Sponsoring a retirement plan can provide significant benefits to a company (and its participants). But with great benefits comes great responsibility…responsibility to follow all of the various regulatory requirements. Since these plans provide hundreds of billions of dollars in tax deductions each year, Congress and the various agencies want to be sure everyone is playing by the rules.
In our first ten installments of the Cash Balance Corner, we have walked through some general topics such as benefit formulas, funding requirements and plan documents. We’ve applied these concepts to Robert Smith, Inc., which sponsors a cash balance plan for its owner and only employee. Our last installment dips a toe into the complex waters that start to emerge when a the first non-owner employee becomes eligible for the plan.
As with many elements of running a business, things start to get complicated quickly with the hiring of employees, and maintaining a cash balance plan is no different. Some of the new requirements include participant disclosures, government reporting, fiduciary responsibility and fidelity bonding, just to name a handful. However, of all the new obligations, very few are as complex – and have as much impact – as nondiscrimination testing.
Over the next few installments, we will dig a little deeper (but don’t worry, not geeky deep) into the vernacular, process and impact the nondiscrimination rules can have. In general, the term nondiscrimination is a broad one that basically means the plan’s highly compensated employees cannot receive benefits that are disproportionately higher than those provided to non-HCEs. Prior to the passage of these rules, plan sponsors could easily provide substantial benefits to owners while excluding most, if not all, the employees.
What does nondiscrimination mean? Good question. There are three main areas in which a plan must be nondiscriminatory:
- Benefits, and
Since nondiscrimination testing compares highly compensated employee (HCEs) to non-HCEs, let’s quickly recap who fits into which category. An HCE is anyone who meets either of the following two requirements:
- Anyone who owns more than 5% of the plan sponsor (or a related company) in the current or immediately preceding year, or
- Anyone who received compensation from the plan sponsor of more than $130,000 (indexed for inflation) in the immediately preceding year.
A non-HCE (or NHCE) is anyone who is not an HCE. As with anything else dealing with qualified plans, the HCE rules get a bit more involved. If you want to dig into those details, we’ve got you covered here.
Now, the time has come to get our feet wet.
Nondiscrimination in Coverage
The basic coverage rules state that the percentage of NHCEs benefiting in a plan must be at least 70% of the percentage of HCEs benefiting in the plan. For example, if all HCEs benefit then 70% of the NHCEs must also benefit. If only half of the HCEs are covered, then only 35% of the NHCEs must (70% x 50% = 35%). Back at Robert Smith, Inc., Robert is the only HCE. Since he is benefitting, that means Simon (the only NHCE) must benefit as well.
If a company has more than one plan, there is a rule that allows the participants in all of those plans to be combined to satisfy the coverage requirement. This is referred to as permissive aggregation. This optional rule is helpful in situations where a cash balance plan is designed to only cover specific groups of employees while excluding others. It is important to keep in mind that any employee exclusions must be clearly defined and follow reasonable business classifications. Some examples include job title, location, or ownership; exclusion by name is typically not suggested.
A more detailed discussion of the minimum coverage test is available for your reading pleasure here.
Nondiscrimination in Benefits
Now that we have an idea of who is covered by the plan, we can talk about the benefits they receive. Much like coverage, a certain percentage of NHCEs must receive benefits that are equivalent to or greater than those provided for a certain percentage of HCEs. We know we threw the word “percentage” around a few times there. Since we promised not to dive too deep into the weeds, we will leave the percentage discussion here for now and discuss how a benefit is deemed equivalent.
There are numerous methods to demonstrate nondiscrimination in benefits. The easiest is to provide everyone the same level of benefits, i.e. the same dollar amount or the same percentage of pay. It is also possible to provide slightly higher benefits to those who earn more than the social security wage base to make up for the fact that they won’t receive social security benefits on that so-called excess compensation. On the plus side, these methods are pretty much guaranteed to be nondiscriminatory; however, they also typically require the highest level of contributions for NHCEs. We expand on these concepts in the context of a profit sharing plan here.
The new comparability (or cross-tested) method of nondiscrimination testing comes into play when a plan provides different levels of benefits to different participants or groups of participants. It is also the most efficient method to use for a combined 401(k)/cash balance plan design.
What is the new comparability method? To really simplify it, the new comparability method tests benefits at retirement rather than current contributions to confirm nondiscrimination. The benefit is determined by first projecting the current allocations (profit sharing and cash balance) to the plan’s stated normal retirement age and converting to a monthly benefit. The younger the participant, the more years to retirement, the longer the projection period, and the higher the benefit used for testing. That works great if those younger participants are non-HCEs, but it can present challenges if one or more of them are HCEs.
Similar to coverage, a plan sponsor can permissively aggregate benefits from multiple plans to prove nondiscrimination. If used, the plans must be permissively aggregated for all purposes.
Why would plans need to be combined for this purpose? Most 401(k)/cash balance combinations are designed to provide most HCE benefits in the cash balance plan and most NHCE benefits in the 401(k) profit sharing plan. If the two are not combined, the cash balance plan could not satisfy the requirement to be nondiscriminatory in benefits.
We’ll look at more examples later, but let’s revisit our friend Robert to illustrate. His plan provides a 66.67% of compensation benefit for himself as the owner and 5% of compensation to all others. When the 5% benefit is projected to retirement, it is not sufficient to pass the nondiscrimination test. As a result, the cash balance and profit sharing allocations must be combined to pass the test.
Nondiscrimination in Participation
This all leads to another question. If the profit sharing allocation for the NHCE will help the plan prove it is nondiscriminatory in benefits and the plans are also combined for coverage, why not exclude the NHCE from the cash balance plan and keep it as owner-only? This is a great question and also a great transition into our last topic – the minimum participation test.
This rule has been around for a while and used to apply to all plans; however, thanks to a law change in the late 1990s, this test now applied only to defined benefit plans. It specifies that a defined benefit plan must provide a “meaningful benefit” to at least 40% of the employees (of if less, at least 50 employees). However, if there are only 2 employees, both must be covered. This last rule is why we cannot keep Simon (Robert’s employee) out of the cash balance plan. If there were a total of 4 employees (2 owners and 2 non-owners) then the cash balance plan could be designed to benefit only the owners (40% of 4 employees = 1.6 employees) with the benefits for the employees provided in the profit sharing plan. The minimum participation rules do not require a certain number or percentage of NHCEs to be covered.
You’re probably wondering how much is a “meaningful benefit” and for good reason since it is not defined in the law or regulations. Instead, the IRS works under the assumption that if the cash balance allocation is large enough to provide a monthly benefit equal to at least 0.5% of salary at normal retirement, then it is meaningful. We will not bore you with additional explanations except to say that a current allocation of 3% to 5% of pay is typically sufficient to meet this threshold for enough participants to pass this test.
That’s enough for one installment. Our next few editions will include some examples of how changes in employee demographics can affect a plan’s compliance with the nondiscrimination rules.