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ABA Section of Business Law


Business Law Today

Is the future more secure?
A look at pensions, retirement and changes in the law
By Donald J. Myers, Michael B. Richman and Sonia A. Chung
Think you understand the newly enacted pension rules? Or at least that your business client does? Read on.

The Pension Protection Act of 2006 (the PPA), which President Bush signed into law on Aug. 17, 2006, is being described as the most significant pension legislation since the Employee Retirement Income Security Act of 1974 (ERISA). This is no small statement, as Congress has passed pension legislation almost every other year since ERISA was enacted.

While the principal impetus for the PPA was to reform the rules for funding defined benefit pension plans, the law makes significant changes in many other areas as well. In this article, we focus on a few highlights of the pension law changes that are intended to create new opportunities for increasing participation in defined contribution plans, stabilizing defined benefit plans, and providing added investment flexibility, to help assure that Americans have sufficient income in retirement.

The first part examines the changes to the rules for 401(k) plans and other qualified retirement plans to encourage better levels of plan participation and funding and describes some of the practical implications for plan sponsors and their counsel to consider with regard to plan design. The second part examines significant changes to the ERISA fiduciary responsibility rules and some of the implications of those changes for pension plan asset management, affecting not only those who manage plan assets but also firms that sponsor funds in which ERISA plans invest.

For 401(k) plans, the PPA contains new guidance on automatic enrollment — enrolling employees in the plan automatically, without requiring them to submit an enrollment form and to select investments and contribution levels — with the goal of offering employees a painless opportunity to take that first step toward saving for retirement. While the basic concept of automatic enrollment is certainly nothing new, Congress has now provided added incentives.

First, the PPA dispels any lingering concern plan sponsors may have had about state laws impeding their ability to offer automatic enrollment, by clarifying that ERISA preempts any such state laws. Second, beginning in 2008, 401(k) and 403(b) plan sponsors who implement specific guidelines for automatic enrollment will receive favorable plan treatment from the Internal Revenue Service, in the form of deemed satisfaction of certain annual nondiscrimination tests. Finally, the PPA offers fiduciary protections for default investments resulting from automatic enrollment. The latter two points merit additional discussion.

Under the PPA's requirements, plan sponsors interested in establishing a so-called "safe harbor automatic enrollment plan" must first set a uniformly applicable initial default contribution limit of no less than 3 percent, rising to at least 6 percent by the fourth year of participation. In addition, the sponsors will be required to provide a matching contribution equal to at least 100 percent of the first 1 percent deferred and at least 50 percent of the next 5 percent deferred, not to exceed 6 percent of compensation. Employer matching contributions may be subject to a maximum two-year vesting schedule.

In providing this safe harbor, the PPA offers a practical incentive for plan sponsors who would have been inclined to use, or are using, a traditional, nonautomatic enrollment safe harbor plan (which also provides nondiscrimination testing relief). Under a traditional safe harbor plan, a plan sponsor is required to contribute a minimum total employer match equal to 4 percent of compensation, which must be fully vested from day one.

Under this new type of safe harbor automatic enrollment plan, however, a plan sponsor's required matching contribution is a half percent lower, at just 3.5 percent, and includes the increased flexibility of the maximum two-year vesting schedule. This combination of the lower required employer contribution and a vesting schedule may translate into savings for plan sponsors.

A significant concern in the area of automatic enrollment plans has been how to appropriately invest the automatic contributions of participants who do not elect an investment vehicle, and whose accounts are therefore invested by default in an option selected by the plan sponsor. To address this issue, the PPA amends Section 404(c) of ERISA, the exception to the ERISA fiduciary rules for participant-directed individual account plans, to cover these default investments.

Under the new rule, participants are to be provided with a notice within a reasonable period of time before each plan year, explaining their right to designate the investment of contributions and how, in the absence of an investment election, their contributions will be invested. They must then have a reasonable period of time after receiving the notice and before the plan year begins to make an affirmative investment election.

In the absence of an affirmative election, the participant is nevertheless treated, for purposes of the ERISA fiduciary rules, as having exercised control over assets that are placed in the designated default investment. This means that the plan fiduciaries are not liable for any losses or other adverse results from that investment (unless the losses result from the imprudent selection of the default investment).

Although Congress' message on the importance of strengthening defined contribution plans could not be clearer, it did not stop there. The PPA also contains stringent defined benefit funding rules (although some argue they may actually hasten the demise of defined benefit pension plans altogether, rather than stabilize them for the good of future retirees).

Under the PPA's new defined benefit plan funding rules, which begin to be phased in for the 2008 plan year, a plan's annual funding target must now be 100 percent of its liability obligations (rather than 90 percent as under prior law). Further, instead of the current 30-year amortization period, unfunded amounts related to past service liabilities must now be amortized over a seven-year period.

If, in a preceding year, a plan has more than 500 participants and plan assets valued at less than specified percentages of the plan's funding target (80 percent when determined without regard to the PPA's special "at-risk" assumptions, and 70 percent when determined with regard to those assumptions), the plan will be deemed to be "at risk." At-risk plans are required to use special, less-favorable actuarial assumptions that will, in turn, effectively increase an employer's required minimum contributions.

In addition to the greater minimum contributions required of at-risk plans, the PPA contains several other provisions aimed at ensuring that plan sponsors have little incentive to underfund their plans.

For example, if a plan is at-risk, and the employer also sponsors a nonqualified deferred compensation plan (as defined by Internal Revenue Code Section 409A — generally, special plans for high-ranking company officers and senior management), the plan sponsor must ensure that it does not "fund" the deferred compensation plan by way of a grantor trust or other similar vehicle during this at-risk period. If the employer does "fund" through such a vehicle, it will likely be subjecting the company's highest officers to the severe penalties applicable to 409A violations, not the least of which is a 20 percent penalty tax.

Further, plan sponsors of underfunded plans who miss a required quarterly contribution will be charged interest at the plan's effective rate, plus 5 percent. Also, if the plan's funding level falls below 60 percent, benefit accruals must stop until the plan's funding exceeds that level.

Turning now to the ERISA fiduciary responsibility rules, the PPA represents the first major change to these rules since ERISA was enacted 32 years ago.

The principal purpose of the PPA's changes is to "modernize" the fiduciary rules, alleviating the effect of its restrictions on nonabusive transactions. To do so, the PPA provides a number of new exemptions and loosens the rules that apply to private investment funds. These changes have a number of ramifications for plan sponsors, plan participants, investment firms and their counsel.

One of ERISA's major changes to pre-1975 law was to impose a series of "prohibited transaction" rules on the management and administration of plans. Some of the rules were based on trust law concepts against fiduciary self-dealing. ERISA went beyond trust law to strictly prohibit transactions with "parties in interest" to plans, because of concerns that such parties could abuse their relationships with the plans for their own benefit. These included plan fiduciaries, plan sponsors, persons providing services to plans and their affiliates.

Under these rules, for example, the plan sponsor could not sell securities or real estate to the plan, or make a loan in the event the plan were to run short of money to pay benefits. Plan service providers were prohibited from engaging in purchases or sales with the plan, or even from providing services to the plan.

This absolute prohibition on transactions with parties in interest has raised many problems, such as how plans were to secure the services necessary for their operation if not from their service providers. For this reason, ERISA included a number of exemptions from the prohibited transaction rules (including for plan service providers to provide services to the plan, thereby removing that dilemma), and provided a mechanism to create additional exemptions that is administered by the U.S. Department of Labor (DOL).

Over the years, DOL has granted a large number of class and individual exemptions. Many of these recognize that transactions with persons whose only relationship with the plan is to provide nonfiduciary services, such as broker-dealers or record keepers, have limited potential for abuse.

Congress has now established a broad exemption for transactions with service providers to plans and their affiliates, covering purchases, sales and extensions of credit. This will provide relief for many technical prohibited transactions that were difficult to monitor, eliminating the need to seek individual exemptions or rely on class exemptions with their own sets of restrictions.

There are two conditions. First, the service provider (or affiliate) may not be a "fiduciary" to the assets involved in the transaction. That means that the service provider may not be the manager of the assets, or provide "investment advice" with respect to those assets. It is unclear whether the exemption is available for a transaction with a service provider who acts as a "manager of managers" and appoints the actual manager of the assets.

Second, the transaction must be for "adequate consideration." This term is defined for publicly traded securities, but its meaning for other types of assets is left to DOL regulations. ERISA already contains a similar definition, and while DOL proposed regulations under that definition in 1988, they were never made final. Depending on the assets involved, it is conceivable that until DOL issues further guidance, parties may be reluctant to rely on the service provider exemption and instead continue to use DOL class exemptions.

Eventually, the new service provider exemption will likely supersede the need to comply with some of the DOL class exemptions, which often have detailed conditions and requirements. Lawyers will want to review arrangements operated under those class exemptions to determine whether compliance with those exemptions continues to be necessary.

The ERISA fiduciary responsibility rules apply to transactions involving "plan assets." Under a DOL regulation, plan asset treatment is not limited to assets held by ERISA plans themselves, but can extend to the assets of funds in which ERISA plans invest.

The general rule is that a private investment fund, such as a hedge fund, is subject to ERISA if at least 25 percent of any class of its equity interests comes from "benefit plan investors." The regulation defines "benefit plan investors" to cover not only ERISA plans but also nonERISA employee benefit plans, which can include state and local government as well as foreign plans.

The result has been to discourage private investment funds from accepting ERISA plan investments because of the restrictions that come from being subject to the ERISA prohibited transaction rules.

The PPA makes two changes to the plan assets rule. First, it requires that the only plans counted for purposes of the 25-percent test be limited to those that are either (1) subject to ERISA or (2) covered by the parallel Internal Revenue Code prohibited transaction rules (for example, individual retirement accounts (IRAs)) (collectively, ERISA investors). Second, it provides that in the event that a fund treated as holding plan assets invests in a second fund, only the percentage of its assets that come from ERISA investors is counted in applying the 25 percent test to the second fund.

The result is a significant narrowing of the plan assets test. The expected consequence is that private investment funds should be more willing to accept ERISA investors.

Private fund counsel should revise the ERISA discussion in funds' offering materials to reflect the change. They also should confirm that the private fund document provisions on the ability to redeem out ERISA investors to stay under the 25 percent threshold conform to the new manner for running the test.

There is a clear trend away from "defined benefit" pension plans, which place investment risk on the employer, in favor of 401(k) and other "defined contribution" pension plans, which place such risk on the employee. While many defined contribution plans require investments to be directed by the employees, employees may lack the knowledge to manage their own investments and require professional investment advice.

However, a person who provides investment advice to plan participants can become a fiduciary, subject to the ERISA fiduciary rules. There have been two consequences: (1) Companies that provide the investment options under the plan, which are the most likely source for advice, may be unable to provide that advice because of conflicts of interest that may violate ERISA; and (2) plan sponsors are concerned about fiduciary liability if they hire advice providers.

Over the years, DOL has identified categories of "investment education" that can be provided without making the provider an ERISA fiduciary, and also has described advice structures that avoid conflicts of interest that could violate the ERISA prohibited transaction rules. Independent advice firms also have sprung up to fill the void. Nevertheless, many have felt that there were still too many barriers preventing participants from receiving the advice they need to be able to effectively manage their retirement savings.

The advice exemption added by the PPA covers investment advice provided to participants by a "fiduciary adviser," defined as a registered investment adviser, bank trust department or registered broker-dealer or their affiliates, employees or agents. The principal condition is that the advice arrangement must follow one of two structures.

Under the first structure, the fiduciary adviser's fees or other compensation must not be affected by the investments selected by the participant as a result of the advice. Under the second, the advice must arise solely from the use of a computer model that meets a series of requirements, including that it be based on objective criteria and independently certified as meeting the conditions of the exemption. Either structure must be independently approved and subject to annual independent review to assure compliance with the exemption.

Regulatory action is required before the computer model portion of the exemption can become available. The certification process, which must be in place before a model can be used, is to be defined by DOL. Also, the computer model approach is not available to IRAs pending a DOL study on whether the approach is feasible for IRAs.

Here is an issue for IRAs because the computer model approach was developed for 401(k) and similar plans that provide a limited menu of investment options that a model can use, while IRAs typically have no limits on available investments. If DOL does not determine that there is a computer model investment advice program feasible for IRAs, then it is to grant an administrative exemption based on the new statutory exemption. So it may be at least a year, and likely longer, before IRAs can benefit from the computer model approach.

The effect of this new exemption is unclear. The limitations may considerably restrict the flexibility of firms in structuring advice programs. Some firms are moving forward to develop computer models that meet the requirements of the exemption (subject to expected DOL guidance), while others — particularly those with large IRA clienteles — are taking a "wait and see" approach.

In sum, the PPA makes a number of significant revisions to the rules for retirement plans. The open questions are whether these changes will be effective at promoting plan participation, increasing retirement savings and improving defined benefit plan funding. If not, more will need to be done to address concerns as to whether Americans will have sufficient income to provide for their retirement.
Myers is a partner, Richman is counsel and Chung is an associate at Reed Smith LLP. Myers and Richman are in the Washington office and Chung is in the Pittsburgh office. Their e-mails are: dmyers@reedsmith.com; mrichman@reedsmith.com; schung@reedsmith.com.

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