Small Closed DB Plans Need to Monitor §401(a)(26) Status

Strategy blocksIn last week’s blog post covering nondiscrimination testing pitfalls for soft-frozen pension plans, we discussed how defined benefit (DB) plans that are closed to new participants can run afoul of the IRC §410(b) minimum coverage rules. Today’s post discusses how small DB plans closed to new entrants can also have difficulties passing the IRC §401(a)(26) minimum participation test.

IRC §401(a)(26) requires that a minimum number of employees receive a “meaningful” benefit from a DB pension plan. Like §410(b), this is intended to prevent an employer from setting up a plan that only benefits a few highly compensated employees (HCEs) while the remaining staff receive minimal or no benefits.

Specifically, §401(a)(26) requires that the number of benefiting employees be equal to the smaller of:

1. 50 employees; or

2. The larger of (a) 40% of employees or (b) 2 employees

For most medium and large-sized pension plans, achieving the 50 employee threshold is easy and §401(a)(26) doesn’t pose an immediate concern. However, small employers can quickly run into §401(a)(26) difficulties because a small change in the number of DB plan members can have a large impact on whether 40% of employees are benefiting in the plan.

Suppose Company A has 50 employees and sponsors a DB plan that was closed to new entrants in 2008. The number of employees covered under the DB plan has steadily shrunk due to natural turnover and there are currently only 22 employees earning benefits in the DB plan. This means that if 5 new employees are hired (55 x 40% = 22) or if 2 current DB participants retire (50 x 40% = 20), then the plan would be on the verge of failing the §401(a)(26) minimum participation test.

So, what should sponsors of small pension plans do if faced with a §401(a)(26) failure? There are no alternative testing options, so the solutions are very similar to the plan changes that can solve a §410(b) failure.

1. Freeze DB accruals for HCEs

2. Freeze DB accruals for all employees

3. Add new participants to the DB plan

Note that Option #1 is only available if (A) the plan is not top-heavy and (B) the plan is not aggregated with any other retirement plans in order to pass other nondiscrimination tests. Most employers will likely choose option #1 or #2.

Since the demographics of small DB plans can change quickly, it’s imperative that plan sponsors monitor their §401(a)(26).status closely each year. Advance planning is the key to avoiding unpleasant corrective measures such as having to add new participants to the plan retroactively.

Beware Nondiscrimination Pitfalls for Frozen Pension Plans

pitfall-signMany defined benefit (DB) pension plans were closed to new entrants over the past several years. Oftentimes, these plan closures were done with a focus on short-term cost control without understanding some of the long-term compliance implications.

Then, one day, the plan sponsor gets an unwelcome surprise from their actuary – their DB plan is failing the IRS’ nondiscrimination tests! How can this happen – particularly if the DB plan is a “safe harbor” formula that has never needed nondiscrimination testing before?

This post explores how closed DB plans are increasingly faced with IRS nondiscrimination testing compliance issues and suggests some strategies for dealing with this situation.

IRC §410(b) requires that a tax-qualified retirement plan “cover” a nondiscriminatory group of employees. In other words you can’t set up a retirement plan that benefits only highly compensated employees (HCEs) – that’s unfair and you need to include some non-highly compensated employees (NHCEs) too.

§410(b) coverage testing is generally a non-issue as long as a DB plan is open to all employees. However, once a DB plan is closed to new entrants, there will eventually be enough staff turnover so that only a fraction of an employer’s total employee group participates in the DB plan. If this grandfathered group is composed of proportionately more HCEs than NHCEs (which happens when there is higher turnover among the NHCEs), then the DB plan will run into §410(b) testing problems.

Technical Details
There are two ways to prove compliance with §410(b) minimum coverage requirements.

1. Ratio Percentage Test (RPT). This is the most straightforward §410(b) testing option. In this test, A divided by B must be at least 70% where:

A = # of NHCEs in the DB plan divided by the total number of NHCEs, and

B = # of HCEs in the DB plan divided by the total number of HCEs.

Note that “total” NHCEs and HCEs includes all employees who would otherwise meet the DB plan’s age and service eligibility requirements.

2. Average Benefits Test (ABT). When you can’t pass the RPT, you must tackle the Average Benefits Test. This is a multi-step process that focuses on the relative disparity of retirement benefits provided to NHCEs versus HCEs. I won’t go into all of the gory details here, but suffice to say that this is a numerically-intensive test and includes benefits provided by ALL of the employer’s retirement plans. If you can pass this test, then your frozen DB plan satisfies the IRS’ §410(b) minimum coverage requirements.

Suppose Company A has 1,000 employees (900 NHCEs and 100 HCEs) and sponsors a DB plan that was closed to new entrants in 2008. The employer still has a total of 1,000 employees (900 NHCEs and 100 HCEs), but the number of employees covered under the DB plan has steadily shrunk due to natural turnover. There are now only 550 NHCEs and 90 HCEs in the DB plan. Their RPT result is: (550/900) / (90/100) = 67.9% which is below the 70% passing threshold.

In this case, the plan sponsor would need to complete an ABT in order to satisfy the §410(b) nondiscrimination rules.

Forewarned is Forearmed
So, what should plan sponsors do if faced with a potential §410(b) failure? Advance planning is the key to avoiding unpleasant corrective measures. Here are a few options:

1. Have your actuary complete a ratio percentage test, especially if you are in a high-turnover industry. This will help you see how close you are to the passing threshold and will suggest how long you have until the DB plan no longer passes the RPT.

2. If your DB plan is close to failing the RPT, have your actuary run an ABT to make sure that it provides passing results and is a viable back-up to the RPT.

3. If the DB plan’s ABT results are marginal as well, then you should consider some contingency plan design options. These include:

– Freezing DB accruals for HCEs
– Freezing DB accruals for all employees
– Adding new participants to the DB plan

Options #1 and #2 are likely the most agreeable. Very few sponsors who have closed their DB plan ever intend to open it up again like Option #3. Whatever your decision, it helps to be familiar with your options ahead of time so that you can address nondiscrimination testing issues quickly when they arise.

Closed DB plans face special challenges with respect to IRS nondiscrimination testing. Although these issues may emerge slowly over time, plan sponsors should be aware of the consequences and develop a strategy to maintain compliance with IRC §410(b) minimum coverage requirements.

Fixing a §401(a)(4) test failure

Our philosophy for coverage and nondiscrimination testing has always been “everything passes, some plans just take a little longer to prove it”.

That was put to the test recently for one of our law firm clients:  an unusually young new partner was causing their  §401(a)(4) nondiscrimination test to fail.  We emptied the whole toolbox on it, but nothing worked.  Thought we were out of luck.  Adding an extra contribution for all NHCE’s was going to be very expensive.

Ah, but wait!  The IRS came to the rescue with the §1.401(a)(4)-11(g) corrective amendment rules.  Within 9½ months after year end, we can amend the plan to give an extra allocation to a carefully selected group.  Problem solved, at very low cost.

Note that the amendment must have “substance”, i.e. provide real benefits for real people.  One that doesn’t is described in Suzanne Wynn’s blog here.  Nice try, creep…

There’s more detail in the regulations.  Go to paragraph (g) for corrective amendments.