Proposed Regulation Under Section 401(a)(4)

By Tom Finnegan • March 15, 2016 • 0 Comments
For the last several weeks, the community of pension professionals has been focused on the potential impact of proposed changes to the general test under Code Section 401(a)(4). The proposed changes would require that in order for a rate group to meet the general test using the Average Benefits Test rather than the Ratio Percentage Test, the allocation (and/or benefit) formula covering the HCE subject of the rate group must cover a “reasonable classification of employees.” 

The change is particularly troubling because the Code and regulations contain no definition of the term “formula” and precious little guidance as to what constitutes a “reasonable classification” of employees. More troubling, however, is that the change disproportionately affects plans of small employers, in essence making the nondiscrimination tests more difficult for small employers than for large employers.

Reasonable Classification Test  

1.410(b)-4(b) Reasonable classification established by the employer. A classification is established by the employer in accordance with this paragraph (b) if and only if, based on all the facts and circumstances, the classification is reasonable and is established under objective business criteria that identify the category of employees who benefit under the plan. 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.

In addition, the proposed regulation appears to further restrict the definition of reasonable by implying, in Example 6, that any classification that has only one participant as a member is deemed to have substantially the same effect as an enumeration by name and is thus not reasonable. (This is a significant change in the IRS position relating to one-person classifications, although they have not given any formal guidance either way.) As you can see, each determination is based on all of the relative facts and circumstances of the particular employer. This means that, for any employer with a design reliant on the average benefits test, there is a risk that the employer will have to be prepared to defend that their classifications are reasonable upon audit and/or in court. This risk is beyond the comfort range of virtually all small employers, especially given that the examples of acceptable classifications cited in the regulation (specified job categories, salaried vs. hourly, and geographic location) may not apply to most small employers and, where they do, may result in classifications containing only one participant.

Formulas

It is difficult to assess the impact of the proposed change due to the fact that there is no definition of “formula” in the proposed regulation. Consider a DC plan that places each participant in his own classification, but normally 20% of pay to the one and only owner and 5% of pay to everyone else. Since in theory a separate formula applies to each participant, each formula applies to an unreasonable classification, as the group covered by each formula is essentially a delineation by name. The logical step would be to amend the plan back to two classifications: one for owners and the other for non-owners. Now the plan has two formulas (we think); however, the formula for owners covers a classification with only one member. The example in the proposed regulation would imply that the owner category given these facts and circumstances would not be a reasonable business classification. Thus, the owner’s rate group could not use the average benefits test and would need to pass the ratio percentage test instead.

But the question remains: What is a formula? Clearly the plan could provide the same benefit it currently provides by using a points allocation where the owner gets four points for each dollar of compensation and non-owners get one point for each dollar of compensation. 

Assume the owner has compensation of $250,000; the same allocation could be accomplished with an allocation of “the greater of 5% of pay or 100% of pay in excess of $200,000.” 

Up until now, each of the above would have been considered a single formula. The proposed regulation does nothing to indicate that each of these would be considered separate formulas for the owner going forward. But the lack of a definition of “formula” makes it difficult to determine: (1) whether the proposed regulation would remove the flexibility of the individual classification design but retain the testing structure if the formulas are codified in the document; or (2) whether it contemplates another definition of formula that considers separate treatment under a single formula as separate formulas.

Documents

Most firms are just coming to the end of their restatements. As part of the restatements, many firms recommended to their clients that they adopt an approach in which each participant is in his own classification. This design, which the IRS has approved for years, could accommodate any allocation that the client had become accustomed to but provided (1) additional flexibility for good years and bad years and (2) the ability to adjust allocations for problems with testing arising from demographic changes, without having to adopt amendments under Treas. Reg. 1.401(a)(4)-11(g).

Just at the close of the restatement window, this proposed regulation is released which provides that plans with this structure, even if they provide each level of allocations to reasonable classifications of employees, would be hamstrung by the inability to use the average benefits test as part of nondiscrimination testing. Thus, if finalized, the proposed regulation would cause these clients to amend their plans again. This involves the cost of meetings, consulting, drafting, review and approval, to have the plan provide exactly the same benefits/allocations it provided before. This type of meaningless tail-chasing and unnecessary expense serves no purpose and discourages employers from establishing and maintaining qualified plans. Given the level of NHCE benefits provided by the plans in question, these plans should be encouraged, not discouraged.

Gateways

The proposed regulation would have its greatest impact on cross-tested DC plans and aggregated DB/DC plans. These plans, for the most part, are subject to a minimum allocation gateway which results in rank-and-file employees receiving allocations and/or benefits significantly greater than the benefits provided by most employers. In fact, the IRS recognizes that the cost of gateways is so significant as to cause employers to choose not to sponsor plans. This is evidenced by the fact that the remainder of the proposed regulation is devoted to options to allow sponsors of closed plans to avoid the gateway allocations, as the IRS was aware that if these plans became subject to the gateway allocations, they would terminate. Yet this section of the proposed regulation results in employers having to risk defending “facts and circumstance determinations” on audit or making contributions significantly in excess of the gateways in order to ensure the rate groups will meet the ratio percentage test.

GAC Activities

The Government Affairs Committees of ACOPA and ASPPA have teamed up to make sure that regulators and policy makers understand the disproportionate impact of this proposed regulation on small business. We are emphasizing the significant level of benefits being provided by gateway plans and the additional burden this change would place on plan sponsors. We are also emphasizing the importance of black-and-white rules for small employers so that they can have confidence that their retirement plans meet the qualification rules. We are detailing the deterrent effect the proposed rule would have on the establishment and maintenance of qualified plans by small employers. See Judy Miller’s article for more detail on our efforts to date, and how you can help.

 

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