The Pension Protection Act of 2006, H.R. 4, will have a far-reaching impact on the operations of private pension plans, in particular, by requiring pension plans to meet a 100 percent funding target in seven years. The bill makes extensive amendments to the benefit provisions of the Internal Revenue Code and to the Employee Retirement Income Security Act of 1974. The bill was passed by the House of Representatives on July 28, and by the Senate on Aug. 3; the president has said he will sign the bill.

[Editor's Note: This analysis is divided into three parts. Please see separate stories for the remainder of this analysis.]

The bill, which took a long and sometimes bumpy road to passage by Congress, would replace the funding requirements for defined benefit pension plans, impose new benefit limits on underfunded plans, and change the premiums that the sponsors of underfunded plans must pay to the Pension Benefit Guaranty Corporation to insure a minimum level of benefits to their participants. Also, the bill would extend certain tax incentives for retirement savings, modify tax provisions relating to spending for health care, establish a safe harbor for employers to provide investment advice to help employees manage their §401(k) accounts and provide for automatic enrollment of employees in §401(k) plans.

The bill would clarify the legal standing of cash balance pension plans, many of which have been in regulatory limbo for years in the IRS's determination letter program.

Numerous but less well-known provisions in the bill would make a variety of changes to the pension and benefit universe, such as modifications to the plan asset rules (new ERISA Section 3(42)), and to the prohibited transaction rules, which prohibit a wide range of transactions between a plan and a party in interest unless an exemption applies. While many of these provisions may seem technical, they could have significant effects on the administration and structure of benefit plans and the manner in which fiduciaries operate.

Bill Provisions

Title I--Reform of Funding Rules for Single-Employer Defined Benefit Pension Plans.

Minimum Funding Rules.

Single-employer defined benefit pension plans are subject to minimum funding requirements under ERISA and the tax code. The amount of contributions required to be made by the plan sponsor for a plan year under the funding rules generally is the amount needed to fund benefits earned during that year and that year's portion of other liabilities that are amortized over a period of years, such as benefits resulting from a grant of past service credit. The amount of required annual contributions is determined under one of a number of acceptable actuarial cost methods. Additional contributions are required under the deficit reduction contribution (DRC) rules for certain underfunded plans. No contribution is required under the funding rules for plans that meet the full funding limit.

Defined benefit plans are required under current law to maintain a special account, called a “funding standard account,” to which specified charges and credits are made for each plan year, including a charge for normal cost and credits for contributions to the plan.

Beginning with the 2008 plan year, the bill would repeal the current-law funding rules, including the requirement that a funding standard account be maintained by single-employer plans. The bill includes an entirely new set of rules for determining minimum required contributions.¹

Funding Standard Carryover or Prefunding Balance. Under current law, employers have considerable flexibility to choose the assumptions and methods used to calculate minimum funding requirements. However, employers with plans that are less than 90 percent funded generally must make contributions to those plans on a more accelerated basis under the DRC rules, using specified interest and mortality assumptions.

The DRC is the sum of (1) the “unfunded old liability amount,” (2) the “unfunded new liability amount,” and (3) the expected increase in current liability due to benefits accruing during the plan year.

The unfunded old liability amount is the amount needed to amortize certain unfunded liabilities under 87 and 94 transition rules. The unfunded new liability amount is the applicable percentage of the plan's unfunded new liability. Unfunded new liability generally means the unfunded current liability of the plan (i.e., the amount by which the plan's current liability exceeds the actuarial value of plan assets), but determined without regard to certain liabilities, such as the plan's unfunded old liability and unpredictable contingent event benefits.

If employers make contributions in excess of the minimum required, the excess is added to the plan's “credit balance,” under current law. The credit balance increases each year with earnings at the interest rate assumed by the plan. The accumulated credit balance can be applied toward the future years' minimum contribution requirements.

Under the bill, the minimum required contribution of a plan sponsor to a single-employer defined benefit plan for a plan year generally would depend on a comparison of the value of the plan's assets with the plan's funding target and target normal cost. Credit balances could be used in certain circumstances to reduce otherwise required minimum contributions. In addition, contributions in excess of the minimum contributions required under the bill would be credited to a prefunding balance that could be used in certain circumstances to reduce otherwise required contributions.

To facilitate the use of such balances to reduce minimum required contributions, while avoiding the use of such balances for more than one purpose, the value of plan assets would be reduced by the prefunding balance and/or the funding standard carryover balance.

A plan's credit balance under current law would become the balance of the “carryover” account under the bill. Contributions in excess of the minimum required under the bill would be added to a new “prefunding” balance. Both the carryover and prefunding balances would be credited with the plan's actual rate of return each year.

Plan sponsors would be prohibited from using credit balances if their plans are funded at less than 80 percent. In other words, plan sponsors could elect to use the carryover and prefunding balances to reduce the minimum required contribution only if the plan's funding target attainment percentage is at least 80 percent. For the 80 percent test, the funding target attainment percentage is determined by subtracting only the prefunding balance from the plan assets.

Interest Rate. The bill would provide a permanent interest rate based on a modified “yield curve” for plan sponsors to measure current pension liabilities as they come due. Assets could be averaged over 24 months, but the result would be limited to 105 percent of market value as of a plan's valuation date. As under the DRC rules, the Treasury would establish the standard mortality table. However, some employers could develop and use plan-specific mortality tables for minimum contribution calculations.

Amortization Periods. Plan sponsors would have to make sufficient contributions in order to meet a full funding target and ease funding shortfalls over seven years so that all plans would be required to be fully funded in seven years under the bill.

The liability for benefits earned under a plan in past years is the plan's “target liability.” The liability for benefit accruals in the current year is the plan's “normal cost.” The plan's minimum contribution requirement for a year is the normal cost plus the amounts required to amortize any funding shortfall over the seven-year period. Under the bill, for the first year, the funding shortfall is the target liability minus assets. In subsequent years, a new shortfall amortization would have to be established to reflect gains or losses during the preceding year. Generally, both the carryover and prefunding balances would be deducted from plan assets to calculate the funding shortfall.

At-Risk Plans. The bill would create an additional liability for “at-risk” plans. A plan would be considered at risk under the bill if the plan's funding target attainment percentage is both less than 80 percent without regard to at-risk liabilities and less than 70 percent counting at-risk liabilities. The funded percentage would be determined by subtracting both the carryover and prefunding balances from plan assets. The 80 percent test is phased in at 65 percent in 2008, 70 percent in 2009, 75 percent in 2010, and 80 percent in 2011 and thereafter.

The plan would determine the at-risk liabilities by assuming that workers eligible to retire in the next ten years will retire as early as possible. The at-risk liability is phased in at 20 percent per year for each consecutive year the plan is at risk. If a plan is at risk for the current year and two out of the previous four years, a load of 4 percent of liability plus $700 per participant is added to the at-risk liability. Plans with 500 or fewer participants are not subject to the at-risk liability.

If a plan sponsor meets one of the above tests, it would avoid the at-risk designation, but it would be required to make up its overall funding shortfall over seven years.

Waiver for Business Hardship.

Under the bill, the Secretary of the Treasury may waive the minimum funding standards for no more than three of any 15 consecutive years (five of any 15 years for multiemployer plans) if an employer (or 10 percent or more of the employers contributing to a multiemployer plan) is unable to satisfy the funding requirements for a plan year without temporary substantial business hardship and satisfying the requirements would be adverse to the interests of the plan participants in the aggregate.²

Benefit Limits Under Single-Employer Plans.

Under current law, employers in bankruptcy may not make a benefit increase effective until the employer reorganizes. Also, if a plan's new current liability funding percentage is less than 60 percent, an increase generally may not be effective until the employer has brought the plan's funding up to 60 percent.

The bill includes limits based on the plan's “adjusted funding target attainment percentage.” The funding target attainment percentage is the ratio of assets (minus carryover and prefunding balances, see above) to target liability (without regard to at-risk status, see above). The adjusted percentage is determined by adding the amount of annuity purchases for non-highly compensated employees in the last two years to both assets and liabilities.

If the adjusted funding target attainment percentage is below 60 percent for a plan year, the bill would prohibit the plan from triggering shutdown benefits or accelerated payments--including lump sums--during the year, and would freeze benefit accruals. If the percentage is below 80 percent, a plan could not have benefit increases. Between 60 percent and 80 percent, lump sum payments would be limited to the lesser of the present value of the participant's PBGC guaranteed benefit and 50 percent of the lump sum the participant otherwise would receive. The balance of the benefit would be payable in the form of an annuity.

The restrictions would not apply to plans that are 100 percent funded without reducing assets for credit balances. Collectively bargained plans would have to convert carryover and prefunding balances to assets if the conversion would eliminate a restriction. Special rules would apply to new plans and to plans of employers in bankruptcy.³

Delayed Effective Date for Funding and Benefit Limits for Certain Plans.

The bill would delay the effective date of the funding and benefit limit rules discussed above for rural electric, agricultural, and telephone multiple employer plans until 2017; eligible government contractors until the earlier of when the Cost Accounting Standards Board allows recovery of the new contribution rates or 2011; and until 2014 for plans of employers that took over sponsorship of a plan so that the PBGC did not have to terminate the plan. In addition, the proposal modifies existing special rules for “a company that is engaged primarily in the interurban or interstate passenger bus service.”⁴

Restrictions on Nonqualified Deferred Compensation.

Under current law, employers may set aside or reserve money to pay nonqualified deferred compensation as long as the plan is not considered funded. The bill would prevent such a reserve for certain executives if the employer or a member of its controlled group is bankrupt, has an at-risk plan (generally less than 80 percent funded; see above) or a plan that has terminated without having sufficient assets to pay all benefits.

The bill would deny an employer a deduction for “gross ups” intended to cover penalties incurred by prohibited funding of nonqualified arrangements.⁵

Title II--Funding Rules for Multiemployer Defined Benefit Plans and Related Provisions.

Multiemployer plans are subject to the same general funding rules as single-employer plans except that longer amortization periods apply to multiemployer plans than to single-employer plans. The bill would retain the funding standard account approach under current law for multiemployer plans but reduce longer amortization periods to 15 years and allow the plan to stop using the shortfall method. A multiemployer plan could get an automatic five-year amortization extension, and another five years with IRS approval. The amortization extension interest is the funding rate but the old rate is grandfathered for extensions under applications filed before June 30, 2005.⁶

The bill would add new funding rules for multiemployer plans that are in endangered, seriously endangered, or critical status, including some relief from excise taxes for an accumulated funding deficiency. Status generally would be based on current funding percentages and projected accumulated funding deficiencies. A plan less than 80 percent funded is in endangered status, and if the plan has an accumulated funding deficiency for six succeeding plan years, the plan is in seriously endangered status. A plan less than 65 percent funded is in critical status. Endangered (and seriously endangered) plans must develop funding improvement plans that will increase the plan's funding percentage over 10 or 15 years. Critical plans must adopt a rehabilitation plan that sets goals for how the plan will get out of critical status within 10 years.⁷

The bill would expand from three to five years the time multiemployer plans in reorganization must determine whether they will be insolvent.⁸

Employers withdrawing from multiemployer pension plans are subject to withdrawal liability. The bill would repeal the limitation on the withdrawal liability of insolvent employers and would update the rules relating to limitations on withdrawal liability based on the company's net worth, effective for sales beginning in 2007. The bill also would address withdrawal liability if work is contracted out (effective for work after the date of enactment); would make the employer participation rules available for building and construction trade plans; would amend the fresh start option rules for calculating withdrawal liability (effective for withdrawals after 2006); and would change the withdrawal liability payment rules if the plan alleges a transaction was undertaken to evade or avoid withdrawal liability.⁹

The bill would extend the ERISA retaliation prohibition against participants for enforcing their ERISA rights to contributing employers of multiemployer plans.¹⁰

The bill would provide an exception from the new multiemployer plan rules for benefit increases made pursuant to an agreement with the PBGC prior to June 30, 2005, as long as the increases are funded in accordance with the agreement.¹¹

Multiemployer plans that have an accumulated funding deficiency are subject to an excise tax. The bill would exempt a small, fishery-related multiemployer plan from any excise taxes that accumulate prior to the earlier of the plan adopting a rehabilitation plan or 2009.¹²

The bill would include a sunset provision for the new funding rules for endangered/critical plans and the automatic five-year extension for multiemployer plans. These provisions would sunset in 2014, except that any plan already in endangered or critical status could continue to follow its plan.¹³

Title III--Interest Rate Assumptions.

30-Year Treasury Rates.

Current law requires the use of a 30-year Treasury rate for certain calculations. For 2004 and 2005, a long-term corporate bond interest rate was substituted by the Pension Funding Equity Act of 2005, P.L. 108-218, §101, for the 30-year Treasury rate for plan funding and PBGC premiums. The bill would extend the 2004 and 2005 temporary rates to 2006 and 2007.¹⁴

Interest Rate Assumption for Determination of Lump Sum Distributions.

A plan's lump sum payment under current law to a participant or beneficiary must be no less than the present value of the annuity to which the participant or beneficiary would have been entitled. For this calculation, the plan must use specified interest and mortality assumptions. The interest rate is the rate on 30-year Treasury bonds.

The bill would require that the plan calculate lump sum values using a three-segment yield curve. The yield curve value would be phased in over five years at 20 percent per year, and the remainder would be based on the existing methodology. The phase in would start in 2008, and in 2012 the yield curve would be fully phased-in. The yield curve would be based on a monthly interest rate not the funding yield curve's 24-month average.¹⁵

Interest Rate Assumption for Applying Benefit Limitations to Lump Sum Distributions.

The maximum benefit a participant may accrue and receive under current law is stated in terms of an annuity. The tax code specifies a minimum interest rate that may be used for conversion to other forms of payment. The permanent rate is the same as the rate for minimum lump sums. However, the Pension Funding Equity Act of 2005, P.L. 108-218, §101, temporarily provided (through 2005) for a conversion at 5.5 percent.

The bill would provide that the rate cannot be less than the greater of 5.5 percent, 105 percent of the minimum distribution interest rate, or the rate specified in the plan.¹⁶

¹ Bill §§102, 112; ERISA §303;I.R.C. §430 (new). Effective for plan years beginning after Dec. 31, 2007.

² Bill §§101, 111; ERISA §302;I.R.C. §412. Effective for plan years beginning after Dec. 31, 2007.

³ Bill §§103, 113; ERISA §206(g);I.R.C. §436 (new). Generally effective for plan years beginning after Dec. 31, 2007.

⁴ Bill §§104, 105, 106 and 115. Generally effective upon enactment.

⁵ Bill §116;I.R.C. §409A. Effective as of date of enactment.

⁶ Bill §§201, 211; ERISA §304;I.R.C. §431 (new). Effective for plan years beginning after Dec. 31, 2007.

⁷ Bill §§202, 212; ERISA §305;I.R.C. §432 (new). Effective for plan years beginning in after Dec. 31, 2007.

⁸ Bill §§203, 213; ERISA §4245;I.R.C. §418E. Effective for plan years beginning after Dec. 31, 2007.

⁹ Bill §204; ERISA §§4225, 4205, 4210, 4211, 4221.

¹⁰ Bill §205; ERISA §510. Effective on the date of enactment.

¹¹ Bill §206.

¹² Bill §214.

¹³ Bill §221.

¹⁴ Bill §301; ERISA §§302, 4006;I.R.C. §412. Effective on the date of enactment.

¹⁵ Bill §302; ERISA §205(g);I.R.C. §417(e). Effective for plan years beginning after Dec. 31, 2007.

¹⁶ Bill §303;I.R.C. §415. Effective for distributions made in years beginning after Dec. 31, 2005.