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.

Background
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.

Example
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.

Strategies
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.

Background
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.

Example
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.

Employers Need to Understand Minimum Profit Sharing Benefits for Frozen/Terminated DB plans

Freezing or terminating a defined benefit (DB) pension plan can have unforeseen implications for a company’s profit sharing plan. This is especially true if the plans are top-heavy or rely on IRS cross-testing methods (e.g., professional firm cash balance plans). This post explores changes to minimum profit sharing benefits that occur when plan sponsors freeze or terminate their top-heavy/cross-tested DB plan.

Background

When retirement plans are top-heavy and/or rely on cross-testing procedures to pass IRS nondiscrimination testing, there are several minimum benefits that must be provided to non-Key employees and non-highly compensated employees (NHCEs). For sponsors of both a DB and a DC plan, these minimum benefits often include:

  • 5% DB/DC top-heavy minimum for all participants employed at year-end or who work at least 1,000 hours during the year (note: separate DB and DC options are available instead of the single 5% minimum)
  • 7.5% DB/DC minimum “gateway” allocation for cross-testing

What happens when the DB plan is frozen or terminated?

When accruals in the DB plan cease, there are a couple of immediate consequences for the minimum profit sharing allocations. Read more…

Now is the Time for Retirement Plan Decisions

Many successful companies (especially professional firms like medical groups and law firms) are considering whether to increase retirement plan deductions for 2011. This post highlights the action steps to take while there’s still time.

Note: We’ll be focusing on cross-tested profit sharing plans and cash balance plans. These plans allow owners to make large tax-deferred retirement contributions in exchange for providing a generous employee retirement allocation (usually 5% of pay if there’s only a profit sharing plan, or 7.5% of pay if there’s a cash balance plan too).

1. Get educated before diving in. Before setting up a retirement plan, you need to understand all of the rewards, risks, and costs. Our “Eyes Wide Open” post is a great place to start. You can also find lots of information by googling a phrase like “cash balance plan FAQ”.

2. Know your deduction goals and be realistic. There are various levels of deductions available in an employer-sponsored retirement plan. Move on to “the next level” only if you have maximized lower-level deductions. We’ve written an article that summarizes the “big, bigger, and biggest” retirement plan deduction opportunities.

You should work with a qualified retirement plan consultant to analyze which options will work best for you in the long run (e.g., if income varies significantly from year to year, then profit sharing is better than a cash balance plan). A recent onwallstreet.com article provides a good summary of the pros and cons of different retirement plans along with examples.

3. Get started now. If you want to set up a plan and make deductions for 2011, then it must be in place (with a signed plan document) by December 31. For profit sharing and cash balance plans, you’ll have until until September 15, 2012 to make contributions for the 2011 plan year.

If you’re focusing on a new plan for 2012, it’s still a great time to get the ball rolling. Having a plan in place early in the year ensures that you have more time to set aside assets to contribute. It’s especially important to get a safe harbor 401(k) plan [which often complements a cash balance or profit sharing plan] set up now because IRS rules require you to notify employees at least 30 days before the new year (i.e., by the end of November).

Profit sharing and cash balance plans can be great tools for business owners to make significant tax-deferred retirement contributions. The deadline for establishing a plan in 2011 is fast approaching, so now is the time to take action.

Strategic 401(k) Design: Preventing ADP Failures

If your 401(k) plan is failing the Actual Deferral Percentage (ADP) test, then it’s time to consider some plan design changes. You need to figure out a way to encourage non-highly compensated employees (NHCEs) to save more retirement money in their 401(k) accounts while keeping benefit costs under control. This post will guide plan sponsors through some strategic (yet straightforward) benefit changes that can improve your plan’s chances of passing the ADP test next year.

1. Add a 401(k) match. If your plan doesn’t already have a 401(k) match, adding one will encourage employees to at least defer a minimal amount into their 401(k) accounts. More NHCE deferrals = better ADP test results.

2. Enhance the current 401(k) match. If your plan already has a match but it isn’t getting NHCEs to defer, then there are a couple of options:

Increase the match: Maybe that 1% match just isn’t worth it for some folks. A 3% match is about average, and any increase can be factored-in when considering an employee’s total compensation package.

“Extend” the match: The goal here is to increase the amount of compensation eligible for a match while not increasing employer costs. For example, if you currently match 50% of the first 6% deferred then consider amending the plan to match 40% on the first 7½% deferred. Both formulas have a potential match of 3% of compensation, but the latter encourages employees to save at a higher rate in order to earn the full match.

3. Add an automatic enrollment feature. An Eligible Automatic Contribution Arrangement (EACA) is a feature where new participants are automatically enrolled in the 401(k) plan at a uniform deferral rate, unless they elect to opt out. If your 401(k) plan is suffering the ADP failure blues because few new hires are deferring, then this is a great way to increase your ADP rate and encourage employees to save for retirement. There’s also the Qualified Automatic Contribution Arrangement (QACA) option, which is a safe harbor plan combined with an automatic enrollment feature.

4. Add a “safe harbor” plan design. If you adopt one of these IRS-prescribed benefit formulas, then you get a “free pass” on ADP testing. Safe harbor benefits are 100% vested immediately and you must provide notice of the safe harbor status to participants at least 30 days prior to the start of the plan year. The minimum safe harbor benefit formulas are:

– At least a 3% automatic (i.e., non-matching) employer contribution to each participant’s 401(k) account; or

– An employer match of at least 100% on the first 3% deferral plus a match of at least 50% on the next 2% deferral (i.e., a potential match of 4% of pay).

If you have a cross-tested profit-sharing plan or cash balance plan, then the 3% non-elective option is often the best choice since those benefits count towards the non-discrimination tests whereas the matching formula does not.

Each of the options above has variations and can be combined with the others. Combined with a thorough campaign to educate participants about the changes, they’ll improve your chances of passing the ADP tests next year and avoid having to refund HCE deferrals as taxable income.

Cash Balance Gateway Contributions

One of the hurdles that business owners face when exploring a cash balance plan is deciding whether the cost of the plan justifies the cash balance deduction opportunities. It is a bit of a balancing act, but this post will review one such cost: the IRS “gateway contribution” for cross-tested cash balance plans.

The IRS allows cash balance plans to have some acceptable disparity between benefits provided to owners versus those provided to non-highly compensated employees. Most small-firm cash balance plans utilize these rules through a process call “cross-testing”. The cross-testing mechanisms are VERY complex and we won’t delve into the intricacies here, but the basic theory is:

  1. Large benefits are provided to owners through the cash balance plan.
  2. A reasonable benefit is provided to non-highly compensated employees through an annual profit sharing plan allocation.
  3. In order for the cash balance plan to pass the IRS non-discrimination testing rules, the cash balance benefits are combined with the profit sharing benefits and a single IRS nondiscrimination test is performed.
  4. IRS rules mandate that if a cash balance plan is cross-tested, then the total annual allocation for each non-highly compensated employee must be at least 7.50% of pay. This 7.5% minimum benefit is the “gateway contribution”.

So, many potential plan sponsors will learn during the plan design process that they have to provide their employees with retirement benefits equal to 7.50% of pay each year. If you are already giving employees a 5% profit sharing contribution each year, then it may be palatable to give them another 2.5% either in the profit sharing plan or in the cash balance plan. This could allow each of the owners to have an annual cash balance accrual of $100,000 or more.

However, if you have a large employee base (relative to the number of owners) or do not already provide generous retirement benefits to your employees, then you may find the cash balance gateway requirement of 7.5%-of-pay to be cost-prohibitive. This is one of the warning flags we talked about in our previous Eyes Wide Open post. You can read more more information on the nuts and bolts of cash balance plans at our informational website.

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.