions is expanded from two-and-one-half months to six months after the close of the plan year for permissive withdrawals under a qualified automatic contribution arrangement, and earnings attributable to such amounts are those allocable through the end of the plan year for which the contribution was made. Permissible withdrawals are taxable to the employee/participant in the year of distribution.
Effective generally for plan years beginning after December 31, 2006, the Act adds a new Section 401(a)(35) to the Code, which applies to all defined contribution plans that hold publicly-traded employer securities (other than certain ESOPs and one-participant retirement plans.) A plan holding employer securities that are not publicly-traded generally is treated as holding publicly-traded securities if any employer corporation, or any member of the employer’s controlled group of corporations, has issued a publicly-traded class of stock.
Under this new section of the Code, if a plan provides for elective deferrals and employee contributions, employees must be provided a reasonable opportunity, at least quarterly, to divest those amounts which are invested in employer securities and reinvest an equivalent amount in other investment options under the plan. The plan must offer at least three other investment options for the reinvestment of such funds (other than employer securities), each of which is diversified and has materially different risk and return characteristics. The plan may not impose any restrictions or conditions (other than those required by securities law) on the investment of employer securities that are not imposed on other investments under the plan. With regard to employer contributions invested in employer securities, if an individual has completed at least three years of service, or is a beneficiary of such participant or of a deceased participant, such individual must be permitted to divest/reinvest amounts invested in employer securities as provided above.
Combined Plans for Small Employers
Effective for plan years beginning after December 31, 2009, a new Section 414(x) has been added to the Code which sets forth benefit, contribution, vesting, nondiscrimination and notice requirements for certain “combined plans” of small employers. “Small employer” for this purpose is generally defined as one not having more than 500 employees.
A combined plan is one that consists of a defined benefit plan and a defined contribution plan with a Section 401(k) feature, the assets of which are held, but separately identified, in a single trust. Generally, for the defined benefit plan portion of the combined plan, the annual retirement benefit must be at least the lesser of (i) 1 percent times years of service, or (ii) 20 percent times final average pay. Final average pay for purposes of this requirement is determined using the period of consecutive years (not exceeding five) during which the participant had the greatest aggregate compensation from the employer. Years of service during which a participant makes, or fails to make, any elective deferral under the cash or deferred arrangement may not be disregarded for this purpose. Interest credit plans are required to provide annual pay credits to participants in percentages of compensation determined by the participant’s age.
Under the defined contribution plan portion of the combined plan, the Section 401(k) component must constitute a “qualified automatic contribution arrangement” and the employer must make a matching contribution on behalf of each eligible employee in the amount of 50 percent of the employee’s elective contributions up to 4 percent of the employee’s compensation. All employees must be 100 percent vested in all matching contributions.
The defined benefit plan portion of the combined plan must provide that an employee who has completed at least three years of service is 100 percent vested in his/her accrued benefit which is derived from employer contributions.