Dale R. Vlasek
McDonald Hopkins LLC
P: (216) 348-5452
E: dvlasek@mcdonaldhopkins

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The Pension Protection Act of 2006 (“PPA”) is a significant revision of the Internal Revenue Code (“Code”) and the Employee Retirement Income Security Act of 1974 (“ERISA”) as it relates to the required funding of retirement plans and the design of the type of defined benefit plans known as cash balance plans. In addition, the PPA made numerous technical revisions to how retirement plans must operate. The following highlights only a few of the more pertinent revisions.

PPA Funding Requirements

The PPA was enacted in part to strengthen the funding of defined benefit pension plans. It does so by drastically revising how employers calculate their obligations to fund their plans and by adding significant restrictions on under-funded plans.

Under the PPA’s new funding rules, if a Plan’s assets fall below 100% of the present value of current benefit liability, the employer must make a minimum contribution which needs to cover the shortfall between the assets and current liabilities as well as enough to cover both present value of benefits expected to accrue in the plan year and benefit increases in past service benefits attributable to increases in compensation. Although these new rules are phased in, they will drastically increase the mandatory funding levels for all defined benefit plans.

In addition, PPA mandated the use of an interest rate for funding purposes and benefit calculations and conversion based on a segmented yield curve using 24-month average of investment grade bonds of varying maturities.

Benefit Restrictions

In addition, the PPA requires that plans which fall below certain funding levels restrict the forms of benefit payments and if funding falls too low actually cease additional benefit accruals.

A plan must monitor its “Adjusted Funding Target Percentage” (“AFTAP”). This is the ratio of the plan’s asset value to the plan’s benefits accrued as of the valuation date. If the AFTAP ratio is 80% or more there are no restrictions. But if it drops below 80%, PPA mandates certain restrictions which become more severe as the ratio drops.

*Limited exception for benefits not based on compensation.
**Accelerated benefits are limited to one-half of the participant’s benefit or one-half of the Pension Benefit Guaranty Corporation’s minimum guaranteed benefit, if greater.

Cash Balance Plans

In addition to revisions to the funding rules, the PPA legitimized “cash balance” defined benefit plans. Very simplistically, cash balance plans are defined benefit plans that have the look and feel of defined contribution plans. Each participant has a hypothetical account which is credited with allocations each year based on the Plan’s formula. This is based on a percentage of compensation. The hypothetical account is also credited annually with hypothetical “earnings.” The total of all the annual allocations increased by the amount hypothetical earnings is effectively the benefit to be paid as a lump sum to the participant. Of course, as defined benefit plans, the law requires to normal form of benefit to be at least a Joint and 50% Survivor annuity. The hypothetical account would be converted into an annuity unless the participant and the participant’s spouse consents to the lump sum payment.

A number of lawsuits had previously been filed challenging cash balance plans that were created by converting existing traditional defined benefit plans into the cash balance plans. PPA provides employers with the blue print of how to design cash balance plans to avoid such challenges. Specifically, PPA lays out the rules for what are technically called “statutory hybrid” plans. Cash balance plans that satisfy the conditions to be “statutory hybrid plans” have a recognized and approved status under the Code.

EGTRRA Limits Permanent

Finally, PPA made the so-call EGTRRA limits permanent. The Economic Growth and Tax Relief and Reconciliation Act (“EGTRRA”) temporarily increased various limits governing retirement plans. The most notable increases for qualified retirement plans are:

These limits, as well as some others, were set to expire for Plan Years beginning in 2011. The limits would have all reverted back to the 2001 limits. This would have been a major cut back in the level of contributions and benefits permitted in Plans. PPA makes the changes “permanent” in that they will not automatically revert back to the pre- EGTRRA limits in 2011.

As an editorial note, with the pressure to balance the budget without appearing to directly raise taxes, it is always possible Congress will reduce these Plan limits. It has happened before. For example, the last time the dollar limit under Code Section 415 was anywhere near as high as the current $49,000 limit was in 1982 when it was $45,475. The Tax Equality and Fiscal Responsibility Act of 1982 (“TEFRA”) reduced the dollar limit to $30,000, a 34% reduction. It stayed at $30,000 for 17 years until the cost of living adjustment finally increased it to $35,000.

Congress could automatically enact a similar reduction of the $49,000 limit. The impact would fall mostly on the higher paid employees who could potentially have a contribution of that amount. This is just one item to watch.

Conclusion

PPA made major revisions to the rules governing qualified retirement plans. The bulk of the revisions are changes which need to be addressed by defined benefit plan sponsors and their actuaries. Defined benefit plan sponsors will need to fund benefit shortfalls more quickly than in the past and monitor funding ratios to avoid benefit payment restrictions and ultimately a mandatory benefit freeze.

The PPA gives cash balance plan sponsors guidance on how to design cash balance plans that should survive any challenges to the concept of such programs as well as guidance on how to operate them under the specific provisions of the Code.

Finally, PPA gives defined contribution plan sponsors some confidence that the EGTRRA limit increases are “permanent” and the larger contributions which have been made can continue to be made in 2011 and thereafter.

©McDonald Hopkins LLC (2009) Dale Vlasek