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Pension Protection Act of 2006: Highlights of provisions affecting defined contribution plans

On August 17, 2006, President Bush signed into law the Pension Protection Act of 2006 (Act), a comprehensive reform of the nation’s private retirement system. This summary will explore some of the highlights of the provisions of the 907-page Act that particularly affect defined contribution plans. Subsequent articles will address how the Act affects plan design changes, cash balance plans and the funding of defined benefit plans

Automatic Enrollment in 401(k) Plan
Although the Employment Retirement Income Security Act of 1974 (ERISA) generally preempts state laws that relate to employee benefit plans, it has remained somewhat unclear whether ERISA would preempt state wage and hour laws that arguably could be construed to prohibit employers from withholding a portion of compensation for deferral into a 401(k) plan without an employee’s consent. The Act provides that states cannot regulate the automatic enrollment of participants in 401(k) plans and that ERISA will preempt state wage and hour statutes that would relate to automatic enrollment. Plan sponsors adopting automatic enrollment features to 401(k) plans, however, must comply with the following requirements to qualify for ERISA preemption:

  • Notice Requirement. Plan sponsors must furnish a notice explaining the participant’s right to elect out of automatic enrollment, to alter the amount deferred, as well as the default investment of any amounts deferred in the absence of participant direction.
  • Default Investment. In the absence of participant direction, any amounts deferred under automatic enrollment must be invested under regulations to be issued by the Department of Labor.

Effective after 2007, the Act also creates a new 401(k) nondiscrimination safe-harbor for automatic enrollment plans that comply with certain requirements:

  • Matching Contributions. There is a required minimum matching contribution of (i) 100% of elective deferrals up to 1% of compensation, plus (ii) 50% of elective deferrals between 1% and 6% of compensation. Matching Contributions must be 100% vested after an employee completes two years of service.
  • Deferral Contribution Rate. The automatic deferral contribution rate, which cannot exceed 10%, must be at least 3% during the first year, 4% during the second year, 5% during the third year and 6% during the fourth and ensuing years.

This automatic enrollment safe-harbor is in addition to the nonelective contribution and matching contribution 401(k) safe harbors available under prior law.

  • Excess Contribution Refunds. Automatic enrollment plans subject to standard non-discrimination tests must refund excess contributions within six months after the end of the plan year of testing.

Accelerated Vesting
Effective after 2006, the Act extends an accelerated vesting schedule to all employer non-elective contributions. Accordingly, profit-sharing contributions will need to vest within three years, unless the contributions vest under a six-year graded schedule.

Hardship Withdrawals of Account Beneficiaries The Act directs the Internal Revenue Service to revise the hardship withdrawal rules to provide that, to the extent an event would constitute a “hardship” under a 401(k) plan if it happened to the participant’s spouse or dependent, the event would be a hardship if it happens to a beneficiary with respect to the participant.

Diversification Rights and Investment Advice
Many defined contribution plans permit participants to direct the investment of their account balances among investment funds. Some defined contribution plans either permit or require participants to invest a portion of their account balances in employer stock. With respect to investing in employer stock, the Act creates certain diversification rights that prohibit employers in certain circumstances from requiring the investment of participant account balances in employer stock. The Act also creates an exemption from ERISA’s “prohibited transaction” rules in order to facilitate giving plan participants investment advice and education.

  • Diversification Rights. Effective after 2006, the Act restricts the ability of employers to require the investment of participant account balances in publicly traded employer securities. Any defined contribution plan, except for an employee stock ownership plan (ESOP), that holds publicly traded employer securities, must permit participants to diversify the investment of their account balances from among at least three materially different alternative investment options. All participants must be able to diversify their 401(k) contributions or after-tax contributions. With respect to account balances attributable to employer contributions (e.g., matching contributions or profit-sharing contributions), participants with at least three years of service must be able to diversify the investment of their account balances. For employer stock acquired before 2007, the diversification rules are phased in over three years – except for participants who already have attained age 55 and have completed three years of service. These rules do not apply to pure ESOPs.
  • Prohibited Transaction Exemption for Investment Advice. Effective for advice given after 2006, there is a prohibited transaction exemption under ERISA for plan fiduciaries that are banks, insurance companies or registered investment companies or broker-dealers that give investment advice to participants, provided, among other things, that either (i) the fiduciary’s fee does not vary depending upon an individual participant’s investment choice or (ii) the fiduciary’s advice is based upon a computer model that is certified by an independent third party.

Benefit Statements
Effective after 2006, the Act requires that plan sponsors issue a pension benefit statement that describes the participant’s total benefits accrued (and the amount that is nonforfeitable) and includes an explanation of any permitted disparity provisions or floor-offset arrangements. For participants that do not have the right to direct the investment of their accounts, such a pension benefit statement must be issued once each calendar year. For participants who possess the right to direct the investment of their accounts, such a pension benefit statement must be issued once each quarter. The pension benefit statement should include a statement of the value of any investments (including any held in employer securities), an explanation of any limitations or restrictions on a participant’s investment rights and an explanation of the importance of diversification.

  • Mary G. Eaves

    Mary is a partner with a focus on employee benefits. Her practice includes design and compliance of qualified retirement plans and employee welfare benefit plans, including COBRA, and nonqualified deferred compensation ...



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