By John Markely, As seen in Plan Consultant Magazine – Summer 2020
Long-sought provisions in the law will result in major relief for nearly all frozen pension plans.
The Setting Every Community Up for Retirement Enhancement (SECURE) Act, signed into law on Dec. 20, 2019, is the most significant legislation related to retirement plans to be enacted in the last decade.The SECURE Act will have significant impacts on defined contribution plans, but there are also major provisions that affect defined benefit and cash balance plans.This article will address the relief provided in the law from multiple nondiscrimination tests in the context of frozen plans.
Background on Nondiscrimination Testing for Frozen Plans
For at least the last decade, sponsors of traditional defined benefit plans have taken action to minimize risk and reduce future contributions. If the plan sponsor had the resources and the plan no longer met the sponsor’s goals, the plan could be terminated. Other common actions have been “hard” freezing the plan, meaning that not only will no new employees enter the plan, but current participants will earn no future benefits. An alternative action was “soft” freezing the plan, meaning that no new participants will enter the plan but current participants would continue to earn a benefit. Since years have passed from the time these actions were taken, many plans have run afoul of IRS nondiscrimination rules, because new employees were not entering the plan, so the employees actually covered by the plan become older, longer-service employees.These employees were likely to be highly compensated employees (HCEs), and the standard IRS nondiscrimination testing rules would lead the sponsors of these plans to potential consequences that were unfavorable, such as additional contributions to the company’s defined contribution plan.
The IRS issued temporary relief in 2013, and plan sponsors hoped and waited for some form of permanent relief in the years that followed. But a permanent solution would have to come from legislation.
Now, at last, permanent relief has arrived! The SECURE Act provides relief from multiple nondiscrimination tests. Following is a description of this relief.
Meet the XYZ Corporation
To start, let’s assume that XYZ Corporation has sponsored a defined benefit plan for several decades. In 2008, the plan was soft frozen; therefore, as of Jan. 1, 2009, no employees could enter the plan. At this time, there were 10 HCEs and 200 non-HCEs (NHCEs). All employees were benefiting in the plan, so the ratio of NHCEs covered to HCEs covered was 100%.The plan had a safe harbor benefit formula.
During the next five years, some of the participants covered by the plan terminated employment or retired, and employees were hired to replace them, but the newly hired employees did not enter in the plan. After five years, the pension plan covered 8 out of 10 HCEs of XYZ and 80 out of 200 NHCEs. The ratio percentage is 80/200 divided by 8/10, or 50%. Since this percentage is less than 70%, the Average Benefits Percentage (ABP) test was completed.The employer has a safe harbor match 401(k) plan with good participation, so the ABP test was passed.Similar testing applied for the benefits, rights and features (annuity form of benefits), and Section 401(a)(4) testing passed.
In 2018, 10 years later, the plan had 8 out of 10 HCEs and 50 out of 200 NHCEs. XYZ is concerned about two testing issues. The plan has only 58 participants; if it drops below 50, 401(a)(26) testing will be violated and the plan will have to be frozen and/ or terminated, or they could add more participants.The plan is also in danger of dropping below a 20% ratio percentage and requiring rate group testing in combination with a defined contribution plan. Since the 401(k) plan provides only matching employer contributions, testing will fail if the ratio percentage continues to decrease.
Now let’s see how the SECURE Act can solve the nondiscrimination testing issues of XYZ Corporation.
Benefits, Rights and Features: Testing Under Section 401(a)(4)
A soft- or hard-frozen plan would still be providing annuity forms of benefits.
Potentially, such a plan could run into issues with benefits, rights and features. The SECURE Act addresses this issue by deeming that closed or frozen plans will pass the BRF testing if:
- the plan passes BRF testing during the year in which the closure occurs and the following two plan years;
- there have been no subsequent discriminatory amendments to modify the closed class or changing the BRF to the closed class; and
- the plan cannot have a substantial increase in coverage or value of the BRF in the five years preceding the date on which the class is closed, which could occur through amendment. However, if the freeze occurred before April 5, 2017, this requirement is met.
Minimum Participation Under Section 401(a)(26)
Let’s consider a plan with five employees that is soft- or hard- frozen. After several years, the plan sponsor has 13 employees, including the five employees from when the plan was frozen.The plan now covers less than 40% of the employees of the employer, so testing under 401(a)(26) fails.The plan sponsor would have to add a participant to pass 401(a)(26), which would be challenging many years after the plan was frozen. Further, temporary relief had not been provided by the IRS before the SECURE Act
for 401(a)(26), so plan sponsors had to devise and implement temporary solutions.
Under the SECURE Act, minimum participation is deemed to pass if:
- the plan is soft-frozen or hard-frozen;
- the plan passed Section 401(a)(26) testing requirements as of the date it was frozen, and
- the plan cannot have had a substantial increase in coverage or benefits in the five years preceding the date on which the class was If the plan was frozen before April 5, 2017, this requirement is deemed to be satisfied.
Let’s look at the XYZ Corporation example.The soft-frozen pension plan has 58 participants and in a year or two, it will drop below 50 participants. Before the SECURE Act, the plan would be in violation of the Section 401(a)(26) testing requirements and some significant change would have to be made to it.Thanks to the SECURE Act, assuming that the above requirements are passed, the XYZ Pension Plan can continue to provide benefits to the remaining participants. The remainder of the relief described below applies only to soft-frozen plans.
Benefits Testing—DB Plans Under Section 401(a)(4)
In the years immediately after a soft freeze, the defined benefit plan will generally continue to pass 401(a)(4) on a benefits basis and without aggregating with another plan. As the years pass after the soft freeze and the percentage of employees in the defined benefit plan decreases and the percentage of employees who are HCEs increases, the benefits testing on a standalone basis fails. Plan sponsors would be continuing the plan either because it is part of their benefit program philosophy or the plan is underfunded and the resources are not available to fund the plan for termination. If the testing fails, a difficult decision has to be made to either increase benefits or include additional employees only because of IRS nondiscrimination rules, which is never a popular reason.
Most employers with a frozen DB plan also have a 401(k) plan with employer contributions. A solution to the failure of the Section 401(a)(4) benefits testing of the frozen DB plan was to combine the plan with the company’s 401(k) plan employer contributions and test on a benefits basis. There were two issues with this solution:
- When testing combined plans on a benefits basis, a minimum gateway contribution must be provided.The gateway contribution was expressed on a contributions basis, and ranged up to 7.5% of the compensation of each participant.
- Matching contributions were not included in the Rate Group Testing, and many employers made most or all of their contributions to the DC plan in the form of a match.
The SECURE Act addressed both of these issues.The aggregated DB and DC plans can be tested on a benefits basis, without a gateway requirement, if:
- The DB plan provides benefits to a closed group of (i.e., a soft freeze).
- The DB plan must have passed nondiscrimination testing in the year the plan was closed and the two following plan
- After the closure, the DB plan cannot be amended to significantly favor HCEs by modifying the closed group or providing the benefits to the closed
- The DB plan cannot have any substantial increase in coverage or the value of benefits for the five-year period preceding the date that the class is closed. A substantial increase in coverage is generally more than a 50% increase in the number of participants. A substantial increase in benefits is generally a 50% increase in the average benefit provided, exclusive of changes due to additional accruals. However, if the closure occurred before April 5, 2017, this requirement is deemed to be satisfied.
- The DC plan must have a matching contribution, provide 403(b) annuity contracts funded by non-elective contributions or a match, or be an ESOP. The ability to use matching contribution or ESOP contributions is breaking new ground for employers with these types of contributions.These employers likely did not expect relief from any permanent relief that would be provided for closed DB plans.
Let’s review our previous example for XYZ Corporation. XYZ would likely fail rate group testing before the SECURE Act as the 401(k) plan has only matching contributions.With the SECURE Act, the young employees will have projected benefits (testing on a benefits basis) that will assist in testing and allow the soft-frozen pension plan to continue.
For plans not frozen as of April 5, 2017, the plan could be soft- frozen after five years without benefit increases and be eligible for compliance testing without the gateway contribution.This could be attractive to DB or cash balance plan sponsors in the future.
Benefits Testing in DC Plans
Another option for employers looking to reduce contributions and risk with a DB plan is to provide replacement contributions in a DC plan. Again, this may lead to compliance testing problems. With the SECURE Act, testing on a benefits basis is available without gateway contributions if the following conditions are satisfied:
- There are non-elective contributions to the DC plan for a closed group of participants whose accruals or benefits have been reduced or eliminated in a DB plan.
- The DC plan must pass the nondiscriminatory classification test of the Section 410(b) regulations for the plan year of closure and the two following
- After the closure of the DB plan, there can be no discriminatory amendments to the DC plan that modify the closed group or changes the allocations or BRFs for the closed
- The DB plan cannot have a substantial increase in the coverage or the value of benefits for the five-year period preceding the date that the benefits are closed. A substantial increase in coverage would generally be a 50% or more increase in the number of participants as of the closure date. A substantial increase in benefits would be a 50% increase in the average benefit provided to changes in the benefit to the plan, not related to additional contributions. However, if closure occurred before April 5, 2017, this requirement is deemed to be satisfied.
Comments Regarding the Nondiscrimination Testing Relief
As a pension actuary who has done significant testing over the years and has numerous clients with frozen plans who were anxiously awaiting relief, I offer the following comments:
- The relief is significant and will result in major relief for nearly all frozen pension
- The relief is broader than the temporary relief that the IRS provided in Relief under minimum participation, Section 401(a)(26) was not part of the temporary IRS relief and will be a challenge to implement in 2020. Matching contributions in 401(k) plans and employer contributions to ESOPs can be included in the nondiscrimination testing, which is welcome relief.
- The relief requires testing results from when plans were originally Many plans were frozen quite some time ago, and the testing results may have been prepared by actuaries or service providers that have been changed many years ago.The IRS should provide guidance on testing results that may not be available.
Where applicable, nondiscrimination testing relief in the SECURE Act can be applicable back to 2014.
In-service Distributions from DB Plans
The law that included the SECURE Act included several other Acts as well. Under one of them, the Bipartisan American Miners Act of 2019, in-service withdrawals from pension plans are now permitted as early as age 59½. (Previously they were permitted at age 62.)
For larger employers, this may allow for “phased” retirement for employees in which an employee could work part time and collect his or her pension. For smaller cash balance plans, this could allow business owners and key employees to withdraw their account balance from the plan and invest the money according to their goals and objectives, as opposed to the needs of meeting a specified Interest Crediting Rate of the cash balance plan.
The SECURE Act was intended to encourage employers to implement and maintain their qualified retirement plans.The good news is that the SECURE Act also addressed significant issues affecting defined benefit plans.There are numerous DB plans that will now have guidance on how to continue with minimal additional cost, and thousands of participants who will receive a benefit from their company pension plan courtesy of the SECURE Act.