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Pensions breakthrough: Retirement protection package
becomes law

By Rob Smith, Ceridian manager of Government Relations

"Years in the making, the pension bill, approved 93-5, represents the most sweeping attempt in decades to shore up defined benefit retirement plans and map rules for the newer world of 401(k) plans and individual retirement accounts." (Wall Street Journal, August 4, 2006)

America's pension system is in trouble. Several large U.S. companies pay over one billion dollars per year to traditional defined benefit pension plans, and the automobile manufacturers and airlines with large plans threaten to bring these cornerstones of our nation's economy to their knees. As defined benefit pensions have grown more expensive to maintain, more employers have declared bankruptcy, terminated pension plans and left the federal pension insurance program holding the bag. As a result, the federal program that insures defined benefit plans, the Pension Benefit Guarantee Corporation (PBGC), is now deeply under funded and strained to the breaking point.

This problem has grown too big not to fix. On August 17, President Bush signed into law H.R. 4, the Pension Protection Act, which aims to increase employer pension responsibility and stem the drain on the PBGC fund. The massive 900 page bill represents over a year's worth of work by Congress and the administration and will bring big changes across the board for America's retirement system.

Previously, companies were given considerable flexibility in choosing methods and interest rate assumptions to calculate plan funding levels and had little or no incentive to ensure plans had the funding necessary to cover the number of workers who could retire in a given year. Under the new law, all traditional pension plans will be required to use a standard interest rate to measure pension liabilities, and for the first time, companies will be required to fund their plans at 100 percent. Employers will have seven years to erase funding shortfalls.

The bill also reins in the use of credit balances to make plans seem more funded than they really are. Credit balances are created when a company contributes money above the minimum funding requirements for its plan. Previous law allowed employers to use an assumed interest rate to calculate the balance's growth, and these funds could be applied toward plan funding targets. However, companies sometimes assumed an interest rate that was more favorable than the actual return, so it appeared that their plans were healthier than they actually were. With the new funding rules contained in H.R. 4, contributions in excess of the minimum required will be added to a plan's balance under an actual interest rate, thus closing the credit balance accounting loophole -- and making companies rely on their money's real value.

In addition, the law will provide significant relief to large airlines that have declared bankruptcy -- namely Delta and Northwest -- and have frozen their pensions so that no new employees receive pension accounts and no existing accounts accrue new benefits. These plans will be given 17 years to reach full funding status rather than the seven years other companies are granted. Airlines that have not frozen their plans have 10 years to reach 100 percent funding.

EGTRRA is here to stay
Oddly enough, some of the most important provisions in H.R. 4 have little or nothing to do with the large defined benefit contribution plans the overall bill seeks to improve. As the American workforce and economy have evolved since the industrial boom following World War II when the traditional defined benefit pension model was established, individual employee defined contribution plans have largely replaced the group employer-managed defined benefit plans that formerly dominated retirement savings. Defined contribution plans, such as 401(k)s and IRAs, provide workers with a tax preferred, self-invested retirement savings account in which they can deposit their own money and take it with them from job to job.

In recognition of this strong shift toward defined contribution plans, Congress enacted legislation in 2001, the Economic Growth and Tax Relief Reconciliation Act (EGTRRA), which included several temporary improvements for 401(k) and IRA type plans that were set to expire in 2010. H.R. 4 eliminates the sunset and solidifies defined contribution plans' place at the top of Americans' retirement investment options.

EGTRRA increased retirement plan contribution limits and established new catch-up contributions workers can make to their plans as they approach retirement age, and added a new savers' credit for lower income workers, and a new tax preferred savings account, the Roth 401(k). Specifically, employees can now contribute up to $15,000 in wages to a 401(k) account and up to $5,000 to an IRA, and these amounts will be indexed in future years. In addition, workers over 50 years of age can contribute an additional $5,000 to their retirement plans each year. The savers' credit allows lower-income workers who contribute to an IRA or other plan to receive an annual federal matching payment for the first $2,000 they contribute to their account.

Since 2001, EGTRRA has contributed to nearly 25 percent more workers who invest in 401(k) accounts, and 5.5 million people have started saving through an IRA. (1) With a dwindling Social Security fund and skyrocketing medical costs, these improvements will become increasingly important to future retirees.

Incentives for 401(k) automatic enrollment
Perhaps the most significant part of the Pension Protection Act are provisions that promise a new world of 401(k) type plans. The new law creates special incentives for employers to automatically enroll new employees in defined contribution plans. By switching from employee opt-in to employee opt-out, automatic enrollment is expected to sharply boost participation in 401(k) type retirement savings plans.

More specifically, the new law authorizes employers to enroll new hires in "Eligible Automatic Contribution Arrangements" under which employees would have 90 days to opt-out and receive penalty-free return of any contributions. Default investments would enjoy 404(c) protection and be preempted from fiduciary liability under Labor Department standards and state laws that prohibit payroll deductions without employee prior approval. Employers would be required to provide annual notice of opt-out rights to employees.

Automatic enrollment incentives take effect beginning in 2008 and apply to 401(k), 403(b) and 457 employer plans. Significantly, such arrangements would have the benefit of an extension of the period for distribution of excess contributions, from the current law of two and a half months to six months following the end of the calendar year. Such distributions would be taxable in the year distributed, not in the previous year as in present law.

Finally, the new law creates an exemption from the ERISA prohibited transaction rule to allow employers to arrange tailored investment advice for employees. Under this provision, companies that manage employer 401(k) type plans would be able to advise participants regarding investment choices and objectives, subject to regulations to prevent any conflicts of interest.

Nondiscrimination safe harbor
The Pension Protection Act of 2006 also creates a special new nondiscrimination safe harbor for certain automatic enrollment plans.

To qualify for this safe harbor, employers need to:

• Meet certain tests relating to employee eligibility.
• Meet minimum percentage automatic contributions.
• Provide employer matching.
• Provide two-year 100 percent vesting of employer contributions.
• Offer 90-day employee opt-out and employee notice.

While it's not known how many employers will qualify for the nondiscrimination safe harbor, lawmakers expect that over time the provision will attract substantial employer interest.

Strengthening retirement security
The Pension Protection Act of 2006 will take many months to fully decipher. The measure is certain to dramatically change the landscape for defined benefit plans, putting some on a stronger financial footing, but putting others under greater pressure to achieve full-funding targets. As President Bush said at the bill signing ceremony: "The message [to companies] is this: You should keep the promises you make to your workers. If you offer a private pension plan to your employees, you have a duty to set aside enough money now so your workers will get what they've been promised when they retire."

At the same time, the new law promises to shift the balance between group-based defined benefit plans and individual-based defined contribution arrangements. It's possible that by 2010 the new law will have accelerated the erosion of defined benefit plans and spurred much greater employee participation in defined contribution plans. Taken together, the new incentives for automatic enrollment and the permanency of EGTRRA contribution limits are likely to create a new world of 401(k) type retirement savings -- strengthening the retirement security of millions of workers and their families.

Ceridian will continue its analysis of the new pension law and keep you informed about what you'll need to do to stay ahead of the curve of the complex and challenging compliance implications.

Sources

1. American Benefits Council