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.
