The Pension Protection Act of 2006, signed into law by President Bush on August 17, 2006, is what the President called the “most sweeping reform of America’s pension laws in over 30 years.” This law, which originated as a bipartisan bill, is designed to strengthen protections for pension plans by tightening the requirements for employer funding.

Like similar laws, the Pension Protection Act encourages employers to participate in automatic employee enrollment for their 401(k) plans. Under this new plan, an employer may automatically enroll its employees at a specified contribution level, while the employee must affirmatively elect to change their participation in the plan by either selecting a different contribution level or opting out of the program completely. All automatically enrolled employees are given 90 days to opt out of the 401(k) program and if they so chose, will receive a penalty-free distribution of the amounts already contributed on their behalf.

The Act will implement a new funding plan beginning in 2008. Because a pension plan is designed to compensate an employer’s current workers after their retirement, an employer’s obligations for pension plan liabilities extend well into the future. In order to determine whether a pension plan is adequately funded, future pension payments are converted into the amount needed to pay off all present plan liabilities. This present value of the plan’s liabilities is then compared with the actual value of the plan’s assets. If the converted value of the plan’s present liabilities exceeds its assets, that plan is underfunded.

Under the current funding rules, effective through 2007, an employer maintaining a single-employer defined benefit plan is not required to make additional contributions (deficit reduction contributions) to underfunded plans, as long as such plans are at least 90 percent funded. Starting in 2008, provisions of the Act which will be phased in over several years and will require an employer maintaining a single-employer defined benefit plan to fund 100 percent of the plan’s target or current liabilities. If the employer has not contributed sufficient funding, the unfunded liability will be amortized over seven years. If the plan is significantly underfunded, as to warrant the threat of potential sponsor default, the employer will be required by law to pay higher contributions to the plan. The Pension Protection Act determines an employer’s minimum required contribution to be based on the plan’s target normal costs and the difference between the plan’s funding target and the value of the plan’s assets. The normal target cost is the present value of all benefits which plan participants will accrue throughout the year. The funding target is the present value of all benefits already accrued by participants from the beginning of the plan year. If the value of the plan’s actual assets are less than the funding target, the plan has an unfunded liability. This liability will be amortized in annual installments for seven years. The employer’s minimum required annual contribution will be the plan’s normal target cost for the plan’s year.

In the past, interest rates used to determine the present value of pension plan liabilities were averaged over a four-year period and the asset values used to determine minimum employer funding contributions could be averaged over five years. These calculations often led to inaccurate or misleading results. The Pension Protection Act proscribes three different interest rates to calculate present value of plan liabilities. These interest rates, as determined by the Secretary of the Treasury, correspond to the length of time until the liabilities are to be paid. Short-term rates will apply to those liabilities to become due within the next five years, while mid-term interest rates will apply to all obligations due between five and fifteen years. All liabilities scheduled to become due after fifteen years will receive a long term interest rate.

Another significant change made by this act is that the 529 tax-free status of college savings withdrawals now becomes permanent. As you may already know, the December 31, 2010 sunset provision allows for qualified tax-free withdrawals from 529 college savings plans. This new act repeals the 2010 deadline so that the tax-free status of such withdrawals now becomes permanent.

Although it may be several years before the extent of this pension reform takes effect, employers would be well advised to prepare now for this change in their pension plan policies. IBI