On August 17, 2006, the Pension Protection Act of 2006 (“Act”) became law. Although much of the publicity surrounding the Act focused on various defined benefit plan reforms such as modifications to minimum funding requirements and the Pension Benefit Guarantee Corporation premiums, many changes affecting defined contribution plans (e.g., profit sharing and 401(k) Plans) are included in the Act. Following is a summary of some of the changes affecting defined contribution plans.

• Faster Vesting.  All defined contribution plans must accelerate vesting to fit within either the three-year cliff or the six-year graded (2-20; 3-40; 4-60; 5-80; 6-100%) schedules. This change is effective after December 31, 2006.
   
• Automatic Deferral Arrangements. The predominant practice of 401(k) Plans, 403(b) Plans and 457(b) Plans has been to require a participant to make an affirmative election to make elective deferrals by completing a payroll deduction authorization. In some states, employers began to adopt an automatic deferral arrangement under which the employer would automatically deduct a stated percentage of compensation and contribute that deduction to the plan on behalf of the participant, unless the participant made a contrary election. Not all state laws allow payroll deduction in the absence of an employee’s affirmative election. The Act amends ERISA to provide a specific preemption of any state law that would prohibit a plan’s automatic contribution arrangement. The automatic contribution arrangement is one in which:

            (i)   Each participant is treated as having elected to defer to the plan a uniform percentage of compensation unless the participant affirmatively elects no deferral or a different level of deferral of compensation; and

            (ii)  The plan fiduciary investing the assets, invests the automatic deferral contributions in accordance with qualified default investment alternatives or pursuant to the participant’s instructions.
  
  The plan administrator must provide a written notice before the beginning of each plan year to each participant to whom the automatic contribution arrangement applies. Specifically, the notice must advise participants of their right to elect against deferrals or to have a different percentage deferred to the plan. Each participant must have a reasonable period of time after receipt of the notice and before the first automatic deferral to make a contrary election and the notice must explain how the plan will invest the automatic deferrals in the event the participant does not direct the investment. The notice is extremely important. Failure to give appropriate notice may subject the plan administrator to a penalty of $1,100 per day.

• Qualified Reservist Distributions.  The Act allows a member of a National Guard or a reserve unit who is called to active duty for an indefinite period or for more than 179 days the opportunity to receive a distribution from an IRA or elective deferrals from a 401(k), 403(b), or SIMPLE IRA during the period beginning on the date of the orders for active duty and ending at the close of active duty. A plan sponsor may elect not to allow qualified reservist distributions. This is an optional plan distribution event, similar to a plan sponsor choosing to allow hardship distributions. A qualified reservist distribution is not subject to a 10% premature distribution penalty. An individual who receives a qualified reservist distribution has the opportunity to repay the distribution at any time during the two-year period beginning on the later of the day after the end of the active duty period or August 17, 2006. The repayment is not made to the qualified plan, but instead the repayment is made to an IRA. The repayments are not treated as contributions to the IRA, are made with after tax dollars and do not affect the limit on the reservist’s then current IRA contributions.
• IRA Distributions to Charity.  In general, for only 2006 and 2007, the Act provides an exclusion from gross income up to $100,000 in each year for a qualified charitable distribution. In general, this is a direct distribution from an IRA (only an IRA and not a qualified plan) to a public charity. For more information on this, see a more detailed explanation titled “Tax-free Distributions From IRAs for Charitable Purposes” posted at www.kmgslaw.com under News & Articles.

• Fiduciary Protection for Default Investments.  ERISA has afforded protection for fiduciaries with respect to participants who actually exercise discretion over their own investments, provided that the plan satisfies the applicable regulations with respect to participant direction of investment. However, before the Act, a plan fiduciary did not have protection regarding the investment of participant assets where the participant had the right to direct investments, but the participant never exercised the right.

The Act affords protection for fiduciaries that invest participants’ account balances in accord with default investment regulations to be issued by the Department of Labor. Even though the Act extends protection for fiduciaries who follow the default investment regulations, plan sponsors continue to have responsibility to prudently select and monitor the investment managers and the qualified default investment alternatives. The Department of Labor has indicated that employers may not rely on the proposed default investment regulations prior to publication in final form. Final regulations are to be issued by February 17, 2007. In general, the default investment will be qualified if it is either a: (i) “life-cycle” or “targeted retirement date” fund based on the participant’s age, that changes asset allocations and risk over time to become more conservative as the participant nears retirement age; (ii) a “balanced” fund that takes into account the ages of the participating group as a whole; or (iii) a “managed account” that is designed and operates in a manner similar to a “life-cycle” mutual fund.

A qualified default investment alternative must generally be a mutual fund or be managed by an investment manager; may not impose financial penalties or restrict a participant from transferring out of the investment alternative into other plan investment options; and generally may not hold employer securities. Participants must be given the opportunity, on no less than a quarterly basis, to transfer funds from the qualified default investment alternative to a broad range of investment alternatives that generally must include at least three diversified funds.

• Prohibited Transaction Exemption for Investment Advice Provided to Participants.  Historically, plan fiduciaries (employer and investment managers) involved with the investment of plan assets have been prohibited from managing the investment of plan assets on the one hand and offering investment advice to participants for fear that their advice would be construed as a conflict of interest (e.g., recommendation of investment products that result in additional fees to the investment manager). Congress finally recognized that participants need help in making investment decisions and plan fiduciaries are usually in the best position to provide this advice because the advisors are usually affiliated with the mutual funds or other investment vehicles offered under the plan. In order to take advantage of the prohibited transaction exemption, the financial advisor must satisfy certain disclosure, qualification and conflict of interest safeguards. The financial advisor is not obligated to monitor the investment advice; however, the employer as plan sponsor must be prudent in its selection of the advisor and must prudently and periodically monitor the advisor. 

To be eligible for the prohibited transaction exemption, the investment advice arrangement must be one in which: (i) the advisor’s compensation does not change because of the investments that are recommended; or (ii) the advice is based on a computer model. The fiduciary advisor may be an investment adviser, bank, insurance company, broker or registered representative of a broker/dealer or employees and affiliates of any of these entities. In order for the computer model to qualify for the exemption, the model must: (i) apply generally accepted investment theories that take into account historic returns of different asset classes over defined periods of time; (ii) use relevant participant information (such as age, risk tolerance); (iii) use objective criteria to provide asset allocation of investments under the plan; (iv) operate in a manner that is not biased in favor of investments offered by the fiduciary advisor; and (v) take into account all plan investment options. Before using the model, the fiduciary advisor must have the model certified as satisfying these rules by an independent third party. Under the computer model approach, the advice given must be exclusively through the model unless the participant requests other advice. As beneficial as the computer model approach may be, time and lessening of the regulatory burdens for its use may be necessary to make it more practical. For example, it is presently difficult to imagine that the Bank X computer model will include competitor’s mutual funds in its analysis and recommendations.

• Benefit Statements.  Beginning in 2007, a plan must provide quarterly benefit statements to participants in participant-directed defined contribution plans (e.g., profit sharing, 401(k)). For non-participant directed investment plans, the plan must provide annual statements. Calendar year plans with participant-directed accounts must issue the first benefit statement for the quarter ending March 31, 2007 no later than 45 days after the end of the quarter. The statement generally should include: total accrued benefits; vested benefits or a statement of the participant’s vested percentage; the value of each investment to which the participant’s account has been allocated. In addition, for participant-directed benefits, the statement should identify any limitations or restrictions on the right to direct investments; an explanation of the importance of having a diversified investment portfolio for long-term retirement security and an advisory that holding more than 20% of a portfolio in the securities of any one entity may not provide adequate diversification and the Department of Labor’s website on investing and diversification. The Act requires the Department of Labor to provide a model statement before August 17, 2007. In the interim, plans should exercise good faith compliance in preparing the statements. Penalty for failing to comply with the requirement is $100 per day per participant.

For additional information, please contact:

David M. Mosier, Esq.
Knox, McLaughlin, Gornall & Sennett, P.C.
120 West Tenth Street
Erie, Pennsylvania 16501-1461
Telephone (814) 459-2800; Fax (814) 453-4530
E-mail: dmosier@kmgslaw.com