Nondiscrimination Relief for Closed Defined Benefit Pension Plans and Additional Changes to the Retirement Plan Nondiscrimination Requirements, 26 CFR Part 1, 81 Fed. Reg. 4976 (Jan. 29, 2016)
The IRS has proposed amendments to the Code § 401(a)(4) nondiscrimination regulations that would, among other things, modify the cross-testing and combined defined benefit and defined contribution (DB/DC) testing rules and add a reasonable business classification requirement for some amounts testing. As background, Code § 401(a)(4) sets forth the general nondiscrimination requirement that a plan’s contributions, benefits, and other features must not disproportionately favor highly compensated employees (HCEs). (The nondiscrimination rules governing 401(k) plans are a subset of these general nondiscrimination requirements.) While the proposed amendments would primarily provide relief for benefits under or related to certain “closed” defined benefit plans, the proposal includes changes that would affect defined contribution plans (including 401(k) plans) that use cross-testing or combined testing for their profit-sharing contributions (whether or not the employer has a closed plan) and tighten the amounts testing rules to discourage qualified supplemental executive retirement plans (QSERPs). Here are highlights affecting defined contribution plans:
- General Test Rate-Group Limitation Would Affect QSERP Design. Profit-sharing contributions that do not satisfy a safe harbor are considered nondiscriminatory if they pass an objective test, known as the “general test,” which applies the coverage testing rules to rate groups based on each HCE’s allocation rate. The purely mathematical nature of the general test has led to plan designs that take advantage of low ratio percentage minimums to provide individualized benefits for HCEs. The proposed amendment would allow minimums lower than 70% to be used only when the allocation formula uses a reasonable business classification based on bona fide objective criteria, making it more difficult for QSERPs (and other individualized designs) to pass.
- Cross-Testing and Defined Benefit Replacement Allocations (DBRAs). Under cross-testing, profit-sharing contributions are “converted” to defined-benefit-type accrual rates for testing purposes (see our Checkpoint article). Generally, to be eligible for cross-testing, a plan must satisfy one of three thresholds: The plan must have broadly available allocation rates, provide age-based allocation rates that rise gradually, or provide a minimum gateway allocation to each non-HCE. The proposed regulations would allow more DBRAs to be disregarded when determining broadly available or age-based allocation rates, in part by adding a rule that would end minimum coverage testing of the DBRA group five years after the related defined benefit plan closes.
- Combined DB/DC Testing: Additional Options. Combined DB/DC plans must satisfy a threshold to cross-test accrual rates. One alternative is a minimum aggregate allocation gateway similar (though not identical) to the gateway used for regular cross-testing. The proposed regulations would make it easier for DB/DC plans to satisfy the gateway by expanding an averaging rule (with certain caps) for determining non-HCE allocations and allowing an average of matching contributions actually made for non-HCEs (up to a certain amount) to be counted. The proposal would also allow a DB/DC plan to avoid the gateway either by determining equivalent benefits using a lower interest rate of 6% or, if the DB/DC plan includes a closed plan, by relying on a special five-year testing rule.
- Benefits, Rights, and Features. Qualifying benefits, rights, and features for grandfathered participants in a closed plan, including matching contributions that are DBRAs, would get an indefinite pass on benefits-rights-and-features testing after the fifth anniversary of the plan’s closure date if they satisfy specified consistency, five-year testing, and amendment requirements. [EBIA Comment: The enhanced matching contributions, however, must be included in the plan’s actual contribution percentage (ACP) test and would likely preclude using an ACP safe harbor design.]
EBIA Comment: Plan sponsors whose 401(k) plan designs require cross-testing or combined testing under Code § 401(a)(4) for their profit-sharing contributions, have related closed plans, or offer QSERPs will want to consult their benefit experts about these proposed amendments. Many of the proposals can be applied for plan years beginning on or after January 1, 2014. However, the proposed changes to DB/DC plan testing relating to averaging allocation rates, taking credit for average matching contributions, and the 6% interest-rate gateway alternative cannot be applied until the rules are finalized. For more information, see EBIA’s 401(k) Plans manual at Sections IX.B (“Matching Contributions”), XX.B (“Code § 401(a)(4): Basics”), and XX.F.2 (“Cross-Testing: Amounts Testing on a Benefits Basis”).
Contributing Editors: EBIA Staff.