10/02/06 - How the Pension Protection Act of 2006 Will Affect Your Retirement (Part 1)

By: Richard Feldman, MBA, CFP, AIF

The beginning of a perfect storm for defined benefit plans and defined contribution plans started in March of 2000 when the Dow, S&P 500, and NASDAQ peaked leading to three years of declining stock market returns, low interest rates, and the collapse of corporate giants Enron and WorldCom. Thousands of employees lost all of their retirement savings and corporate defined benefit plans became vastly under funded due to actuarial assumptions and substandard investment returns. Congressional attention soon followed with the focus on improving the system and rights of individual retirement participants and providing a framework to help workers reach their retirement goals and protect their retirement savings.

Pension Benefit Guaranty Corp (PBGC)

At the end of 2004, the Pension Benefit Guaranty Corporation reported claims in excess of $11 Billion dollars, covering over 391,000 participants. The bulk of these stem from a few large plan terminations that took place in 2002, 2003, and 2004. In many cases, the terminating plan was under funded and the PBGC assumed responsibility for payments of benefits. The terminations threatened the long term solvency of the PBGC and called into question the ability to meet assumed pension obligations. Since the end of 2004, more large plans have terminated and still others threaten termination.[1]

The Pension Protection Act of 2006

The Pension Protection Act of 2006 was signed into law by President Bush on August 17th, 2006 and contains over 900 pages of provisions designed to strengthen the federal pension insurance program and protect company employee pensions. The new legislation provides the most sweeping set of changes to the U.S. pension rules in over 30 years. In brief, the act will simplify and transform rules governing funding of defined benefit plans, accelerate funding obligations of employers, prospectively clarify the rules for cash balance plans, make permanent the revisions enacted in 2001 that were set to expire in 2010, strengthen diversification rights and investment education provisions for plan participants, and encourage automatic enrollment in defined 401(k) plans.[2]

Ensuring Employers Fund Their Pensions Promises to Workers

The Act also:

• Provides a permanent interest rate based on a modified yield curve (interest rates) for employers to more accurately measure current pension liabilities as they come due.
• Requires employers to make sufficient contributions to plans in order to meet a 100 percent target immediately. The phase-in of the 100 percent target starts in 2007.
• Requires employers to make additional contributions to erase funding shortfalls below 60 percent, within a five year phase-in. Reduces the smoothing of interest rates to protect plans against market and funding volatility.
• Prohibits employers from using credit balances if their plans are funded at least 80 percent.
• Permits employers to make additional maximum deductible contributions of up to 150 percent of current liability.

Adjusting Premiums Paid by Employers to the PBGC

• Raises premiums employers pay to the PBGC but phase-in the increase over time.
• Raises the flat per-participation rate premium from the current $19 per participant to $30 per participant over three years for pension plans that are less than 80 percent funded.
• Indexes the flat-rate premium annually to worker wage growth thereafter.
• Raises multiemployer premiums from the current $2.60 per participant to $8 per participant.
• Requires employers that terminate their pension plans in bankruptcy to pay a premium of $1,250 per participant to the PBGC for three consecutive years after they emerge from bankruptcy.

New Retirement Planning Opportunities

The Pension Protection Act outlines new rules regarding defined contribution plans (401 (k) plans, Profit Sharing Plans, and Money Purchase Pension Plans) and the ability of a nonspouse beneficiary to roll over the retirement account balance to a newly established inherited IRA.

This is a dramatic change in the retirement laws and will save individuals billions of dollars in tax cost due to the ability to stretch tax payments on the inheritance over the beneficiary's lifetime. The old laws did not provide the ability to rollover the proceeds to a stretch IRA and typically provided that the funds needed to be distributed to the beneficiary no latter than five years from the date of death of the participant.

For example, if your mother or father passed away with a $500,000 401(k) account and you were the sole beneficiary of the account, you would need to distribute the proceeds no later than five years after the date of death. This would lead to $500,000 of taxable income over that five year period which might be taxed as high as 35%. That means $175,000 of the $500,000 could go to taxes. The new law allows a beneficiary to rollover the proceeds to an inherited IRA and distribute the funds according to the beneficiary's life expectancy, which could be 50 - 60 years if the beneficiary is young enough.

Roth Conversions Directly From Company Plans

The Pension Protection Act has language that now allows Roth conversions directly from employer sponsored retirement plans. In the past individuals who wanted to convert a portion of their corporate retirement plan would first have to roll over the proceeds to a rollover IRA account and then convert that IRA account to Roth IRA. Under the new laws you can by pass the two step process by converting the funds directly from an employer plan.

This is a direct benefit due to the ability to convert after-tax contributions made to an employer retirement account. In the past if their were any after tax contributions made to an employer account those funds would need to be distributed to an IRA and then converted to a Roth. Under IRA rules regarding after tax contributions once the funds are commingled with other IRA assets you were governed by the pro-rata distribution rules.

Under the pro-rata rules for distribution purposes all IRAs are considered to be one IRA and all distributions are pro-rated between after-tax and pre-tax amounts. This means if you have a $200,000 IRA balance of which $20,000 is after tax contributions and you wanted to convert $100,000 of the balance 10% or $10,000 would be deemed after-tax and the other $90,000 would be taxable as ordinary income. Under the new rules all after-tax funds can be converted to a Roth IRA from a corporate retirement account thus bypassing the pro-rata IRA rules governing after tax contributions.

Summary

The new Pension Protection act goes a long way towards helping and protecting American worker's retirement benefits. The act forces corporations to fully fund future retirement liabilities while also enabling individuals to continue to contribute at higher rates in their 401 (k) and IRA retirement savings accounts. In addition the act has helped shore up the PBGC which guarantees worker's benefits up to $47,658.96 per year. My next article will summarize the changes surrounding 401(k) plans and retirement savings.

[1] Securing Retirement, An Overview of the Pension Protection Act of 2006, Deloitte

 

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