In recent years, sponsors of many defined benefit (“DB”) pension plans have closed their plans to new entrants. Following such a “soft freeze,” new hires instead receive contributions (or larger contributions) to a 401(k) or other defined contribution (“DC”) plan. Unfortunately, some of those closed DB plans are now in danger of violating the Tax Code rules designed to ensure that qualified retirement plans do not favor highly compensated employees (“HCEs”) over non-HCEs. In Notice 2014-5, the IRS has acknowledged this problem ‒ allowing somewhat more lenient nondiscrimination testing during a two-year period, and also inviting comments on more permanent solutions.
The Underlying Problem
Even if a DB plan complies with all the Tax Code rules at the time it is closed to new entrants, it may later violate the “minimum coverage” requirement if the group of employees participating in the plan comes to consist of a disproportionate number of HCEs. This could happen because there is greater turnover among non-HCEs, or because certain of the non-HCEs participating in the plan move into the HCE category.
Existing Regulatory Relief
One solution to such a minimum-coverage failure is to aggregate the closed DB plan with a DC plan sponsored by the same employer. This should solve the minimum-coverage problem. However, in order to aggregate two plans for minimum-coverage purposes, the plans must also satisfy the Tax Code’s “nondiscrimination” requirements on an aggregated basis. And although IRS regulations do permit DB and DC plans to be aggregated for this purpose, they must first satisfy fairly stringent requirements.
For instance, existing nondiscrimination regulations allow for the aggregation of DB and DC plans only if one of the following three conditions is met:
- Primarily DB in Character. More than half of the non-HCEs participating in the aggregated “plan” are accruing larger benefits under the DB plan than under the DC plan;
- Broadly Available Separate Plans. Each of the two plans would separately satisfy the minimum coverage and nondiscrimination requirements if they were given a pass on the “average benefit percentage test” under the minimum coverage regulations; or
- Gateway Test. All of the non-HCEs participating in the aggregated “plan” receive at least a minimum percentage allocation (with the specific minimum tied to the highest allocation made to any HCE).
Problems with the Existing Relief
In the recent Notice, the IRS concedes that even a normal change in the composition of an employer’s workforce can eventually undermine the employer’s reliance on either of the first two alternatives. That is, the same factors that can cause a closed DB plan to fail the minimum-coverage requirement when tested on its own will eventually have that same effect under these two testing alternatives.
That would still leave the gateway test. However, the minimum non-HCE allocation required to satisfy this alternative is so large that many employers would rather freeze their DB plans entirely. This would undermine the expectations of those employees who were covered under the closed plan.
The Interim Relief
In response to requests from sponsors of closed DB plans, the IRS has announced a two-year period of limited interim relief. Assuming a DB plan was closed to new entrants before December 13, 2013, that plan may now be aggregated with a DC plan (for both minimum coverage and nondiscrimination testing purposes) for the next two plan years if either of the following conditions is met:
- During the plan year beginning in 2013, the DB plan satisfied both the minimum coverage and nondiscrimination requirements without needing to be aggregated with the DC plan; or
- For the plan year beginning in 2013, the DB plan was aggregated with the DC plan in an arrangement that satisfied one of the first two existing alternatives (i.e., the aggregated plan was either primarily DB in character or consisted of broadly available separate plans).
This interim relief is available only for plan years beginning before January 1, 2016. Moreover, when aggregating a DB plan with a DC plan, only employer non-elective contributions to the DC plan may be considered; matching contributions may not be taken into account.
Request for Comments
The Notice makes clear that the IRS is also considering longer-term solutions to this problem. For instance, the Notice outlines a number of possible alternatives under which DB and DC plans might continue to qualify for testing on an aggregated basis. The IRS has invited comments on these proposals. Any comments must be received by February 28, 2014. Presumably, the IRS will consider those comments in time to craft permanent relief before this interim relief expires.