Beware Nondiscrimination Pitfalls for Frozen Pension Plans

pitfall-signMany defined benefit (DB) pension plans were closed to new entrants over the past several years. Oftentimes, these plan closures were done with a focus on short-term cost control without understanding some of the long-term compliance implications.

Then, one day, the plan sponsor gets an unwelcome surprise from their actuary – their DB plan is failing the IRS’ nondiscrimination tests! How can this happen – particularly if the DB plan is a “safe harbor” formula that has never needed nondiscrimination testing before?

This post explores how closed DB plans are increasingly faced with IRS nondiscrimination testing compliance issues and suggests some strategies for dealing with this situation.

IRC §410(b) requires that a tax-qualified retirement plan “cover” a nondiscriminatory group of employees. In other words you can’t set up a retirement plan that benefits only highly compensated employees (HCEs) – that’s unfair and you need to include some non-highly compensated employees (NHCEs) too.

§410(b) coverage testing is generally a non-issue as long as a DB plan is open to all employees. However, once a DB plan is closed to new entrants, there will eventually be enough staff turnover so that only a fraction of an employer’s total employee group participates in the DB plan. If this grandfathered group is composed of proportionately more HCEs than NHCEs (which happens when there is higher turnover among the NHCEs), then the DB plan will run into §410(b) testing problems.

Technical Details
There are two ways to prove compliance with §410(b) minimum coverage requirements.

1. Ratio Percentage Test (RPT). This is the most straightforward §410(b) testing option. In this test, A divided by B must be at least 70% where:

A = # of NHCEs in the DB plan divided by the total number of NHCEs, and

B = # of HCEs in the DB plan divided by the total number of HCEs.

Note that “total” NHCEs and HCEs includes all employees who would otherwise meet the DB plan’s age and service eligibility requirements.

2. Average Benefits Test (ABT). When you can’t pass the RPT, you must tackle the Average Benefits Test. This is a multi-step process that focuses on the relative disparity of retirement benefits provided to NHCEs versus HCEs. I won’t go into all of the gory details here, but suffice to say that this is a numerically-intensive test and includes benefits provided by ALL of the employer’s retirement plans. If you can pass this test, then your frozen DB plan satisfies the IRS’ §410(b) minimum coverage requirements.

Suppose Company A has 1,000 employees (900 NHCEs and 100 HCEs) and sponsors a DB plan that was closed to new entrants in 2008. The employer still has a total of 1,000 employees (900 NHCEs and 100 HCEs), but the number of employees covered under the DB plan has steadily shrunk due to natural turnover. There are now only 550 NHCEs and 90 HCEs in the DB plan. Their RPT result is: (550/900) / (90/100) = 67.9% which is below the 70% passing threshold.

In this case, the plan sponsor would need to complete an ABT in order to satisfy the §410(b) nondiscrimination rules.

Forewarned is Forearmed
So, what should plan sponsors do if faced with a potential §410(b) failure? Advance planning is the key to avoiding unpleasant corrective measures. Here are a few options:

1. Have your actuary complete a ratio percentage test, especially if you are in a high-turnover industry. This will help you see how close you are to the passing threshold and will suggest how long you have until the DB plan no longer passes the RPT.

2. If your DB plan is close to failing the RPT, have your actuary run an ABT to make sure that it provides passing results and is a viable back-up to the RPT.

3. If the DB plan’s ABT results are marginal as well, then you should consider some contingency plan design options. These include:

– Freezing DB accruals for HCEs
– Freezing DB accruals for all employees
– Adding new participants to the DB plan

Options #1 and #2 are likely the most agreeable. Very few sponsors who have closed their DB plan ever intend to open it up again like Option #3. Whatever your decision, it helps to be familiar with your options ahead of time so that you can address nondiscrimination testing issues quickly when they arise.

Closed DB plans face special challenges with respect to IRS nondiscrimination testing. Although these issues may emerge slowly over time, plan sponsors should be aware of the consequences and develop a strategy to maintain compliance with IRC §410(b) minimum coverage requirements.

5 thoughts on “Beware Nondiscrimination Pitfalls for Frozen Pension Plans

  1. For smaller plans, 401(a)(26) can be an issue, too. It requires the plan to benefit at least the lesser of 1)50 or 2)40% of employees for the year.

    1. That’s absolutely correct! We’re actually working on a post regarding 401(a)(26) and small plans and should have it ready in the next couple of days. Stay tuned!

  2. I find the title of your article confusing. It says there may be pitfalls for “Frozen” DB plans; however, by the end of the article (paragraph 3) you suggest that “Freezing” accruals plan will provide a solution against discrimination problems. Shouldn’t the title refer to plans with Frozen “Eligibility”?

    1. Good point! The article is meant to address “soft-frozen” plans, i.e. plans closed to new entrants. “Hard-frozen” plans (no new benefit accruals for anyone) generally get an automatic exemption to 410(b) as long as they’re not fully-funded.

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