Your Retirement

June 18, 2007       Eddie Adkins      

The Pension Protection Act of 2006 (PPA), which was signed into law by President George W. Bush this past August, contains provisions that affect nonprofit organizations.

As its major thrust, the PPA brings about significant changes related to retirement plans. The primary objectives of the PPA are to strengthen the funding of defined benefit pension plans by imposing stricter funding requirements, and to encourage greater participation by employees in defined contribution plans through automatic enrollment procedures. The PPA also resolves some long-standing controversies regarding cash balance plans, at least on a prospective basis.

The PPA includes provisions that will facilitate your use of automatic enrollment in 401(k) and 403(b) plans. When you use automatic enrollment, a prescribed percentage of an employee’s pay is automatically withdrawn from the person’s paycheck. If your employee does not wish to participate in the plan, the employee must affirmatively opt out of the plan. Surveys indicate that participation and contribution rates are significantly higher in plans that use automatic enrollment than in plans that do not use this approach.

Under current law, some employers have implemented automatic enrollment, but many have not done so, due at least in part to concerns about state laws that prohibited automatic deductions from pay. Effective August 17, 2006, all state laws that prohibit automatic enrollment are preempted by Federal law.

In addition, the PPA directed the U.S. Department of Labor (DOL) to issue regulations related to default investments that apply when an employee is automatically enrolled. The DOL issued the proposed regulations in September. Under these regulations, you may use a “life cycle” or “targeted retirement date” fund as a default investment. These funds use a mix of equity and fixed income investments based on the participant’s age, target retirement date or life expectancy. Several mutual fund companies currently offer these funds.

Alternatively, under the proposed regulations, your plan can provide that an investment manager will create the type of investment mix described above for each of your participants, rather than using a fund made available through a mutual fund company. A final alternative under the regulations allows your plan to use a default investment that is based on the same criteria as above, but using the demographics of all your plan participants taken as whole, rather than for each participant individually.

The DOL plans to finalize the regulations in early 2007, and it is possible that they will make changes, based on comments that they are receiving. For example, several commentators are unhappy that less risky funds, such as stable value funds, are not included in the regulations as an acceptable default investment.

Starting in 2008 (plan years beginning after December 31, 2007), if your plan offers automatic enrollment and meets certain requirements, you will be exempt from the usual nondiscrimination tests that apply to your employees’ elective deferrals in a 401(k) plan and your matching contributions in a 401(k) or 403(b) plan (commonly referred to as the “ADP” and “ACP” tests).

These requirements include a range of automatic enrollment contribution percentages that your plan must use (starting at 3 percent the first year the employee is in the plan, and increasing to 6 percent for the fourth year and beyond), a minimum level of employer matching contributions (100 percent on the first 1 percent of compensation contributed by the employee, and 50 percent on the next 5 percent), and minimum vesting requirements (100 percent vesting after two years of service).

As an alternative to matching contributions, you can simply contribute 3 percent of compensation on behalf of each eligible employee. Implementing the PPA safe harbor will relieve you of the considerable aggravation of calculating and passing the nondiscrimination tests. However, you will want to consider whether it is worth it to use the safe harbor, given the fact that the safe harbor requires you to make contributions to the plan on behalf of your employees.

As you might know, another safe harbor to avoid the nondiscrimination tests has existed for several years. You may implement either the new safe harbor or the old safe harbor, and you will not be subject to the nondiscrimination tests. However, when compared to the new safe harbor discussed above, the old safe harbor requires higher, more front-loaded matching contributions (100 percent on the first 3 percent of compensation contributed by the employee, and 50 percent on the next 2 percent).

The alternative, non-matching contribution is the same under both safe harbors (3 percent of your employees’ compensation). The old safe harbor also requires immediate vesting, compared to two-year vesting under the new safe harbor. This will cause the old safe harbor to be more expensive than the new safe harbor in organizations with high turnover. Also, the two-year vesting schedule under the new safe harbor provides more of an incentive than the old safe harbor for your employees to continue working for you.

Under current law, prohibited transaction rules preclude plan fiduciaries from giving investment advice to plan participants. The PPA creates an exemption from these rules. Starting in 2007, plan fiduciaries can provide investment advice to plan participants by using a computer model, or by other means as long as the investment advisor’s compensation does not vary based on the investments that are selected.

Your employees’ own salary deferral contributions are always 100 percent vested. However, the contributions you make as an employer can be subject to a vesting schedule. The PPA creates two alternative vesting schedules. Your defined contribution plan’s vesting schedule must provide for vesting that is at least as rapid of one of the alternative schedules.

The first schedule provides that your plan participants will have no vesting until three years of service, at which time they will be 100 percent vested. Current law contains a similar vesting schedule, but uses a five-year period rather than three years. The second alternative schedule provides for no vesting until your plan participants have two years of service, at which time they are 20 percent vested. Your participants then vest an additional 20 percent per year, so that they are fully vested after six years of service.

Current law contains a similar schedule, but the vesting does not commence until three years of service. The PPA’s vesting schedule is already required under current law for matching contributions. Thus, the PPA has adopted the existing matching contribution vesting schedule for all contributions.

Effective for plan years beginning after December 31, 2006, you must provide a benefit statement each quarter if your plan allows participants to direct the investment of assets in their accounts. If your participants do not have this right, then your must provide a benefit statement annually. Benefit statements are typically prepared by a mutual fund company, investment firm, or other investment manager that holds the investments and administers the plan. Many plans already meet the PPA benefit statement requirements. However, your plan administrator should review the statements to make sure all of the required information is included.

Under current law, your 401(k), 403(b), and 457 plans may provide that distributions will be made as a result of a hardship or unforeseeable emergency on the part of your plan participants, as well as their spouses and dependents. The PPA expands these distributions, effective immediately, to include hardships and unforeseen financial emergencies of any plan beneficiary, including those who are not a spouse or dependent of the participant.

If you have between two and 500 employees, you can create a combined defined benefit and 401(k) plan, starting in 2010. You will pay lower administrative costs by maintaining a combined plan, versus maintaining separate plans. This is the case because the assets are in a single trust, and you have to file only one Form 5500. However, in the long run, the combined plan could be more expensive, because maintaining a combined plan is conditioned upon providing a certain level of benefits.

The defined benefit portion of the plan must provide a benefit that is at least equal to 1 percent of each employee’s final average pay times years of service, with a maximum required benefit of 20 percent of final average pay. The PPA sets forth an alternative benefit formula that you may use, where each year’s benefit accrual is based on the employee’s age as of the beginning of the year. The 401(k) portion of the plan must provide for automatic enrollment at a contribution rate of 4 percent of pay.

You must make a matching contribution equal to 50 percent of the employee’s contribution, on the first 4 percent of pay that the employee contributes to the plan. The matching contribution must be fully vested. Given all of these conditions, along with the general trend away from defined benefit plans, many organizations will probably not elect to maintain a combined plan.

PThe PPA repeals the sunset provisions of EGTRRA with respect to EGTRRA’s pension provisions. Thus, these provisions become permanent. The provisions include the following:

  • Increases in the limits on contributions, benefits and compensation under qualified retirement plans, tax-sheltered annuities, and section 457(b) plans;
  • Retirement plan catch-up contributions for individuals age 50 and older;
  • Ability to treat 401(k) and 403(b) elective deferrals as after-tax Roth contributions.

The changes to retirement plans brought about by the PPA are substantial. Employers must consider the impact of each change on their plans. A good starting point is for you to focus on the changes that have already gone into effect. For example, the automatic enrollment provisions for 401(k) and 403(b) plans are already in effect, so you may want to convert your plan to automatic enrollment. The new hardship distribution rules are also already in effect, so you may wish to provide for hardship distributions to beneficiaries who are neither the spouse nor the dependent of the plan participant.

Additional provisions of the PPA went into effect in 2007. Some of these provisions are mandatory, whereas others are elective. For example, your defined contribution plans must adopt a faster vesting schedule in 2007. In addition, you may wish to consider offering investment advice to your participants. Finally, you must meet the new requirements for benefit statements, starting in 2007.

Fortunately, you do not have to amend your plans right away, even though some of the PPA changes are already in effect, or will go into effect shortly. You have until 2009 (i.e., the last day of the first plan year that begins on or after January 1, 2009) to amend your plans to reflect the PPA provisions. *** Eddie Adkins is the compensation and benefits partner Grant Thornton’s national tax office practice in Washington, D.C. His email is eddie.adkins at gt.com. Harvey Berger is a retired tax partner with Grant Thornton and currently serves as a consultant on nonprofit tax issues. His email is harvey.berger@gt.com. Greg Goller is Grant Thornton’s National Partner-in-Charge of Not-for-Profit Tax Services and is based in the Washington, D.C. area office. His email is greg.goller@gt.com