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.

1. The top-heavy minimum benefit decreases from 5% to 3% of pay. In addition, only participants who are employed at year-end need to receive this allocation. So, you no longer have to provide a top-heavy minimum benefit to employees who terminate during the year. Note: even if the DB plan is terminated and benefits paid out, those DB payments for active employees must still be considered in the remaining plans’ top-heavy determination for up to five years.

2. Since there are no DB plan benefit accruals to test any more, the only cross-testing that may be needed is for the DC plan itself. This means that the “gateway” minimum allocation decreases from 7.5% of pay to 5% of pay.

Plan sponsors generally welcome the reduction in minimum profit sharing benefits that accompany a DB plan freeze or termination. However, there’s at least one important HR consideration: What’s the impact on employee morale when a DB plan freeze/termination is accompanied by a reduction in profit sharing?

This “double-whammy” could make employees very unhappy. An alternative is to keep profit sharing rates unchanged for a while and then decrease them in future years if that fits into the company’s overall benefits strategy. If you’ve frozen or terminated your DB pension plan during 2011, now is the time to explore your options before year-end profit sharing allocations are due!