On Thursday, August 17, the President signed the Pension Protection Act of 2006 ("Act"), which significantly alters the employer-sponsored retirement plan landscape by amending dozens of provisions of the Internal Revenue Code of 1986, as amended (the "Code") and the Employee Retirement Income Security Act of 1974, as amended ("ERISA"). The changes affecting 401(k) and other defined contribution plans are wide-reaching and impact minimum vesting rules for employer nonelective contributions, impose diversification requirements on employer securities held by plans, provide investment-related guidance, encourage automatic 401(k) plan enrollment and contain other requirements.
I. Faster Vesting Of Employer Nonelective Contributions
Currently, employer nonelective contributions to a defined contribution plan (e.g., profit sharing or money purchase pension contributions) and related earnings must vest on a schedule that provides either for graded vesting at a rate of at least 20% a year from 3 to 7 years of service or 100% vesting no later than 5 years of service. The Act requires that for contributions for plan years beginning after December 31, 2006, employer nonelective contributions and related earnings must vest at a rate of at least 20% a year from 2 to 6 years of service or must be 100% vested no later than 3 years of service. Employer nonelective contributions made on or before December 31, 2006 and related earnings may continue to to vest on their prior vesting schedule. This new faster vesting schedule is the same schedule that currently applies to matching contributions.
II. Diversifying Investments In Employer Stock
In a significant departure from current law, the Act requires that certain defined contribution plans provide enhanced diversification rights with regard to investments in employer securities. While many employers have already added various diversification rights to their plans, the new rule now requires that certain defined contribution plans that invest in publicly-traded employer securities allow immediate diversification into alternative investments for any employee elective deferrals and after-tax contributions. Further, participants with three years of service or beneficiaries of such participants must be allowed to diversify employer contributions such as matching and non-elective contributions. There is generally a three-year transition rule with respect to employer contributions made prior to January 1, 2007 that requires one-third to be unlocked each year.
Subject to certain exceptions and transition rules, the new diversification requirements apply for plan years beginning after December 31, 2006. The diversification requirements do not apply to a one-participant plan, or to an employee stock ownership plan (ESOP) if the ESOP (1) does not hold elective deferrals, after-tax contributions or matching contributions, or (2) is a separate plan from any other qualified retirement plan of the employer.
A plan subject to the foregoing diversification requirements is required to provide a choice of at least three investment options, other than employer securities, each of which is diversified and has materially different risk and return characteristics.
A plan administrator must provide to participants (and beneficiaries, if applicable) notice regarding their right to divest employer securities not later than 30 days before the first date on which the individual is eligible to divest. The notice, which must be written in a manner calculated to be understood by an average participant, may be delivered in written, electronic or other appropriate form if the form is reasonably accessible to the individual. The notice is required to describe the importance of diversifying retirement account assets. To the extent that an individual's right to divest different contributions becomes exercisable at different times ( i.e., immediate divestiture of employee contributions versus three years of service for employer contributions), the individual is entitled to receive separate notices. Congress has directed that the Secretary of Treasury, in consultation with the Secretary of Labor, prescribe a model notice within 180 days of the enactment of the Act. Failure to provide the required notice could result in a civil penalty against the plan administrator of up to $100 per day for each violation.
III. Investment Of Contributions Under An ERISA Section 404(c) Plan
ERISA Section 404(c) protects plan fiduciaries from liability with respect to investment decisions where plan participants exercise control over the investment of their individual accounts in a defined contribution plan. Since the enactment of ERISA Section 404(c), plan sponsors have been concerned as to their level of protection in cases where a participant fails to make an investment election. The Act extends the protection of ERISA Section 404(c) where a participant fails to exercise an investment election, and treats a participant as exercising "control" over investments in an individual account plan, if the assets are invested in a default arrangement that complies with forthcoming Department of Labor regulations (to be issued pursuant to Congressional directive within six months of enactment of the Act). For this ERISA Section 404(c) protection to apply, the plan administrator, within a reasonable period before each plan year, must give the participant written notice explaining the participant's rights and obligations, including the right to exercise control over investments, and how contributions will be invested if the employee fails to make an investment choice. This provision is effective for plan years beginning after December 31, 2006.
IV. Blackout Periods
The Act provides continuing ERISA Section 404(c) protection in certain cases after investment options under a participant directed defined contribution plan are changed. For this rule to apply, a plan administrator must furnish a written notice to participants which includes a comparison of the old and new investment options and explains how assets will be invested absent direction by the participant; such notice must be provided at least 30 but not more than 60 days before the change in the investment options. Further, the characteristics of the new investment options chosen on the participant's behalf must be reasonably similar to the investment options offered immediately before the change. Also, the participant must have exercised control of his investment assets prior to the change such that the investments chosen immediately before the change were the product of that exercise of that control. Significantly, the Act provides that ERISA Section 404(c) protections do not apply during a blackout period during which the ability to direct assets is suspended, unless the plan sponsor or fiduciary meets ERISA requirements for authorizing and implementing a blackout period. This provision is effective for plan years beginning after December 31, 2007, with a delayed effective date for collectively bargained plans.
V. Encouragement Of Investment Advice For Participants
The Act seeks to encourage the provision of investment advice to participants in defined contribution plans who have the right to direct investments of their accounts by creating a prohibited transaction exemption for investment advice given by a fiduciary advisor through an eligible investment advice arrangement. The exemption does not apply to investment advice provided by plan sponsors. An eligible investment advice arrangement must satisfy a number of requirements and must be either a "flat fee" arrangement or an arrangement that uses a computer model to provide investment advice. A "flat fee" arrangement is an arrangement that provides that fees (including commissions or other compensation) that are received by the fiduciary adviser for investment advice or with respect to the sale, holding, or acquisition of any security or other property for purposes of investment of plan assets do not vary depending on the basis of the investment option selected. If an eligible investment advice arrangement provides investment advice pursuant to a computer model, the computer model must meet several conditions and an eligible investment expert must certify that the model meets such conditions.
VI. Encouragement Of Automatic Enrollments
The Act encourages automatic enrollment in 401(k) plans by eliminating actual deferral percentage (ADP) testing with respect to elective deferrals and "top-heavy" rules for plans that meet certain requirements. A plan which includes an automatic enrollment feature is not required to meet these requirements, however, such a plan will not be exempted from ADP testing or the top heavy rules. A qualified automatic enrollment feature must provide that, unless an employee elects otherwise, the employee is treated as automatically making an election to defer a certain percentage of compensation. The deferral amount is capped at 10%, but cannot be less than 3% in the first year of participation with the minimum deferral percentage increasing by 1% each year until it reaches 6% for years four and thereafter. The plan must treat all eligible employees the same with regard to default deferral percentages.
The employer must also satisfy either a matching or nonelective contribution requirement. The nonelective contribution requirement is at least 3% of compensation on behalf of each non-highly compensated employee who is eligible for the automatic enrollment feature. A plan will satisfy the matching contribution requirement if the employer makes a matching contribution on behalf of each non-highly compensated employee that is equal to 100% of elective deferrals up to 1% and 50% of elective deferrals between 1% and 6% and the rate of match with respect to elective deferrals for highly compensated employees is not greater than that for non-highly compensated employees. Any such nonelective contribution or matching contribution (and earnings thereon) must be fully vested after 2 years of service. These provisions also apply to Code Section 403(b) arrangements.
In addition to the rules above, in order for a plan to be deemed to satisfy the actual contribution percentage (ACP) test with respect to matching contributions, the plan must satisfy certain additional rules, including that matching contributions may not be made with respect to elective deferrals in excess of 6% of compensation.
The plan must give each eligible employee: (1) notice of the employee's right to refuse participation; (2) notice of the right to change elective amounts; and (3) information on how contributions will be invested if the employee fails to make an investment choice. Finally, the Act specifically preempts all state laws that would prohibit or restrict an automatic contribution arrangement. The automatic enrollment provisions are effective January 1, 2008.
VII. Miscellaneous
The Act clarifies the fiduciary responsibilities regarding the selection of an annuity provider to provide annuities as a form of distribution of a defined contribution plan. An interpretive bulletin from the Department of Labor had previously required a fiduciary to obtain the safest available annuity provider in such a situation. The Act rejects that standard as of the date of enactment and directs the Secretary of Labor to issue a final regulation clarifying that the general prudence standards of ERISA Section 404(a) apply when selecting an annuity contract as a form of distribution.
The Act directs the Treasury to issue rules within 180 days of enactment that allow hardship withdrawals under a 401(k) plan for events that would constitute a hardship event with respect to any person who is a beneficiary under the 401(k) plan.
Effective for distributions from qualified retirement plans after December 31, 2006, a non-spouse beneficiary of a deceased participant may direct a rollover to an inherited IRA. This will allow for a payout from the IRA over the beneficiary's life expectancy.
Many of the notice and consent time periods for qualified retirement plans, including the notice and consent time period applicable to cash outs from defined contribution plans, have been extended from no more than 90 days to no more than 180 days before the date distributions commence.
Finally, of great significance to defined contribution plan sponsors, the general sunset date of 2010 for all pension and IRA provisions under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) has been repealed and all such provisions have been made permanent.
Published September 1, 2006.
