President Bush signed the Pension Protection Act of 2006 into law on Aug. 17, 2006. While the 907-page document covers a broad range of new provisions, it presented a few opportunities that will impact 401(k) plans.
The first "hooray" is for the permanent extension of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) retirement savings provisions. No longer will employers or participants have to be concerned about the sunset possibility for the limits and options provided under EGTRRA. Many employers have been hesitant to add a Roth option to their 401(k) plans because the sunset provisions would have eliminated the option in just a few years. Making the EGTRRA provisions permanent allows employers and participants the ability to plan long term. This sends a message of the long-term commitment to bolster employer-sponsored retirement plans, which will help participants achieve a secure retirement.
One of the strengths of the new law is that it directly addresses many of the issues that have been challenging to plan sponsors. Previously unused provisions may now become more attractive to employers. Additionally, the act creates new plan design options: an automatic enrollment safe harbor plan and a DB(k) plan. Advisors are now in the enviable position of being able to help employers update or redesign their plans in new employer and participant-friendly ways. Following are a few of the provisions with ideas on how they may be utilized.
The new safe harbor plan
One of the new plan designs created under this law is the automatic enrollment safe harbor plan. For plan years beginning after Dec. 31, 2007, 401(k) plans can have the advantage of being treated as safe harbor yet reduce the percentage the employer must contribute on the match. (Safe harbor plans have become a very popular option for 401(k) plans by eliminating the problems involved with ADP/ACP testing, refunds, and top-heavy requirements.) Currently, employers have the option of matching employee deferrals for a total of 4 percent of pay (100 percent of the first 3 percent and 50 percent of the next 2 percent) or contributing 3 percent for all eligible employees. Under the new plan design, employers could lower their match to a total of 3.5 percent of pay (100 percent of the first 1 percent and 50 percent of the next 5 percent).
Additionally, the vesting on this new plan is more liberal than the vesting on current safe harbor plans. Instead of having 100 percent immediate vesting on the safe harbor contributions, the new plan contributions could vest over no greater than two years.
So why is the law making it easier for these plans? There is a great deal of evidence that automatic enrollment provisions in 401(k) plans increase participation significantly. Inertia seems to be the biggest drawback for getting employees to join 401(k) plans. Many employers have been reluctant to add automatic enrollment because of practical implementation concerns. For example, if an employee is enrolled under the automatic feature and then a couple of weeks later opts out of the deferrals, the employer is stuck maintaining and administering an account with a smaller balance than the fees required to account for it.
The new law contains special rules that will fix this; it allows employees, within 90 days of the first payroll period when the automatic enrollment took effect, to treat the deferrals as erroneous contributions and have them refunded out of the plan without causing problems. (Currently, the employee would likely not be eligible for a distribution of the money, but even if they did qualify for a distribution, the employee would likely get hit with a 10 percent penalty tax.) This will help tremendously as those participants who don't want to participate can actively get out within 90 days while those who never got around to the paperwork will remain active participants. Another concern in automatic enrollment has been the fiduciary concern regarding where to invest the participant's money.
The new law gives guidance to employers, which suggests that asset allocation funds or target benefit funds could be more prudent for automatic enrollment than a money market fund.
Although the new plans have some wonderful features, one of the provisions of the automatic enroll-ment safe harbor plan could be troublesome to administer. In trying
to encourage participants to increase their deferrals over time, the provision that allows automatic enrollments to start at 3 percent and scale up to 6 percent over time could put a burden on employers from an administrative point of view. (While the initial automatic enrollment percentage can be as low as 3 percent or as high as 10 percent, there is a requirement that the percentage be no less than 4 percent in the second year of participation, no less than 5 percent in the third year of participation, and no less than 6 percent in any subsequent year of participation.) Unlike most plan provisions that are tracked entirely by plan administrators, payroll deferral changes need to be done at the payroll level. In many cases that means the employer or their payroll company would have to track initial automatic enrollment dates and percentages and assure they are increased at the correct time -- not earlier, not later. This has the opportunity for errors and may be an area that could dampen the enthusiasm for this new plan. Employers could just opt to use an initial 6 percent automatic enrollment to avoid the administrative problems, but starting at this percentage may discourage new participants from keeping their automatic enrollment. Stay tuned to see what ideas and systems appear to help solve this dilemma.
More flexible rollovers
New options for participants and beneficiaries have been created that will help them keep their retirement nest egg intact. Non-spouse beneficiaries will now have the option of rolling qualified plan money into their own IRA without being taxed until the money is withdrawn. Currently, this option is only available to spouses. Extending this option to other beneficiaries opens a huge planning opportunity for all beneficiaries, including domestic partners and children. Another added pro-vision will allow direct rollovers from qualified plans to Roth IRAs. This will avoid the duplicate paperwork currently required in the two-step process of rolling first to a traditional IRA and then from the traditional IRA to the Roth IRA.
Defined benefit plans
While the new law extensively impacts defined benefit plans, we discuss only changes on the defined contribution side. However, the new single plan defined benefit(k) crosses over. This is a new plan design that won't be available until 2010 but will allow small businesses to have the benefits of both a defined benefit plan and a 401(k) without maintaining two qualified plans. The DB side is limited to specific plan formulas, and the 401(k) option must have an automatic enrollment feature and fully vested match. This new plan design should prove to have some great applications, and it appears that with a 2010 effective date, there is plenty of time to be creative.
Investment advice
Investment advice and education for 401(k) plan participants has been an area where employers and providers alike have sought guidance. This new law gives very specific requirements in order for investment advice to be exempt from the prohibited transaction rules and for plan sponsors to have some fiduciary relief for investment performance based on this advice. While the relief available for sponsors and plan fiduciaries is significant, it is neither complete nor inexpensive. The plan fiduciary will still be responsible for prudently selecting and monitoring the investment advisor as well as providing the required notices. On the plan provider level, there will now be a series of requirements in order to offer advice that fits under the exemption. If anyone thought that pension law would ever become less complex, this certainly proves them wrong.
This new law is the most extensive pension revision since the Employee Retirement Income Security Act and promises both significant opportunities and extensive complications. More than ever, employers and participants will need our advice and expertise to help them make wise choices.
This law creates many opportunities for advisors. Not only will every employer need to reexamine their 401(k) plan, but those who have yet to establish plans will also have a reason to reevaluate. As advisors, we can now find out what an employer doesn't like about their existing plan, and it is likely that the new law offers a solution. For example, if the employer has low participation, automatic enrollment may be the answer. If the employer has highly compensated employees complaining about not being able to save enough, safe harbor offers a solution. If the employer is fearful of the fiduciary liability they have on their plan, the new investment advice options should provide some relief. For advisors who are not in the qualified plan market, this law still offers planning opportunities. The non-spouse beneficiary provisions offer a tremendous way to keep retirement assets intact without current taxation. The new ease of rolling plan assets into Roth IRAs, and the permanence of the Roth provision offer new legacy-planning opportunities for wealthy individuals who previously could not qualify for Roths or were hesitant to begin funding a Roth 401(k) option. It is also likely that we will see many new investment models and planning tools.
This will be an exciting time as product developers redesign their 401(k) offerings to take advantage of the new capabilities created under this law.
Michelle L. Hoesly, CLU, ChFC is a 28-year qualifying and life member of MDRT, as well as a Top of the Table qualifier. She is an expert in retirement planning, financial planning, insurance, and investments. Ms. Hoesly formed Capital Resources in 1990 and began Resource One in 2000. She can be reached at resource1@prodigy.net.
