By: Brian Goddu, ASA

To maintain their tax preferred status, pension plans are required to offer benefits that do not discriminate in favor of highly compensated employees (HCE) as defined under § 414(q) of the Internal Revenue Code.  The consequences of running afoul of these nondiscrimination tests can be quite severe, including costly corrections to the plan of benefits or even the loss of qualified status.  While the rules for nondiscrimination testing are extensive, there are a few strategies that can help avoid common pitfalls and maintain regulatory compliance when making changes to an existing plan or setting up a new plan.

A prospective Plan Sponsor has many options when setting up a new pension plan.  Aside from the plan type they want to sponsor (such as a Variable Annuity Plan) they must also design the structure of the benefits: the benefit accrual formula, the subsidies, the eligibility requirements, etc.  While Plan Sponsors are afforded some flexibility in designing a new plan, it should be noted that each layer of complexity in the plan’s design further complicates the required nondiscrimination tests.  To that end, the IRS has approved a number of ‘Safe Harbor’ plan designs that automatically pass nondiscrimination testing under § 401(a)(4).  A plan designed with these ‘Safe Harbors’ in mind can avoid a lot of the work (and cost!) associated with testing for nondiscrimination.

The ‘Safe Harbor’ rules for defined benefit plans are described in §1.401(a)(4)-3(b). For one, these regulations require plans to satisfy a number of uniformity requirements.  One of these uniformity requirements is that the same benefit formula applies to all participants and that benefits accrue over the same years as used in the benefit formula (i.e. a career average pay plan cannot satisfy this uniformity requirement if it continues to account for changes in compensation but freezes service accruals for its participants).  In addition to satisfying all of the uniformity requirements, the regulations require plans to satisfy one of a menu of ‘Safe Harbor’ plan designs.  An astute Plan Sponsor should consider these nondiscrimination ‘Safe Harbors’ when designing a new plan.  Doing so can save the plan time and money in the future.

For an existing plan design, one of the more difficult nondiscrimination traps to avoid is the requirement that benefits, rights and features (BRF) are offered to employees in a nondiscriminatory fashion.  This requirement should be carefully thought through whenever there is a proposed change to the plan of benefits.

Each BRF is deemed to be made available in a nondiscriminatory manner if it satisfies the current availability requirement and the effective availability requirement.  A benefit is “currently available” to a participant if she or he is eligible to earn the benefit, without regard to age or service requirements.  In other words, an optional form of benefit is treated as currently available to an employee based on all other criteria (class, location, etc.), but without regard to the employee’s current age or years of service, and without regard to whether the employee could potentially meet the age and service conditions prior to attaining normal retirement age.  The more robust version of this test is that of the “effectively available” requirement.  The “effective availability” requirement is more subtle and nuanced, and it can be more of a challenge for plan sponsors to maintain compliance in this area.  A BRF meets the “effective” availability requirement if based on all “facts and circumstances” it is effectively available in a way which does not favor HCEs.  The examples below (taken from the regulations and lightly edited for length) provide more clarity and highlight how good faith efforts taken by plan sponsors can still run afoul of nondiscrimination rules.

EXAMPLE A – Plan A provides an early retirement benefit payable upon termination to employees who terminate from service with the employer on or after age 55 with 30 or more years of service.  All HCEs meet the age and service requirement or will have 30 years of service by the time they reach age 55.  All of the NHCEs were hired on or after age 35 and, thus, cannot qualify for the early retirement benefit because unlike the HCEs, they cannot earn 30 years of service prior to age 65.

Even though the early retirement benefit is currently available in a nondiscriminatory way when age and service are disregarded, absent other facts, the group of employees to whom the early retirement benefit is effectively available substantially favors HCEs.

Note that with regard to these requirements the testing population for each BRF changes each time the demographics of the plan’s participants change.  Special care must be taken when significant changes in these demographics are expected and when amendments to the plan of benefits are considered.  The next example illustrates this point.

EXAMPLE B – By amendment Plan B provides an early retirement window that is available only to employees who terminate employment during a two-week window, and who meet an age and service requirement.  Assume that the only employees who terminate from employment with the employer during the two-week period in which the early retirement benefit is available are HCEs.  In general, under these facts, the group of employees to whom this early retirement window benefit is effectively available substantially favors HCEs.

As these examples illustrate, a Plan Sponsor should be aware of their current and expected participant population in order to avoid complications arising from the availability of BRFs.  Additionally, aspiring Plan Sponsors can avoid a lot of future testing by designing a plan that fits within the Safe Harbors.  The full breadth of nondiscrimination testing can be quite complex, but careful planning can help manage these difficulties and insulate Plan Sponsors from costly mistakes.