In 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.
A colleague just showed me this blog post. Curious: if you freeze the plan, how do you pass the prior benefit structure test of 1.401(a)(26)-3(c)?
Thanks for the good question and sorry for the slow response. 1.401(a)(26)-3(c)(1) is a pretty straightfoward numerical test that most mid- and large-sized plans can pass for quite a while (smaller plans might have more difficulty). 1.401(a)(26)-3(c)(2) is more of a facts and circumstances test. There’s no guarantee that any frozen plan will – or won’t – pass this test. It depends heavily on the plan design.