It’s enough to make even the most seasoned human resources professional dizzy.
The Pension Protection Act of 2006 that was signed into law last month not only amends the Employee Retirement Income Security Act but the U.S. tax code all to establish new minimum funding standards for employer defined-benefit pension plans. It also seeks to clear up murkiness in how retirement plans can be structured, a confusion that has left companies open to lawsuits.
But while employer groups have generally applauded the changes to the ERISA law, it all can be confusing. What follows is a primer that covers the essential elements of the act.
The Big Picture
Under the law, companies are expected to fund 100 percent of their pension commitments, up from 90 percent. And to shore up worker safety nets, the law encourages employers to strengthen their 401(k) defined contribution plans.
In return, the legislation gives employers time to do so: Most have seven years to fully fund their obligations, with airlines in bankruptcy proceedings that have frozen their pensions getting an additional 10 years. Airlines with active plans also get 10 years instead of seven to meet their obligations.
The law further requires companies to give employees more information about their pensions. It also puts their pension obligations before other compensation provisions. For example, underfunded companies will have a harder time fulfilling any “golden parachute” clauses in an executive’s employment contract that promise generous benefits if a company is acquired and the executive’s employment is terminated. The restrictions will apply to the rank and file as well: Employers and unions won’t be able to promise higher benefits when a pension is underfunded.
Employer groups received a big benefit in the legislation when “cash balance” hybrid plans which have been growing in popularity and are similar to a 401(k) but with some traditional pensions’ features were given greater protection from age-discrimination and other liability challenges.
Defined Contribution Changes
A key change regarding defined contribution plans encourages employers to automatically enroll workers in a 401(k) plan, with the onus on the employee to opt out of the program. Currently, it is up to employees to opt in and thus at least a third of workers don’t enroll. In addition, there is a process for gradually increasing the amount saved, and employers get incentives to match some of the money that workers put in the plan.
The law also allows plan providers chosen by the employer to offer investment advice to workers, with safeguards against conflicts of interest; any manager who recommends financial products and receives commissions must rely on computer-generated recommendations.
The law also:
-Enables people to put more money in their IRA and 401(k) accounts. That includes a new option, Roth 401(k)s, that became available this year. Similar to a Roth Individual Retirement Account, the plans have workers pay tax on their earnings before saving, but the money accumulates and can be spent tax free in retirement.
-Makes permanent higher annual contribution limits that were set to expire in the next decade, and allows future adjustments for inflation. IRAs and Simple IRA plans (which allow employer contributions and are often used by small businesses) are included. For 401(k)’s the limits are $15,000, for Simple plans $10,000 and for IRA’s $4,000, and up to $5,000 in 2008.
-Makes permanent additional contributions, known as catch-up contributions, for employees age 50 and older. The catch-ups are $1,000 for IRA’s, $2,500 for Simple IRA plans and $5,000 for 401(k)’s in 2006. The law provides for potential inflation adjustments to the Simple IRA and 401(k) limits in future years.
-Employers with 100 or fewer employees that offer new plans can take a tax credit of up to $500 a year per employee for each of the first three years for pension plan startup costs.
-There’s also clarification of the “safest available annuity” standard, which makes it easier for a 401(k) or other retirement plan to offer an annuity distribution option for retirees who have limited time to monitor their account asset allocation.
-Allows workers to leave benefits to a domestic partner or dependent, not just a spouse. And workers could draw on retirement funds for medical or financial emergencies involving domestic partners or other beneficiaries.
-Prevents employers from forcing workers to invest too heavily in company stock rather than in more diversified holdings.
