Interview conducted by Roberta Hess of Princeton Marketing
Understanding coverage and nondiscrimination testing in DB plans.
What plan sponsors and advisors must know about coverage and nondiscrimination testing.
Jeff Thornton is a Senior Actuary at The Retirement Advantage, Inc. TRA. He has 18 years of experience in cash balance plans, financial accounting, nondiscrimination and coverage testing, plan design and government reporting. In this article, Jeff talks about nondiscrimination testing in defined benefit plans.
Can you provide a high level overview of the coverage and nondiscrimination requirements for defined benefit plans?
There are many tests that defined benefit plans must pass each year, but I will discuss three of the major tests.
The first one I will discuss is coverage where you are evaluating how many people are covered in the plan. This test is not looking at the benefit amounts and is strictly making sure that enough employees are participating in the plan.
The second test I will discuss looks at how many employees are getting “meaningful benefits” under the plan where “meaningful benefits” are defined in regulations. This test does not look at who is highly compensated versus who is non-highly compensated. It just looks at how many people are covered and getting a meaningful benefit from the plan. The magic number there is 40% of employees. For example, if you have ten people in your company, that would mean at least four people would have to get a meaningful benefit from the plan. What constitutes a meaningful benefit? For a cash balance plan, you would project the hypothetical account balance forward with interest to your normal retirement age, typically 62 or 65, then you convert that into an annuity. As long as that annuity works out to at least half a percent of your compensation, that’s a meaningful benefit. An exception to the 40% rule mentioned earlier is that if it’s a one-person or two-person plan, then 100% of your people have to get a meaningful benefit. But if you have three or more, that’s when the 40% rule comes into play.
The third test is the most complex test, which is the nondiscrimination testing. This test looks at the level of benefits that are being received by the highly compensated employees (HCEs) and compares it to the level of benefits received by the non-highly compensated employees (NHCEs). Some parts of the test are looking at the average benefit amounts for the HCEs vs. the average benefits for the NCHEs, but there is also a component of the test that ensures that each HCE does not get a disproportionately large amount of the benefits for the retirement plan.
One of the main drivers to setting up a retirement plan sponsor is for the tax deduction. Those are very appealing to plan sponsors, but if you want those tax savings, you have to play by the rules. That means you can’t just set up a plan for yourself (the owner) and then not give your staff anything. You also can’t just set it up for yourself (the owner) and then give everybody a dollar. So where is the line drawn on how much you must give? There’s a certain minimum threshold the law says you have to give to your staff in order to qualify as a tax deferred retirement plan which are explained in the Internal Revenue Code and regulations. These rules are there to protect the “average Joe”.
When does the last test that you discussed (the nondiscrimination testing) become an issue for a small business owner?
It really becomes an issue if you have a mix of plan participants…at least one highly compensated employee (HCE) and at least one non-highly compensated employee (NHCE). If you have all HCEs or all NHCEs, then there’s no possibility for discriminating. One common misunderstanding is that determining HCEs is solely based on compensation. There is also an ownership factor that comes into play that, in general, makes the owner and the owner’s direct relatives all HCEs regardless of their compensations. Therefore, if you are an owner but not paying yourself a large amount, you would still be considered an HCE, and if you have employees, then you would need to worry about nondiscrimination testing.
How have the rules changed for coverage and nondiscrimination testing?
For the most part, there have not been many recent changes to the rules related to testing. However, one law that recently passed that changed some key provisions was the SECURE Act, that gave certain relief to some plans that were “frozen”. “Frozen” plans are either “soft frozen” or “hard frozen”. Soft frozen plans exclude any new participants from entering the plan while the existing participants continue to accrue benefits. A hard freeze is to exclude new participants from entering the plan plus ceasing all future accruals for the existing participants.
Many of these frozen plans were having trouble passing testing, but the SECURE Act has come in and provided some much needed relief so that these plans can continue to pass the coverage test and meaningful benefits test.
Are there any tips that you have for plan sponsors in terms of passing nondiscrimination testing?
A very popular design is where the company sponsors both a defined benefit plan (such as a cash balance plan) and one defined contribution plan (401(k) profit sharing plan). The rules and regulations are set up so that you can, in most cases, “cross test” the two plans. That often does produce some much better results in terms of passing the testing compared to trying to get a plan to pass discrimination testing on its own. The reason for this is that the rules are slightly different with how you project the employer benefits forward in a defined contribution plan versus a defined benefit plan. By allocating the majority of the benefits to non-highly compensated employees in your 401(k) plan and providing the majority of the highly compensated employees’ benefits in the defined benefit plan, the testing results are typically more beneficial in terms of getting the testing to pass.
Although the cost of administering two plans is greater than administering one plan, the additional costs are commonly more than offset by the savings realized by aggregating the plans for testing purposes.
What is the new comparability allocation method and how does it relate to nondiscrimination testing?
The new comparability allocation method is a method of allocating a profit-sharing amount in a defined contribution plan. It basically says that each participant is in their own group and, therefore, gets their own profit-sharing allocation. For example, participant A could get a 4% profit share, then participant B could get a 5% profit share, and participant C could get a 6% profit share under the new comparability profit share design. The other profit-sharing allocations methods are not as flexible as this. The appeal of the new comparability profit sharing allocation method is that you have a greater degree of flexibility when you are performing an aggregated test with the defined benefit plan. You can target a certain person (with some limitations) to get a profit-sharing amount that would help the test pass, and not everybody would have to get the same profit-sharing amount.
If a small business starts off owner-only, maybe with a spouse or partner, then starts adding employees, when should you start working with an experienced third party administrator? And why?
At TRA, we have quite a bit of owner-only plans. Owner-only plans sound simple, from the sense that you don’t really have discrimination and coverage testing. There are a lot of things you don’t have to worry about. However, there are still a lot of things you do have to worry about, such as minimum funding requirements. The calculation of the minimum funding requirement and the certification that the minimum funding requirement was met does require an actuary each year. In summary, even though a plan is an owner-only plan, they must still work with a third party administrator with an actuary on staff.
In terms of why plan sponsors should work with an experienced third party administrator, the first reason why is making sure that your plan is being run in accordance with the law and regulation. A second reason is the consulting side of it. I have seen some plans designed by others where it appears that they were just “stuck in a box” where that box might not be the optimal way to operate your plan. A plan that the plan sponsor is satisfied with requires a strong and ongoing dialogue with the client in order to identify pain points, educate the client about how the plan works, and provide proactive solutions.
It sounds like knowing all the rules and doing the tests correctly isn’t easy. What’s a small business owner to do?
A small business owner should find a knowledgeable and trustworthy third party administrator that can assist them in running their plan. I believe a major difference between 401(k) and defined benefit plans is that we run into clients that don’t understand how their plan works or they don’t realize something until it’s too late. For example, we sent this client a report that said there are minimum funding requirements in defined benefit plans, and that they have to fund it or else there’s a penalty. The client said that they can’t afford the minimum funding requirement, and unfortunately there wasn’t anything that we could do about it per the rules and regulations surrounding the calculation of the minimum funding requirements. Many times if they had said something sooner, it could have been either avoided or the issue could have been made better in some fashion. The consulting side of it is much more important than it is with a 401(k) plan. The consulting and the education about how the plan operates, I believe, is the key to ensuring that the plan sponsor is satisfied with their defined benefit plan.
At TRA, our business is knowing your business. Whatever challenges you face or goals you want to reach as a plan sponsor or advisor, TRA’s Actuarial Team has the expertise, partnership and integrity to create a customized defined benefit solution.
