Almost every employer-sponsored retirement plan (whether it’s a pension plan or a 401(k) plan) must satisfy certain nondiscrimination tests set forth in the internal revenue code. The IRS mandates these tests to ensure that if an employer is getting retirement plan tax deductions, then the plan should be designed so that benefits are not skewed towards Highly Compensated Employees (HCEs). This post deals with a particular test required under section 401(a)(26) of the internal revenue code that may be particularly difficult for cash balance plans to pass in 2009 and 2010.
The 401(a)(26) test is a two pronged test. It mandates that:
- A minimum number of employees (the smaller of 50 people or 40% of the group) receive benefit accruals in the plan; and
- These accruals must be “meaningful”.
According to the IRS, “meaningful” means a benefit accrual of at least ½ % of pay per year, payable at normal retirement age.
Most employers can easily satisfy the first prong of the test by ensuring that a minimum number of employees are covered under the plan. It’s the second prong of the test that is often overlooked.
For cash balance plans, the “meaningful” measurement requires a benefit projection using the plan’s interest crediting rate. The IRS guidance doesn’t refer to a ½% cash balance credit; it’s a credit big enough to generate a ½% retirement benefit.
Since many cash balance plans’ interest crediting rates are tied to the 10-year or 30-year Treasury rates (which are at near-historic lows), the projection of accruals to normal retirement age is lower than it may have been in prior years. This is especially true for young participants in professional service cash balance plans who are already receiving a lower benefit accrual rate than the (usually older) owners. The end result is that the plan may fail the 401(a)(26) test because not enough young (non-owner) employees are earning “meaningful” benefits.
The simplest way to fix this testing failure is to increase the annual pay credit rate for the non-owner employees. Usually this is a relatively inexpensive plan amendment, but care must be taken to make sure that your actuary is monitoring the situation each year. This also highlights the importance of thoughtful cash balance plan design and not setting up a plan that only provides minimal benefits to non-owners, in case there are unintended consequences down the road.