The Pension Protection Act of 2006
(Another Law That No One Noticed)

Pension and Retirement Memo
April 2007

Two laws were enacted last year that affected us dramatically. Both of them were mostly ignored.

The first was the Deficit Reduction Act, which reformed Medicaid. It makes clear that Medicaid is not a universal entitlement program for nursing home costs. Oversimplified, it means that most of us will have to buy private long term care insurance instead. I have written extensively about this, and you can retrieve my memos on the Medicaid changes from my website.

The second law was the Pension Protection Act of 2006 ("PPA 2006"). It made headlines for a few hours and was then eclipsed by the latest on Brittany Spears.

PPA 2006 is a retirement planning tsunami: an unnoticed undersea earthquake triggering far reaching tidal waves of changes. Just as the Medicaid reform forces us to "go it alone" for long term care, PPA 2006 put the responsibility for retirement income saving (other than social security) squarely at the feet of you and me. Employers are no longer the "single payer system" for retirement income. Employees must become active and informed players when it comes to retirement savings.

Background PPA 2006 finalizes Congress’ architectural plan on how Americans will pay for retirement.

The first step of the federal pension law evolution was the Employee Retirement Income Security Act of 1974, or “ERISA.” In the 32 years following ERISA's passage, Congress enacted new pension laws almost every year as it struggled to "reform" its previous "reforms." Each change entailed complexity and confusion. The pension laws went from merely complex to entirely incomprehensible. My own view was that even the IRS could not understand, much less administer, the pension laws. The financial burden on employers during this period has been enormous.

This 32 year process was conducted in the context of globalization. Our manufacturing economy became an information based economy. The pension laws had to reflect this reality, whether we like that reality or not.

PPA 2006 brings finality and certainty to critical retirement savings issues. It is 907 pages long and mindlessly complex. PPA 2006 was ignored because it cannot be explained in a thirty second sound bite or a couple of paragraphs. Brittany Spears is far more interesting.

PPA 2006 implements critical decisions on who will pay for retirement, how much can be saved pre-tax, how retirement income is taxed, and how unused benefits are transferred, and taxed, at death. The behind the scenes political battle over these issues was difficult, so don’t expect Congress to revisit these pension laws anytime soon. The long march from ERISA to PPA 2006 is over. Elvis has left the building, but you probably missed him.

Overview of PPA 2006 Let's see what Congress did. Here are a very few important contours of the new law. They go well beyond mere "reforms" or "changes." They reflect an upheaval in how the private sector pension system will work in the 21st century.

In each of these you can see Congress' response to a mobile, information based economy, and a shift of responsibility from employers to employees.

You can also envision the brutal political battles that were fought to produce PPA 2006.

• Old-time defined benefit pension plans (like the ones our parents had) are officially dead. Employers can now convert them to "cash balance" plans. Cash balance plans have the look and feel of a defined contribution plan, such as a profit sharing plan, but they are really pension plans in drag. Cash balance plans favor younger, lower paid employees who are likely to migrate from employer to employer, and disfavor older, long-term employees. Cash balance plans are overall much less expensive for employers.
  
  
• Underfunded defined benefit pension plans, the toxic waste sites of the retirement plan landscape, must be fixed. PPA 2006 has real teeth here. People who really understand the economics and politics of pension plans went right to the underlying causes of sick plans. Antiquated actuarial and funding rules, some of which were from la-la land, are modernized. Damage control is implemented for defined benefit plans in the worst shape. The Pension Benefit Guaranty Corporation ("PBGC"), the federal agency that guarantees a portion of pension benefits, will not be the open-door orphanage for mismanaged pension plans.
  
  
• The responsibility for retirement savings is shifted from the employer to the employee. 401(k) plans and IRAs will be the centerpieces of our retirement savings.
  
• The limits for annual contributions to plans and IRAs are increased to offer more incentives for pre-tax savings.
  
  
• Participation in 401(k) plans is encouraged through automatic enrollment for new hires, participant access to investment information, and permissible "default" investment choices. Disclosure requirements are expanded. Distribution rules for non-spouse beneficiaries have been improved.
  

Effect on Employers Employers must examine the suitability of their plans under these new laws.

For small employers, the most popular plans will continue to be simplified employee pensions (SEPs), SIMPLE plans, and bare bones 401(k) plans. Expanded contribution levels, simplicity, and low administrative costs make these more attractive than ever.

For larger employers, the full blown 401(k) plans will be the mainstay. Employers will pay for some, but not all, retirement benefits.

Where employers have highly paid executives and relatively few rank and file employees, cash balance plans will be attractive. I expect that cash balance plans will be popular with medical groups and other professional practices.

Defined benefit plans not converted to cash balance plans will be terminated or frozen.

Effect on Employees Employees can no longer be passive, waiting for the employer to put its own money aside for them and make all investment decisions. Employees now must be active and informed players.

Employees must make greater contributions to amass any kind of realistic retirement income. The long term economic and psychological effects of this responsibility will become apparent as time passes and reality sinks in. The appalling statistics on current savings levels make one wonder if many people will change their savings habits.

Employees will have exclusive responsibility for making their own investment choices. The PPA 2006 allows employers to provide more investment information and offer "default" investment choices. Again, the question is how many employees will take advantage.

Effect on the Financial Service Providers The changes here will be dramatic.
The providers of plans and investments will create entirely new products and services. The competition for retirement investment business will become even more ferocious. With several trillion dollars now in retirement accounts and growing, the financial service providers will be fighting for their share of the market.

Before PPA 2006, employers could not offer the slightest bit of investment advice to employees without running afoul of ERISA's prohibited transaction rules. PPA 2006 loosens that prohibition so that basic investment information can be made available to plan participants. Financial service providers will use this opportunity.

Plan costs will be a battleground. As financial service providers compete for retirement planning business, we can expect better disclosure of costs and, perhaps, an overall lowering of costs for plan participants.

Summary PPA 2006 is an unnoticed financial and tax landmark. It makes us responsible for our own retirement savings, and it gives us some tools and incentives. It gives the private financial services industry the opportunity to develop more and better products and services.

PPA 2006 is certainly imperfect and subject to criticism. But, that's what it is, and it will be with us for a long time.

© 2008 Eugene Parrs