Outside the complex world of qualified plans, the term “nondiscrimination” can take on many different meanings based on many different points of view. Fortunately, in the qualified plan world, the meaning of “nondiscrimination” is well defined, albeit quite complex. Here, the only point of view that matters is that of the IRS.
We summarized the nondiscrimination requirements as they relate to qualified plans in general here and how they apply to cash balance plans more specifically in the February installment of Cash Balance Corner. Here, we will illustrate how cash balance plans can pass the nondiscrimination tests and why, in most cases, it is more cost-effective to do so in combination with a 401(k) plan.
But first, a math alert! We will include a few formulas as we work through a couple examples. Don’t worry; they are just meant to give you an idea of how the calculations work. There won’t be a quiz at the end.
Congress and the IRS wrote the nondiscrimination rules to allow multiple methods of compliance. The most straight-forward is to provide every eligible participant with the same benefit as a percentage of his or her pay. For example, if all the highly compensated employees (HCEs) and non-HCEs alike receive 5% of plan compensation, the plan satisfies the nondiscrimination requirements. This is referred to as a “safe harbor” formula, not to be confused with a safe harbor 401(k) plan. For plan sponsors with only a 401(k) plan, an employer contribution of 5% may be acceptable and fit into the retirement budget.
However, when a company adopts a cash balance plan, the allocation for the owner typically exceeds 50% of pay and many times approaches 100%. Not only would an across-the-board benefit of that amount likely exceed other limits, but it would also be budget-buster for most companies.
That is where cross-testing come into play. Cross-testing uses the time value of money to help demonstrate that a plan can provide different levels of benefits to different participants and still be nondiscriminatory. Here is how it works.
Each participant’s allocation is projected to the normal retirement age specified in the plan document and then converted to a benefit as a percentage of plan compensation. This is where it starts to get a bit tricky. The interest rate used to project the profit sharing allocation must be between 7.5% and 8.5% (though almost always 8.5%), while the cash balance allocation must be projected at the plan’s specified interest crediting rate (3% for most of the plans we work with).
Let’s pay a visit to our friends at Robert Smith, Inc. to see how this works in action.
Robert’s cash balance allocation is $100,000 - 66.67% of his $150,000 plan compensation.
We project that amount from his current age of 52 to the plan’s normal retirement age of 62, using the 3% interest credit as follows:
$100,000 x (1.03)^10 = $134,391
We then convert that result to an annuity (starting at age 62) by dividing it by an annuity factor based on the 3% interest credit:
$134,391 / 16.5 = $8,145
That represents a monthly amount the plan will pay to Robert for life, starting at age 62.
Next, we divide the projected annuity by Robert’s plan compensation to arrive an accrual rate:
$8,145 / $150,000 = 5.43%
Note that the interest rates and annuity factors are prescribed by the IRS, so don’t feel bad if you couldn’t figure out where those figures came from.
Now let’s do the same calculation for Simon (Robert’s employee). Simon is 30 years old with plan compensation of $50,000. His cash balance allocation is $18,000 or 36% of pay. His accrual rate is 5.62%, calculated as follows:
Step 1. $18,000 x (1.03)^32 = $46,351
Step 2. $46,351 / 16.5 = $2,809
Step 3. $2,809 / $50,000 = 5.62%
Since Simon's accrual rate exceeds Robert's, the plan passes this nondiscrimination test with Robert receiving 66.67% of plan compensation and Simon receiving 36%. Robert's business is doing well, but not so well that he can afford 36% of compensation for retirement benefits to his employee.
Here’s how combining a cash balance plan with a profit sharing plan leads to a more affordable plan design. We’re sure you’re wondering how adding a second plan can be more affordable than just a single plan. A very valid question. The answer lies in the higher interest rate we can use to calculate the accrual rate for profit sharing contributions. The law allows the use of the 8.5% rate for both the projection to retirement AND the annuity conversion.
Let’s assume that Robert’s full benefit comes from the cash balance plan, which creates the 5.43% accrual rate shown above.
Simon, on the other hand, receives nothing in the cash balance plan and a profit sharing contribution equal to $2,000 or 4% of his plan compensation.
Step 1. $2,000 x (1.085)^32 = $27,213
Step 2. $27,213 / 9 = $3,024
Step 3. $3,024 / $50,000 = 6.05%
Note not only does the 8.5% interest rate create a larger balance at age 62 ($27,213 vs. $5,150), but the smaller annuity factor produces a higher projected annuity ($3,024 vs $312) which translates to a higher accrual rate.
So, by moving Simon’s allocation from the cash balance plan to the profit sharing plan, the associated cost decreases by $16,000.
But what about minimum participation?
Well done! You remembered our March discussion. If there are only two eligible employees in a cash balance plan, both must receive a meaningful benefit in that plan. That means Robert must provide a cash balance benefit to Simon even though the total benefit amounts are nondiscriminatory with him only receiving a profit sharing contribution.
We will spare you the calculation of Simon’s meaningful benefit amount, but suffice it to say that 4% of compensation will do the trick. That produces an accrual rate of 0.59%, which means we only need to increase it by an additional 4.84% to equal Robert’s 5.43% accrual rate.
We’ve already thrown enough math at you for one column, so we’ll cut to the chase. A profit sharing allocation of $1,600, or 3.2% of Simon’s pay, yields an accrual rate of 4.84%.
WooHoo! The plan passes nondiscrimination! Almost…
Right about now, you must be wondering, “Wait, what do you mean almost?” There is one more piece to this puzzle – the minimum gateway contribution. We’ll explain.
The IRS was concerned that if the demographics fall just right, plans could satisfy the numerical nondiscrimination tests while providing very minimal benefits to some or all of the non-HCEs. To alleviate that concern, they created what is called the minimum gateway contribution, which is a sort of cover charge a sponsor must pay to even be allowed to use cross-testing to demonstrate nondiscrimination. When dealing with just a 401(k) profit sharing plan, the minimum gateway contribution is usually 5% of pay. However, when combined with a cash balance plan, the gateway is typically 7.5% of pay.
In the above example, Simon has a total accrual rate of 5.43%, which is the same as Robert’s. Even though the plans pass testing without the gateway, Robert must provide Simon with an additional profit sharing allocation to meet the gateway requirement. In this case, Simon is already receiving 3.2% in profit sharing, and after the actuarial calisthenics, the 4% cash balance allocation translates to about 0.5% towards the gateway. That means it takes an extra 3.8% of pay to get there. However, at only $1,900 in this situation, the additional gateway contribution is still far less expensive than what it would take to pass without cross-testing.
The accrual rate examples require some additional fine tuning, but we’ve already gone far enough into the weeds for one column.
There is one more thing we should point out. In our example above, we have only Robert and Simon - one HCE and one non-HCE. That means Simon’s accrual rate must be at or above Robert’s. However, if one or more additional non-HCEs become eligible, not all of them must be at that same level. As long as “enough” non-HCEs have accrual rates at or above Robert’s, the others can be at a lower rate.
That’s all for now. In the next installment, we’ll take a look at some of the design tweaks that may be preferred in the 401(k) profit sharing plan to ensure it pairs with the cash balance plan most effectively.