The Pension Protection Act of 2006 - a comprehensive reform package.

• Author: Walker, Deborah

EXECUTIVE SUMMARY

* The PPA '06 makes many changes that will facilitate certain plan designs and affect how plans operate.

* The PPA '06 makes permanent more than three dozen EGTRRA rules affecting IRAs and retirement plans.

* Several provisions are designed to increase funding for retiree medical costs and provide incentives for funding healthcare and LTC costs.

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The Pension Protection Act of 2006 (PPA '06) makes sweeping changes to retirement plans and other employee benefits.

This article is an overview of the PPA '06's more significant retirement plan and healthcare-related provisions.

President Bush signed the Pension Protection Act of 20061 (PPA '06) on Aug. 17, 2006. The PPA '06 will simplify and transform rules governing the funding of defined-benefit plans, accelerate employers' funding obligations, prospectively clarify the rules for cash-balance plans, make permanent revisions enacted in 2001 that were set to expire in 2010, strengthen diversification rights and investment education provisions for plan participants and encourage automatic enrollment in defined-contribution Sec. 401(k) plans. These changes will also have dramatic effects on the cashflow, reported earnings and benefit payments of businesses sponsoring plans--issues of great concern to chief executive officers, chief financial officers and human resources directors. This article provides an overview of these and other significant PPA '06 changes.

Employer's Funding Obligation

PPA '06 Section 112(a) completely replaces the prior rules governing the funding of single-employer, defined-benefit pension plans with a new standard keyed solely to the plan's funded status. The general principle is that a plan's required contribution should equal the present value of benefits earned by participants during the current year, plus the amount necessary to amortize any funding shortfall over no longer than seven years. In the case of severely underfunded (i.e., at-risk) plans, special rules increase the funding obligation. These rules are generally effective in 2008. The PPA '06 also extends--for 2006 and 2007--funding relief enacted in 2004.

Employee's View

As part of its efforts to increase the solvency of defined-benefit plans, the PPA '06 addresses the competing interests of current retirees on the one hand, and future retirees and plan sponsors on the other.

New Assumptions for Calculating Lump-Sum Distributions

PPA '06 Section 303(a) changes the assumptions for calculating lump-sum distributions from defined-benefit pension plans. If such a plan offers a lump-sum distribution as an optional benefit form, the PPA '06 requires it to convert accrued benefits to lump-sum equivalents using interest rates based on the corporate bond yield curve. Similar to the funding rules, segment rates apply to the calculation. Thus, the interest rate will depend on when the benefit would have become payable had the participant delayed distribution until the plan's normal retirement age.

Beginning in 2008, a participant's lump sum will be determined based on a mixture of the corporate bond yield curve and the 30-year Treasury rate, with full implementation of the corporate bond yield curve in 2012.

Under the PPA '06, the mortality assumptions used to value lump-sum distributions will be determined by reference to the mortality table published by Treasury for funding purposes, but very large plans will be able to request permission to use tables based on their own experience.

Limits on Benefits Based on Plan's Funded Status

PPA '06 Section 113(a)(1)(B) imposes a variety of new benefit limits on single-employer plans whose funded status falls below specific levels. Poorly funded plans may be subjected to restrictions on benefit accrual, benefit increases or accelerated payment of benefits, depending on the degree of underfunding. Exhibit 1 on p. 652 summarizes the assorted restrictions that will begin to apply at various levels of underfunding.

In addition, PPA '06 Section 116 restricts an employer's ability to set aside assets in a trust or other arrangement to fund nonqualified deferred compensation for its top five executive officers during the (1) period that the employer's defined-benefit plan is deemed at risk, (2) period that the employer is in bankruptcy and (3) 12-month period beginning six months before the termination of an underfunded plan. If amounts are set aside in violation of these rules, or subject to provisions that they will be set aside in these circumstances, the executive will owe tax on them. The tax will not apply to assets set aside before the restriction period.

Any tax gross-up payment provided by the employer to defray an individual's tax liability, under PPA '06 Section 116, is deemed deferred compensation subject to a 20% additional tax under Sec. 409A(b)(5)(A). In addition, an employer cannot deduct these gross-up amounts, under Sec. 409A(b)(3)(C)(iii). These rules apply to transfers made after Aug. 17, 2006.

Plan Design and Operation

The PPA '06 will help facilitate the adoption of certain plan designs and will affect how plans operate.

Cash-Balance and Other Hybrid Defined-Benefit Plans

PPA '06 Section 701 resolves, but only prospectively, three of the major controversies surrounding cash-balance and other hybrid pension plan designs:

* Age discrimination. It protects hybrid plans against challenges under age discrimination rules found in the Code, the Employee Retirement Income Security Act of 1974 (ERISA) and the Age Discrimination in Employment Act (ADEA), so long as...