Retirement Plan Blog

The Pension Protection Act of 2006 makes significant changes affecting 401(k) plans - for the most part favorable to plan sponsors and participants.

Here is a summary of those changes effective in 2007:

• Increased 401(k) Limits. For 2007, the annual limit for 401(k) contribution increases to $15,500. The catch-up for age 50 and older remains at $5,000.
  

• Default Investments. Beginning after January 1, 2007, the Act permits the use of default investment choices beyond money market and stable value funds that plan sponsors can use for employees who do not make investment elections. The Department of Labor issued proposed regulations late last year which will be finalized soon.

• Investment Advice. Beginning after January 1, 2007 the Act encourages plan sponsors to make investment advice available to 401(k participants. There will be much to comment upon later this year.
  

• Faster Vesting of Employer Non-Elective Contributions. Effective in 2007, employer non-elective contributions, i.e., profit sharing, must vest according to rules applicable to matching contributions: no less favorable than either 3-year cliff vesting (100% vested after 3 years of service), or 6-year graded vesting (20% after two years, 20% a year thereafter, 100% after six or more years).
  

• More Frequent Benefit Statements. Effective in 2007, the new law requires that Plan Administrators must provide a benefit statement: 1) at least once a quarter to participants in plans in which they can self-direct their accounts, 2) at least once a year to participants in plans in which they cannot self-direct the investment of their accounts, and 3)upon request to any beneficiary.
  

• Diversification of Investments in Employer Stock.  Effective in 2007, participants must be given the right to diversify their investments in employer stock. Exceptions to the new law are provided for certain privately-held companies and Employee Stock Ownership Plans.
  

President Ford signing the Employee Retirement Income Security Act (ERISA) on September 2, 1974.

Just like Sergio Leone's classic 1966 movie, 2006 will indeed be memorable.

And so with apologies to Mr. Leone and Clint Eastwood, here are my 2006 choices for the Good, the Bad, and the Ugly in Pensionland:

• The Good: The passage of the Pension Protection Act of 2006 (PPA). The new law makes significant changes to practically every retirement plan in which approximately 44 million people are participants. The 900 page bill affects all types of retirement plans including defined benefit plans, profit sharing and 401(k) plans, cash balance plans, and employee stock ownership plans (ESOPs). Most of the changes are effective in 2007 and 2008 but some are retroactive or delayed. The PPA significantly enhances 401(k) plans - now the retirement plan of choice by corporate America.

• The Bad: The decline of the defined benefit plan system. While defined benefit pension plans were on the rocks prior to 2006, there was a “perfect storm” this year. A combination of new accounting regulations, rising interest rates, uncertainty in the financial markets and escalating premiums to the Pension Benefit Guaranty Corporation is causing an acceleration of defined benefit pension plans being terminated and frozen. Will 401(k) plans fill the void?

• The Ugly: the increasing number of scams and outright thefts from retirement plans. Sizeable account balances and the Boomers starting to retire have become targets. While the numbers are relatively small, they can have a profound impact on plan participants and retirees. The regulatory agencies - the National Association of Security Dealers, the New York Stock Exchange, and the Department of Labor - are ramping up their enforcement activities to deal with this growing problem. 

It’s complicated, but in brief, the Pension Protection Act of 2006 allows donors to exclude up to $100,000 per year in gross income for what would otherwise be a taxable distribution from traditional IRAs and Roth IRAs for “qualified charitable distributions”. The new tax benefit is only good for 2006 and 2007 if made by an IRA owner who is at least 70½ years old on the date of the distribution to the charity.

As with all tax laws, there is lots of fine print. Marc D. Hoffman, Editor-In-Chief of the Planned Giving Design Center, provides an excellent guide to the new law in question and answer format in his article, The Pension Protection Act of 2006: A Guide to Charitable IRA Rollovers.

One of those year-end retirement plan housekeeping matters is for plan sponsors to review the adequacy of the plan's fidelity bond required by Department of Labor (DoL) regulations. Here is a summary of the fidelity bond rules.

Overview

A fidelity bond is required to protect the assets in a retirement plan from misuse or misappropriation by the plan fiduciaries. In other words, intentional acts of fraud or dishonesty by a fiduciary who is a trustee and  any person who has:

• Physical contact with cash, checks or other Plan property.
• Power to transfer or negotiate Plan property for a price.
• Power to disburse funds, sign checks or produce negotiable instruments from the Plan assets.
• Decision making authority over any individual described above.

1. Maximum Amount. The new Pension Protection Act of 2006 increases the maximum bond amount to $1 million for retirement plans that hold employer stock or other employer securities. A retirement plan would not generally be considered to hold employer stock or other employer securities if these assets are part of a broadly diversified group of assets such as mutual funds. The new bonding provision is effective for plan years beginning on and after January 1, 2007.
2.  Non-Qualifying Assets. If more than 5% of the plan assets are in limited partnerships, artwork, collectibles, mortgages, real estate or securities of "closely-held" companies and are held outside of regulated institutions such as a bank; an insurance company; a registered broker-dealer or other organization authorized to act as trustee for individual retirement accounts under Internal Revenue Code Section 408, the plan sponsors need to do one of two things: a) make certain that the bond amount is equal to 100% of the value of these "non-qualified" assets or b) arrange for an annual full-scope audit, where the CPA physically confirms the existence of the assets at the start and end of the plan year.

There can be serious consequences for not purchasing and maintaining a sufficient ERISA fidelity bond.

1. It can be a red flag to the DoL that they need to take a closer look at the plan.
   
2. In cases where a retirement plan has more than 5% in non-qualified assets, a serious underwriting risk may arise if the non-qualified assets are not properly listed on the bond application. This is because non-qualifying assets carry a higher level of risk for loss. If the non-qualified assets are not listed on the bond, the underwriter would have cause to deny coverage if there was a loss due to misuse or misappropriation by a plan fiduciary. Under those circumstances, the loss may be denied and the trustees could be liable for the losses to the plan.

“It” refers to the Pension Protection Act of 2006 which provides fiduciary relief in several areas. This relief includes:

• Investment Advice. Many plan sponsors were previously reluctant to add an investment advice component to their 401(k) plans. The Act specifically permits qualified fiduciary advisers to deliver personally-tailored investment advice to participants in 401(k) plans and other tax-advantaged savings vehicles. This is effective after December 31, 2006.

• Default Investments. If a participant failed to make an investment election, most 401(k) plans used a money market or stable value fund as a default fund because of fiduciary liability concerns. The Act provides for a safe harbor subject to Department of Labor (DoL) regulation. The DoL’s recently issued proposed regulation permits the default fund to be either an asset allocation fund, target-maturity fund, or professionally managed fund.

• Blackout Periods and Mapping. The Act provides fiduciary relief during a “blackout period” including fund “mapping” if DoL prescribed conditions are met. A blackout period occurs when fund investments are changed, and a participant has limited or no ability to make fund changes. Mapping is that process in which a participant’s funds are transferred to similar mutual funds as determined by asset category, class and investment style. This is effective for plan years beginning after December 31, 2007.

A recent study by implication supports the use of asset allocation and lifestyle funds as default funds which were those designated in the Department of Labor's recent proposed regulation.

The study by Tekeshi Yamaguchi, Olivia S. Mitchell, Gary Mottola, and Stephen P. Utkus, "Winners and Losers: 401(k) Trading and Portfolio Performance" (October 2006) for the Pension Research Council  found that::

... in aggregate, the risk-adjusted returns of traders are no different than those of nontraders. Yet certain types of trading such as periodic rebalancing are beneficial, while high-turnover trading is costly. Interestingly, those who hold only balanced or lifecycle funds, whom we call passive rebalancers, earn the highest risk-adjusted returns  (emphasis supplied).

Hat tip to Barry Barnitz' Financial page blog which links through to the entire article.

From its humble beginning in 1974 as part of the Employee Retirement Income Security Act of (ERISA), the Individual Retirement Account along with cousins Roth, SEP, and SIMPLE, has grown up. It's now an increasingly important investment vehicle for retirement savings and tax planning. And it will become even more so as the Boomers start retiring.

In just 5 short years since the passage of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) in 2001, we have seen some significant - and positive - changes in the tax laws that affect IRAs with more to take effect between now and 2010. These include:

• Portability between IRAs and qualified retirement plans.
• Increased IRA contribution limits including the addition of a catch-up.
• Roth 401(k) option starting in 2006.
• IRA distribution to charity for donors over age 70½ for 2006 and 2007.
• Rollover to an IRA from a qualified retirement plan by a non-spouse beneficiary beginning in 2007.
• Direct transfer of tax refund to an IRA starting in 2007.
• Direct rollover to a Roth IRA from a qualified retirement plan beginning in 2008.
• Elimination of the Roth IRA income restriction for converting a traditional IRA to a Roth IRA starting in 2010.

For an excellent history of the IRA, download a copy of The Individual Retirement Account at Age 30: A Retrospective (24 pages PDF) published in 2005 by the Investment Company Institute, the national association of the U.S. investment company industry, i.e, mutual fund companies.

Right after the Pension Protection Act of 2006 was passed, I read comments that the new Act would help employees by removing uncertainty about funding, and it would avoid pension plan terminations and freezes.

Not!

A Quick Poll recently released by SEI revealed that almost a third (29%) of the employers polled said that they will either close, freeze or terminate their pensions by the end of 2007. If that were to occur, 52% of all US and Canadian plans polled will be closed, frozen or terminated by the end of 2007.

We can expect to see freezes become much more common in the last quarter of 2006 as employers prepare to comply with new accounting rules that put pension obligations directly on their balance sheets.

The emergence of pension plan freezes (a cessation of future benefit accruals in an existing pension plan) apparently engendered the Pension Villain's Elegy on the Pensions & Benefits Weblog.

The risk’s not worth the burden. Time to freeze.
But not to worry: we have a great 401(k)!
This cut will benefit our employees.

FAS 158 gives our balance sheet the squeeze
While our cash projections wobble from PPA.
The risk’s not worth the burden. Time to freeze.

Our workers need to be their own trustees.
Just educate them; they’ll learn to find their way.
So this cut will benefit our employees.

Our old plan’s tangled up in legalese.
The DB pension system’s seen its day.
The risk’s not worth the burden. Time to freeze.

Our competition’s boosted their DCs,
And what works for Wall Street’s good for the U.S.A.
This cut will benefit our employees.

We know you thought we promised more, but please,
Eventually as a hybrid plan we may.
The risk’s not worth the burden. Time to freeze,
And this cut will benefit our employees.

Should we benefit people start using the term 401(k)world instead of Pensionland?

"GUARDIAN UNIVERSITY"
Tuesday, November 7, 2006

Lanny D. Levin Agency, Inc,
presents

Pension Protection Act of 2006:
Challenges and Opportunities
(3 hours CE credit applied for)

Speakers:
Jerry Kalish, National Benefit Services, Inc.
Lanny D. Levin, CLU, ChFC, LANNY D. LEVIN AGENCY, Inc.

Some of the topics:

• Extension of EGTRRA Provisions
• Retirement Plan Provisions
• Long Term Care Provisions
• New 401(k) Safe Harbors
• New Rules on Taxation of Employer-Owned Life Insurance
• Charitable Rollover Rules
• New Distribution Rules for Non-Spousal Beneficiaries

Here is the link to the registration form (PDF), or
Call Phyllis Scholnick (847) 266-2243 or Email phyllis_scholnick@levinagency.com

As we know, the recently issued proposed 401(k) default investment regulations by the Department of Labor (DoL) allows 401(k) plan sponsors to select default investments funds that strive to achieve long-term capital appreciation as opposed to mere preservation of capital.

But what was the DoL's basis for permitting the use of investments other than the historically selected money market and stability of principal funds?

The DoL used  a simulation model to estimate the impact of the proposed 401(k) default investment regulations on retirement savings in the U.S. The model, called PENSIM, was developed by the firm Policy Simulation Group that specializes in the use of computer simulation models to estimate the implications of private sector and public sector policies in the areas of portfolio management, health insurance and pensions.

For you policy wonks - and actuaries - in the crowd, here is a link to the 231 page PDF Overview of PENSIM.

Hat tip to Prudence Mann's Fiduciary Investor blog.

The picture shown above is a screenshot of a title screen from The Investment Simulation Spreadsheet developed and copyrighted by Tom O'Haver, University of Maryland. It is believed that the use of a limited number of web-resolution screenshots qualifies as fair use under United States copyright law, as such display does not significantly impede the right of the copyright holder to sell the copyrighted material, is not being used to turn a profit in this context, and presents ideas that cannot be exhibited otherwise.

A lot if Vanguard's experience with providing on-line financial plans for individual investors is a guide. According to Investment News, Vanguard is now providing 4,000 new plans a month - up from 15,000 for all of last year.

Here is the link to the Investment News article.

Investment News reports that investment advisors are not altogether happy about the Pension Protection Act (PPA) provision that provides fiduciary relief for providing investment advice to 401(k) participants.

The reason? The PPA's fee restrictions on face-to-face advice. Their lobbyists, says Investment News, are trying to convince Congress that the restrictions in the Act were a mistake and should be fixed in a follow up technical corrections  bill before Congress adjourns for the year - and before the January 1, 2007 effective date.

But critics of the move see the price cap as a deliberate component of a legislative compromise - one that should remain in effect.

To be continued.

Here is the  link to the Investment  News article.

That's the subject of a recent study by Vanguard Retirement Research, the results of which were that nearly two-thirds of participants adopting a managed account advisory service saw a sharp increase in their equity exposure. Expected returns rose by 82 basis points (after fund expenses but before any managed account fee), while Sharpe ratios improved by 22%.

The January 1, 2007 effective data is fast approaching for the Pension Protection Act provision that provides fiduciary relief to plan sponsors who make investment advice available to 401(k) plan participants. Whether plan sponsors should, however, is a blog post for another day.

In the meantime, here is the link to Vanguard's study (PDF).

Hat tip to Barry Barnitz' Financial page.

One thing we can say for sure about new ERISA legislation. It does create more acronyms. Like for instance QDIA which is Pensionland shorthand for Qualified Default Investment Account.

So attorney B. Janelle Grenier will be adding one more to her 160 plus and counting Benefits Acronym Lexicon.

More to follow.

The Department of Labor (DoL) issued the first regulation under the Pension Protection Act of 2006 (PPA) which deals with what is a permissible default fund.

The PPA provides a safe harbor for plan fiduciaries investing participant assets in certain types of default investment alternatives in the absence of participant investment direction. The regulation provides fiduciary relief if the fund is a qualified default investment account (QDIA) as defined in the proposed regulation. As expected, the default fund could have equity exposure as in a:

• Targeted-retirement-date fund;
• Balanced fund; or
• Professionally managed account

Plan fiduciaries still have responsibility for the selection and monitoring of the QDIA.

Here is the link to the DoL's Fact Sheet that summarizes the proposed regulation.

The sun will not be setting after all on the favorable retirement plan tax provisions that were part of the Economic Growth and Tax Reconciliation Act of 2001 (EGTRRA).

For budget scoring purposes, the more than three dozen rules which included increases to contribution and benefit limits for IRAs and qualified retirement plans had “sunset” provisions which were set to expire on December 31, 2010. (Budget scoring is the process of calculating the budgetary effects of pending and enacted legislation and assessing their impact on the targets or limits in the budget resolution).

The new Pension Protection Act of 2006 (PPA) now makes permanent the EGTRRA rules. One result of which is to allow participants in defined contribution plans to make larger contributions in the future. Such as:

• 401(k) limit now $15,000 in 2006 would have been reduced to $13,500 in 2011.
• 401(k) catch-up (age 50+) now $5,000 in 2006 would have been totally eliminated in 2011.
• IRA limit now $4,000 in 2006 would have been reduced to $2,000 in 2011.
• IRA catch-up (age 50+) now $1,000 in 2006 would have been totally eliminated in 2011.
• SIMPLE IRA limit now $10,000 in 2006 would have been $8,000 in 2011.
• SIMPLE IRA catch-up (age 50+) now $2,500 in 2006 would have been totally eliminated in 2011.

Former President Bill Clinton, whose birthday was yesterday, was heard last week lamenting the fact that he was about to turn age 60. Don’t feel bad, Mr. President, there are another 3 million who will join you this year - part of the first entrants of the baby boom generation. While few of them have retired, they are certainly considering it.

While the financial industry is getting ready to capture those retirement dollars, the new Pension Protection Act of 2006 liberalized distribution and payment options. Some of which are:

• Direct Rollover to Roth IRA. Distributions from a qualified retirement plan generally can not be rolled over to a Roth IRA. The rollover had to be a 2-step process. First, from the qualified retirement plan to a traditional IRA and then to the Roth IRA. Beginning in 2008 a distribution from a qualified retirement plan can be rolled over directly to a Roth IRA provided the current Roth conversion rules are met.
  

• IRA Distribution to Charity. Amounts distributed from IRAs are generally taxed as ordinary income with charitable contributions deductible under special rules. For 2006 and 2007, a tax free distribution of up to $100,000 per year can be made from an IRA directly to charity if three conditions are met: 1) the donor is over age 70 ½ , 2) the distribution would otherwise have been taxable, and 3) the donation cannot be used to increase the allowable deduction for charitable contributions on an individual’s tax return.

• Hardship Rules. Hardship distributions from qualified retirement plans can only be made on account of a financial hardship of the participant. Under the new law hardship distributions from qualified retirement plans can be also be made on account of hardship of the participant’s spouse or dependent. The new law directs the Treasury Department to effectuate this change 180 days after the enactment of the law.

• In-Service Distribution. Pension plans cannot generally make distributions unless the participant terminates employment or reaches the plan’s normal retirement age which is usually age 65. Beginning in 2007, in-service distributions can be made to a participant who attains age 62 and continues to work.

• Rollover by Non-Spouse Beneficiary. Prior law did not permit a non-spouse beneficiary to rollover the participant’s benefit into an IRA. Beginning January 1, 2007, a non-spouse beneficiary can transfer inherited qualified retirement plan benefits into an inherited IRA and adopt tax treatment of the inherited IRA.

That's the amount of new money that  Bloomberg estimates will go into 401(k) plans as a result of the Pension Protection Act of 2006 because the new law:

• Permits automatic enrollment of employees in 401(k) plans
• Allows small employers to establish combined defined benefit and automatic enrollment 401(k) plans
• Makes permanent higher contribution limits for 401(k) plans and IRAs

We’re talking big money. For example, Fidelity alone is expected to see fees for advice increase from $200 million annually to as much as $1 billion.  Bloomberg cites Jim Lowell, editor of the independent trade newsletter Fidelity Investor, as making this estimate.

Potential for conflict of interest? You bet! Let's hope that the regulatory agencies are able to meet the challenge and that plan sponsors learn how to buy - and not be sold - 401(k) services.

The new Pension Protection Act of 2006 opens the door for ERISA fiduciaries - a registered investment advisor, bank, insurance company or broker/dealer - to be compensated for giving investment advice to retirement plan participants. The Act creates a prohibited transaction exemption to these fiduciaries subject to certain safeguards to protect participants from abuse. More on the details at a later date.

With January 1, 2007, the effective date of the prohibited transaction exemption, the marketing process has already started. The investment advice provider will hopefully take the plan's demographics into account. And those demographics, suggests a 2006 study conducted by The Pension Research Council at the Wharton School, are not socio-economic factors but rather “money attitudes” which include:

• Successful Planners  who have a strong, goal-oriented vision of a successful retirement
• Up and Coming Planners who are similar to Successful Planners but don’t have as much confidence about their plans
• Secure Doers who have a strong interest in savings, particularly out of a sense of responsibility or duty towards themselves or others
• Stressed Avoiders who find financial matters to be a source of stress, anxiety and confusion
• Live-for-Today Avoiders who are uninterested in the future

On Thursday, August 3, the Senate passed significant pension reform legislation by a wide margin (93 to 5). The bill enacted by the Senate is identical to the one passed by the House of Representatives last week. The President is expected to sign the bill into law.

The legislation, called the “Pension Protection Act of 2006", makes significant changes to practically every retirement plan in which approximately 44 million people are participants. The 900 page bill affects all types of retirement plans including defined benefit plans, profit sharing and 401(k) plans, cash balance plans, and employee stock ownership plans (ESOPs). Most of the changes are effective in 2007 and 2008 but some are retroactive or delayed.

The Act includes the following provisions:

Defined Contribution Plans

• Encourages automatic enrollment in 401(k) plans
• Permits employees to diversify their company stock accounts among other investments
• Removes the scheduled expiration of increased contribution limits, Roth contributions, and the saver’s credit
• Requires faster vesting of employer profit sharing contributions
• Allows non-spouse beneficiaries to rollover their distributions to IRAs
• Adds new requirements for notice to participants
• Changes the rules for 401(k) providers to provide investment advice to participants
• Resolves major controversies surrounding cash balance plans on a prospective basis

• Requires faster funding of pension obligations
• Allows larger tax deductions based on funded status of the plan
• Changes the method of calculating the lump sum equivalent of annuity benefits
• Requires additional survivor option
• Changes the basis of calculating PBGC premiums
• Allows participants age 62 and older to take in-service distributions
• Permits certain small employers to have defined benefit pension plans with 401(k) provisions