The Employee Benefits & Executive Compensation Group at Gray Plant Mooty is grateful for the opportunity to work with you over the past year. We hope this has been a year of fulfillment for you personally and for your organization. Our sincere wish is that this holiday season brings you peace, joy and a prosperous New Year.
In our field of law, the wonder and anticipation of the holidays are always joined by two other year-end phenomena: effective dates and deadlines. This eBenefits Alert discusses the most significant changes in the employee benefits arena that we should be thinking about as 2007 becomes 2008. Links to more detailed discussions are included for some topics. As always, we invite you to call us with your questions.
PPA Vesting Change
Vesting schedules come in two shapes. The more common schedules take a participant from 0% to 100% vesting in a series of steps – often in 20% annual increases. This is sometimes called “graded vesting.” “Cliff vesting” schedules, like an express elevator, take participants from 0% to 100% vesting in one jump after the completion of a specified number of years of service. Prior to the Pension Protection Act of 2006 (“PPA”), the longest permissible graded vesting schedule extended for seven years, with 20% vesting after three years and 20% increases for each additional year. The longest cliff vesting schedule before the PPA required five years of service for full vesting (and participants with less than five years of service were 0% vested).
In the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), Congress shortened the maximum vesting schedules for employer matching contributions to a 401(k) plan from seven to six years for graded vesting and from five years to three years for cliff vesting. The PPA imposes identical changes for all other employer contributions to qualified defined contribution plans, including profit sharing contributions and ESOP contributions.
If your plan has a seven-year graded vesting schedule or a five-year cliff vesting schedule, the schedule must be shortened to comply with the new requirements. (It is possible to change from one style of vesting schedule to another – for example, from five-year cliff vesting to six-year graded vesting – but in that case participants with at least three years of vesting service may have additional rights that must be observed.) As long as you begin operating under a permitted schedule, you may delay amending the written plan document until 2009. The new law only applies to employer contributions made for plan years beginning in 2007 or later years, unless the employer decides to apply the change to older contributions as well. This flexibility gives you, as the employer, several planning options:
The PPA change to the vesting requirements does not apply to defined benefit plans. Therefore, cash balance plans and traditional defined benefit pension plans may continue to operate under five-year cliff vesting or seven-year graded vesting schedules. The change applies to ESOPs, because they are defined contribution plans, but the effective date may be delayed if the ESOP had outstanding on September 26, 2005, a loan used to purchase employer stock. If that condition was met, the ESOP is not required to adopt the shorter vesting schedule for plan years beginning before the earlier of (1) the date on which the loan is fully repaid, or (2) the date on which the loan was, as of September 26, 2005, scheduled to be repaid. Defined contribution plans maintained pursuant to collective bargaining agreements may also be subject to a delayed effective date, depending on when the most recent agreement terminates.
Participant Benefit Statements
Most companies with a 401(k) plan, profit sharing plan or ESOP are already providing benefits statements to participants on a quarterly or annual basis, even though, as a matter of legal compliance, benefit statements were required under prior law only upon request of the participant. Under the Pension Protection Act of 2006, starting with the 2007 plan year, statements must be provided at least quarterly and no later than 45 days after the end of the quarter for plans that permit participant direction of investments. For plans that do not permit participant direction, the Department of Labor (DOL) has stated that benefit statements must be provided at least annually and that plan administrators will be treated as acting in good faith compliance if the statements are provided no later than the Form 5500 filing due date (including any extension). Statements for defined contribution plans must include the participant’s account balance, the amount invested in each investment fund or in employer stock, and vesting status. Statements for plans that permit participant-directed investment must also include an explanation of the importance of a diversified portfolio and a direction to the U.S. Department of Labor’s website for sources of more investment and diversification information. The DOL website address for this purpose is www.dol.gov/ebsa/investing.html. Model language for the explanation is available in Q&A 6 of the DOL’s Field Assistance Bulletin 2006-03, which can be found at www.dol.gov/ebsa/regs/fab_2006-3.html.
Nonspouse Beneficiary Rollovers
Many retirement plan participants have named beneficiaries who are not married to the participant. Upon the death of the participant, these “nonspouse” beneficiaries have been at a disadvantage from a tax perspective. The distribution provisions of the plan may have forced them to take the entire death benefit in a single lump sum payment within the five-year period following the year of the participant’s death. Because IRA rollovers have not been available to beneficiaries other than surviving spouses, nonspouse beneficiaries often found themselves in the highest tax brackets, facing large tax bills because they could not spread the taxable death benefit over multiple tax years.
The Pension Protection Act of 2006 allows employers to help with this problem by amending their plans to permit direct rollovers by nonspouse beneficiaries (including certain trusts) into special IRAs called “inherited IRAs.” The rollover amount cannot include the portion of the benefit that must be distributed to the beneficiary in the year of the rollover under the minimum required distribution rules.
Inherited IRAs must meet certain requirements. The title of the inherited IRA must indicate that it is held by the individual as beneficiary of the deceased participant. A beneficiary who establishes an inherited IRA may generally control when amounts are withdrawn as taxable income, provided that minimum required distributions are taken each year over the beneficiary’s life expectancy. A beneficiary may not contribute additional amounts to an inherited IRA and may not make rollovers from the inherited IRA to other IRAs or retirement accounts.
An employer who wishes to add this provision to its qualified plan, 403(b) arrangement or governmental 457(b) plan may do so immediately because the new opportunity for nonspouse beneficiaries may be applied to any distributions made after December 31, 2006. However, the statute insists that the rollover be paid directly from the plan to the IRA (a “trustee-to-trustee” transfer) so it is too late to salvage a distribution that has already been paid to a nonspouse beneficiary in 2007.
Lump Sum Distributions Under Defined Benefit Plans
Lump sum distributions are computed using the so-called “applicable interest rate.” Beginning with the 2008 plan year, the Pension Protection Act changes how the applicable interest rate will be determined. Currently, the applicable interest rate is an indexed rate based on 30-year Treasury Bonds. Under the new rules, the applicable interest rate will be based on high-grade corporate bonds. The new index will be based on short-term, mid-term or long-term corporate bond yields for the short term, mid-term and long term segments of the time period used for discounting a participant’s annuity benefit to its lump sum present value. In addition, the new index will be phased in from 2008 through 2011. During that time, an increasing percentage of the lump sum will be computed applying the new corporate bond index and a declining percentage will be computed using the old index based on 30-year Treasury Bonds.
The net result is that, beginning with your 2008 plan year, lump sums likely will be smaller. Generally, individuals close to retirement will be affected the least; those further away from retirement the most. Even though your plan document may say that lump sums are to be calculated using the 30-year Treasury Bond index, you may still apply the new index , as adjusted by the phase-in rule, for the plan year beginning in 2008. If you follow this course, conforming plan amendments must be adopted by the end of the grace period provided by the Pension Protection Act, which is generally the end of the 2009 plan year. Some plan sponsors, however, may wish to use the old 30-year Treasury Bond index, especially if the plan has a cash balance or similar formula or the plan provides a full lump sum option, i.e., the lump sum form of payment is not just confined to the payment of small benefits, such as lump sums of $1,000 or less. If this is the case, you should consult with us concerning the implications of retaining the old index and the amendments that may be necessary to your plan
This article is provided for general informational purposes only and should not be construed as legal advice or legal opinion on any specific facts or circumstances. You are urged to consult a lawyer concerning any specific legal questions you may have.
Gray Plant Mooty is recognized as one of the leading corporate law firms in Minnesota and one of the top franchise firms in the world. Our roots go back to 1866. Today, we are a full-service firm with nearly 180 attorneys and offices in Minneapolis and St. Cloud, Minnesota; Washington, D.C.; and Fargo, North Dakota.