Cross-Tested Plans Survive a Major Challenge

Spring 2016Articles For Your Benefit

In general, the favorable tax treatment afforded to the participants and sponsor of a qualified retirement plan are contingent upon the plan satisfying certain statutory and regulatory requirements, including the prohibition against discrimination in favor of highly compensated employees. Compliance with this requirement can be tested by any of a number of alternative methods prescribed by the regulations.

Typically, defined contribution plans are evaluated with reference to the allocation of contributions. However, they may be tested by converting the contributions allocated to participants to equivalent benefits, using a permissible interest rate. Likewise, defined benefit pension plans and defined contribution plans may be aggregated and tested as a single plan using similar methodology. This is referred to as “cross-testing.”

One popular cross-tested plan design often is referred to as “new comparability.” This, typically, is a defined contribution plan that assigns participants to allocation or rate groups for allocation purposes and thereby is able to provide greater contribution amounts for older and more highly compensated employees while nevertheless satisfying the non-discrimination requirement by converting those contributions to equivalent benefits and testing on that basis. Over time, the IRS has imposed additional requirements on new comparability plans, including a “minimum gateway” requirement with higher minimum contribution amounts for non-highly compensated employees, while granting additional flexibility, even extending to the assignment of each participant to a separate allocation group. These plan designs have proven to be enormously popular.

At the same time, the growing trend has been a transition away from traditional defined benefit pension plans toward defined contribution plans (including new comparability plans) and cash balance pension plans. Many employers that previously maintained traditional defined benefit plans have closed those plans to new employees while allowing those who previously participated to continue to accrue benefits. However, it becomes increasingly difficult for these closed plans to continue to satisfy the nondiscrimination requirements as the group of grandfathered employees (who continue to accrue benefits under the plan) tends to become more highly compensated, as compared to the total workforce, based on ordinary demographic changes and the passage of time.

In January of this year, the IRS issued proposed regulations that were designed to make it easier for these closed plans to meet the nondiscrimination requirements. While welcomed in those situations, the proposed regulations could adversely impact all cross-tested plans, particularly new comparability plans, because they require that, for nondiscrimination testing purposes, each allocation group must satisfy the “reasonable classification” requirement.

As explained by the regulations, reasonable classifications generally include specified job categories, nature of compensation (i.e., salaried or hourly), geographic location and similar bona fide business criteria. An enumeration of employees by name or other specific criteria having substantially the same effect as an enumeration by name is not considered a reasonable classification.

A plan that places each employee in a separate allocation classification or group, by its very nature, cannot satisfy the reasonable classification requirement. Likewise, no classification that has the same effect as naming individuals could satisfy the requirement. Consequently, the proposed regulations, were they to be implemented, would necessitate substantial restructuring of most new comparability plans (and other cross-tested plans) and, no doubt, would result in significantly higher employer contribution rates, making those plan designs far less effective and desirable.

Understandably, the benefits community was alarmed and quickly mobilized its members to lobby the Treasury Department, IRS and Congressional staff and engaged plan sponsor groups in petition and letter-writing campaigns. These efforts were rewarded with the publication, on April 14, of Announcement 2016-16, by which the Treasury Department and IRS announced that they would withdraw the provisions of the proposed regulations relating to the nondiscrimination rules while retaining the relief for closed pension plans.