On January 29th, the IRS proposed revisions to the nondiscrimination testing regulations of §1.401(a)(4). The title of proposed regulations (and most of the attention generated by them) is focused on the relief for closed defined benefit (DB) plans. This post summarizes the proposed changes that would affect more than just closed DB plans. Most of them are beneficial to plan sponsors, but one is not.
The bad news – benefit formula restrictions
The biggest surprise is a proposed restriction in setting different benefit levels for different participant groups.
Currently, plans can generally separate the participant population into groups with different benefit levels/formulas as desired, so long the plan is doesn’t disproportionately favor Highly Compensation Employees (HCEs) relative to non-HCES. Plans can even go so far as to separate each plan participant into his or her own “group”.
The proposed regulations would require HCEs’ benefit formulas to apply to a “Reasonable Classification” of employees*. This is a “facts and circumstances” determination. §1.410(b)-4(b) states that “reasonable classifications generally include specified job categories, nature of compensation (i.e. salaried or hourly), geographic location, and similar business criteria”. Picking participants by name (or in a way that effectively does that) is not considered a reasonable classification.
This is an important issue for plans that allow each participant to have a separate benefit level and rely of the Average Benefit Test to satisfy §1.401(a)(4). Other plans may need to consider if their benefit groups are a reasonable classification.
*Unless the rate group satisfies the Ratio Percentage Test.
The good news – cross-testing gateways for aggregated DB/DC plans
The favorable part of the proposed regulations is more flexibility in combining DB and DC plans for nondiscrimination testing. These proposed changes were suggested by the IRS in Notice 2014-5, so they aren’t a surprise to those that have kept up with the IRS’s previous relief efforts for closed DB plans. However, those suggestions haven’t got much attention so they are good news for many.
Plans must pass through a “gateway” before aggregating DC and DB plans in a cross-test. A cross-test is generally much more favorable than testing each plan separately. The currently available gateways are:
- The DB/DC plan is “primarily defined benefit in character”
- The DB/DC plans consist of broadly available separate plans
- The DB/DC plan provides a minimum allocation to all benefitting non-HCEs
The proposed regulations would expand the DB/DC gateway options in three ways:
1. New gateway: The proposed regulations would add another gateway – passing the cross-test test with a 6% interest rate (rather than the standard 7½% to 8½%). While the DB/DC would technically still need to pass the cross-test with a standard interest rate, this option could practically eliminate the gateway requirement for DB/DC plans that can pass with 6% interest.
2. Matching contributions use: The proposed regulations would allow the average matching contribution for non-HCEs (up to 3% of pay) to count toward the DB/DC minimum allocation gateway. Matching contributions would still not be included in the cross-test.
3. Option to average DC allocation rates: Current rules allow DB allocation rates for non-HCEs to be averaged for satisfying the minimum allocation gateway. The proposed regulations would allow the same treatment for DC allocation rates. The purpose of this change is to allow plans to provide lower allocation rates for those with less service by providing higher rates to those with more service.
The IRS notes that they’re considering if restrictions on this option are needed to ensure it is used as intended, and not as another technique for minimizing non-HCE benefits. The proposed regulations would also limit averaging of DB and DC rates to reduce the impact of outliers.
Many plans that satisfy the §1.401(a)(4) requirements with a general test will need or want to revisit their benefit formula design if these proposed regulations become final. There is sure to be a lot of resistance to the benefit formula restrictions, so the regulations may not be finalized as proposed. If you would like to send comments on the proposed regulations you can do so until April 28, 2016.
Plan sponsors may apply the proposed regulations specific to closed DB plans right away, but may not use the flexibility of the other proposed cross-testing rules until they are finalized. We encourage you to contact your actuary if you have questions about how these proposed rules would affect your plan.