IRS Withdraws Troubling Provision of Proposed Nondiscrimination Regulations

Yesterday, the IRS released Announcement 2016-16 withdrawing parts of the nondiscrimination regulations it proposed at the end of January. Those proposed regulations had troubled many in the defined benefit industry since their proposal for a number of reasons (more below). From the standpoint of the IRS, the troubling part of the proposal addressed some serious abuses by practitioners and the sponsors they consult to. From the standpoint of practitioners, the proposed regulations took an objective test that has been around for quite a while and essentially changed the rules of the game.

I'm going to have to get a little bit technical here before I bring you back to reality. What the proposed regulations would have done was to make retirement plans with multiple formulas show that each formula applied to reasonable business classifications of employees or to pass a more difficult test.

Under regulations that were finalized in 1993 and then amended for cross-tested plans in the late 90s, a rate group in the testing population must have a coverage ratio at least equal to either

• 70% if the plan uses the Ratio Percentage Test to pass minimum coverage tests or
• The midpoint of the safe harbor and unsafe harbor (the midpoint is typically in the 25% to 40% range, but is determined through a somewhat convoluted formula) if the plan uses the Average Benefit Test to satisfy minimum coverage

It is far easier for a rate group to satisfy a lower minimum coverage ratio than a higher one. And, many plans had been designed around satisfying the lower threshold. While the preamble to the proposed regulation said that it was targeting QSERPs, practitioners found that they also were potentially problematic for many plans of small businesses and plans of professional service firms. 

Why would this be troubling? Certainly, among larger corporations, the prevalence of ongoing defined benefit plans has dropped precipitously, but many small businesses and professional service firms have adopted new defined benefit plans (DB) over the last 15 years or so and many of these plans would have found it more difficult or perhaps impossible to pass these proposed rules.

This doesn't mean that DB plans of this sort are out of the woods yet, so to speak. Clearly, the current Treasury Department views that plans of this sort may be abusive in their application of the nondiscrimination regulations, so we could see another effort from the IRS to make the regulations a bit less QSERP-friendly. 

In the meantime, there are some great DB designs that exist for companies that wish to provide meaningful retirement benefits to their rank and file employees. You can learn more about them here.

IRS Proposes Updated Pension Nondiscrimination Rules

I wrote recently about some of the causes of the relative demise of defined benefit (DB) plans. Last Thursday, although it was dated Friday, the IRS released a new proposed nondiscrimination regulation. We had been told that this was coming down the pike. It was going to be all good. It was going to provide relief so that a DB plan that was compliant and was frozen to new entrants (sometimes called soft frozen) would not suddenly become non-compliant due to natural turnover and promotions of active employees in the plan. That the IRS addressed this nearly 23 years after the regulations were finalized was long overdue, but good news.

We didn't know that there were going to be other changes. One of the hallmarks of the suite of nondiscrimination regulations (nondiscrimination, coverage, minimum participation) is that they provided objective tests to determine whether a plan discriminated unfairly in favor of highly compensated employees (HCEs). In fact, the final regulations tell us that satisfying the various tests included in them are the sole method of demonstrating nondiscrimination. While this caused a significant burden for some companies and their plans, it gave plan sponsors comfort in knowing that passing those tests meant that there plans were, in fact, nondiscriminatory. Many design and redesign studies were done because of this knowledge.

Then came last week,

I now digress into some technical mumbo jumbo the likes of which this blog has not seen for a while. If you don't like or care about the technical stuff, please stick with me; I'll return to the more common language soon.

The rules for nondiscrimination in amount under 1.401(a)(4)-2 and -3 contain something known as the general test. Under the general test, there exists a concept known as the rate group. For each HCE, there is a rate group consisting of that HCE and all other nonexcludable employees whose normal and most valuable accrual rates are at least as big as those of that particular HCE (people with similar accrual rates can be grouped to be considered to have the same accrual rate as each other). Once we establish the rate groups, we must demonstrate that each rate group satisfy the head counting portion of the same coverage test under Code Section 410(b) that the plan uses to satisfy coverage. So, if the plan uses the Ratio Percentage Test to satisfy 410(b), then each rate group must have a ratio percentage of at least 70%. On the other hand, if the plan uses the more complex Average Benefit Test to satisfy 410(b), then each rate group must have a ratio percentage at least equal to the lesser of the actual ratio percentage for the testing population or the midpoint of the safe and unsafe harbors (this threshold is far less than 70% and is frequently in the neighborhood of 30%).

This has been the case since 1993. In fact, there are now people performing testing who were not alive when we started doing testing this way.

Under the proposed regulations, however, that lower threshold would not be available to plans that have separate formulas for which there is not a reasonable business criterion. The proposed regulation tells us that naming names (common in designs often known as QSERPs) does not constitute a reasonable criterion. The problem is that when the word reasonable is used, we, the practitioners never know what someone else thinks is reasonable.

So, will we be left doing tests that we think are correct only to learn that someone else with a higher authority thinks that we have misconstrued what is reasonable? Is this a calling to just stop providing retirement benefits? After all, we could design perfectly good retirement plans for our clients today that we learn tomorrow have suddenly failed to still be nondiscriminatory.

From a personal standpoint, the good news is that even most of the aggressive designs that my colleagues work with would seem to satisfy the reasonable business criterion test. There are lots of plans out there, however, that do not, and these plans may be in trouble if and when the proposed regulations are finalized.

Would you like to know if your plans seem safe or potentially in trouble? I'll be happy to help you figure that out.

Another Argument for Defined Benefit

I know, defined benefit (DB) plans are dead. Actually, while there aren't as many as there used to be, I'm going to give you one more argument why they make more sense as a retirement vehicle.

Yesterday, I wrote about managing the risk in active pension liabilities. Way back in 2010, I wrote about generally managing risks and noted that plan sponsors tend not to manage defined contribution plan risks. Most of those risks that I have considered have been financial risk. Today, I am going to focus on the intersection of financial risk and compliance risk and make a case to have a DB plan as your primary retirement vehicle rather than a 401(k) plan.

In the world of 2015, we see consolidation in many industries. We also see companies, often private, being gobbled up by private equity firms. Either of these actions will usually create a larger controlled group. And, people who focus on retirement plan compliance know that most retirement plan compliance testing must be done on a controlled group basis.

Before working to point out a solution, let me give you an example to help focus on the problem.

BPE is a big private equity firm. Their general approach to retirement plans (and other benefits) has been to ignore them and let each company do what it wants. But, as BPE get bigger, its controlled group gets more complex. Having multiple industries represented in its portfolio, BPE is ultimately the sponsor of all kinds of 401(k) plans. Their engineering company (EC) has an extremely generous 401(k) plan that matches 150% on the first 8% of pay that an employee defers. Their pork rinds company (PRC) has a 401(k) plan that matches 10 cents on the dollar on the first 2% of pay that an employee defers.

BPE never saw this as a problem. But, then one day, an inquisitive Principal (IP) at BPE was reading my blog (of all things) and came across this. He saw that BPE might have a compliance problem in its controlled group because of the disparate nature of its 401(k) plans.

Ring ring ring -- that's my phone as IP calls me. He wants to know how to fix the problem. He says that surely this problem can't be real. After an hour on the phone, we have inventoried all the plans at BPE and found that they have failed to satisfy various compliance tests (coverage under Code Section 410(b), for example) for several years.

IP has a solution though. He tells me that BPE will force some of its companies to retroactively cut the employer match in some of these more generous plans.

Bzzz!

You can't do that. In fact, if BPE were to choose to fall on its sword and approach the IRS for a negotiated retroactive solution, we would suspect that the IRS would only be receptive to increasing benefits for nonhighly compensated employees (NHCEs) in the less generous plans.

IP is not happy about this. PRC runs on very low margins, but because they make more pork rinds than any company in the world, they do throw off a lot of cash. However, increasing benefits would eliminate most of that free cash that is being generated. There is stunned silence on the other end of my phone.

While the story is fictitious, the gist of the scenario is not. I've seen this happen. By being a serial acquirer, companies run into compliance problems and with 401(k) plans not being the easiest to prove nondiscriminatory, either costs escalate or they get cut at the portfolio companies that tend to employ more higher paid individuals.

What sort of plan tests better? A few weeks ago, I wrote about some. Suppose BPE had a defined contribution looking cash balance plan. One of the nice things about these plans is that they test well. Designed properly, and proper design truly is a key, financial risk is manageable. And, with that as their primary plan, the secondary 401(k)s can be managed so that compliance there will no longer be an issue.

Unfortunately, the benefits world has been resistant to this whole concept. But, you have an open mind, don't you?

We need to talk.

Get Your 401(k) Design Right

I happened to read a few things today about 401(k) matching contributions. One in particular talked about stretching the match. Apparently that means that if you are willing to spend 3% of pay on your workforce, consider making your match 50 cents on the dollar on the first 6% of pay deferred instead of dollar for dollar on the first 3% of pay deferred. This will encourage employees to save more.

That might be a really good idea ... for some companies. For other companies, it might not be.

First and foremost a 401(k) plan is, and should be, an employee benefit plan. Taken quite literally, that means that it should be for the benefit of employees.

Plan sponsors may look at the plan and say that they get a tax deduction. That's true, but they also get a tax deduction for reasonable compensation. And, there is probably less of a compliance burden with paying cash than there is with maintaining a 401(k) plan.

Where does the typical 401(k) design come from? Usually, it's the brainchild, or lack thereof, of someone internal to the plan sponsor or of an external adviser. Either way, that could be a good thing or a bad thing. Most plan sponsors have plenty of smart and thoughtful employees and many external advisers are really good.

On the other hand, when it comes to designing a 401(k) plan, some people just don't ask the right questions. And, just as important, they don't answer the right questions. We often see this in marketing pieces or other similar propaganda that talk about designing the best plan. We might see that the best plan has all of these features:

• Safe harbor design (to avoid ADP and ACP testing)
• Auto-enrollment (to get higher participation rates)
• Auto-escalation (so that people will save more)
• Target date fund as a QDIA (because virtually every recordkeeper wants you in their target date funds)

All of these could be great features for your 401(k) plan, but on the other hand, they might not be. Let's consider why.

Safe harbor designs are really nice. They eliminate the need for ADP and ACP nondiscrimination testing. They also provide for immediate vesting of matching contributions. Suppose your goal, as plan sponsor, is to use your 401(k) plan at least in part as a retention device. Suppose further that every year, you pass your ADP and ACP tests with ease. Then, one would wonder why you are adopting a plan with immediate vesting whose sole benefit is the elimination of ADP and ACP testing. Perhaps someone told you that safe harbor plans were the best and you listened. Perhaps nobody bothered to find out why you were sponsoring a 401(k) plan and what you expected to gain from having that plan.

Auto-enrollment is another feature that is considered a best practice. (Oh I despise that term and would prefer to call it something other than best, but best practice is a consulting buzzword.) Most surveys that I have read indicate that where auto-enrollment is in place, the most common auto-enrollment level is 3% of pay. Your adviser who just knows that he has to tell you about auto-enrollment tells you that it is a best practice. Perhaps he didn't consider that prior to auto-enrollment, you had 93% participation and that 87% of those 93% already deferred more than 3% of pay. Since he heard it was the thing to do, he advised you to re-enroll everyone and now, you are up to 95% participation, but only 45% of them defer more than 3% of pay. Perhaps nobody bothered to ask you how your current plan was doing.

In the words of a generation younger than me, this is an epic fail.

I could go on and on about other highly recommended features, but the moral of the story is largely the same. Your plan design should fit with your company, your employees, your recruiting and retention needs, and your budget. That your largest competitor has a safe harbor plan doesn't make it right for you. It may not even be right for them. That the company whose headquarters are across the hall from yours has auto-escalation doesn't make it right for you. It may not be right for them either.

If you are designing or redesigning a plan for your company, ask some basic questions before you go there.

• What do you want to accomplish with the plan?
• Enough wealth accumulation so that your employees can retire based solely on that plan?
• Enough so that the plan is competitive?
• Something else?
• Will eliminating nondiscrimination testing be important?
• What is your budget? Will it change from year to year? As a dollar amount? As a percentage of payroll?
• What do you want your employees to think of the plan?
• It's a primary retirement vehicle.
• My employer has a 401(k) plan; that's all I need to know.
• My employer has a great 401(k) plan.
• My 401(k) is a great place to save, but I need additional savings as well.
• Will any complexity that I add to the plan help my company to meet its goals or my employees to meet their goals? If not, why did I add that complexity?

These are the types of questions that your adviser asked you when you designed or last redesigned your plan, aren't they?

They're not?

Perhaps it's time to rethink your plan.

IRS Gives Limited Pension Nondiscrimination Relief

Just 10 days ago, I wrote about the request to the IRS and Treasury from Senators Portman and Cardin to provide pension nondiscrimination testing relief to sponsors who have soft frozen their defined benefit (DB) plans. In Notice 2014-5, the IRS has done that, albeit on a temporary basis.

For background, a DB plan is soft frozen typically when a grandfathered group of participants are allowed to continue accruing benefits, but no new entrants are allowed into the plan. From a testing standpoint under Code Sections 401(a)(4) and 410(b), the plan will typically pass in the early years as the group benefiting under the plan will look a lot like the group that was benefiting immediately before the soft freeze. Eventually, however, as turnover tends to be higher among nonhighly compensated employees (NHCEs) than among highly compensated employees (HCEs) and because more participants will 'graduate' from NHCE status to HCE status than conversely, testing results get worse.

The typical alternative then is to aggregate the soft frozen DB plan with one or more DC plans for testing purposes. The aggregated plan is then referred to as a DB/DC plan, a name that does not quite roll off the tongue, but is descriptive nonetheless. DB/DC plans may be tested on a benefits basis (usually will pass) or on a contributions basis (usually will fail), but in order to be tested on a benefits basis, the DB/DC plan must jump through one of a number of hoops. Without going into detail, this is usually easy in the early years and gets more and more difficult with each passing year. Add to that that the DC plan being aggregated with the DB plan cannot be a plan subject to Code Section 401(k) or 401(m) (or a part of a larger plan subject to one of those sections) or be an ESOP and the process gets a little bit more difficult to deal with.

According to the Notice, if a sponsor soft froze its DB plan before December 13, 2013 and its DB/DC plan met one of the requirements to be cross-tested on a benefits basis for the 2013 plan year, then for any plan year that begins before 2016, the sponsor generally may continue to test this DB/DC plan on a benefits basis. In the meantime, IRS has requested comments on this notice and will continue to evaluate how such situations should be handled.

This relief is only short-term in nature and there are many situations that will not be helped by this relief, but if you are one of the lucky sponsors, this may give you the help you were looking for.

Senators Portman and Cardin Appeal to Treasury for Retirement Nondiscrimination Help

We don't see it much in Washington these days, but Senators Rob Portman (R-OH) and Ben Cardin (D-MD) are teaming up once again. That's right, senators from opposing parties are finding common ground to do something together. And, they have a worthy goal. The key question, in my mind, is whether or not they have found a good way to achieve that goal.

A little more than a week ago, the dynamic duo penned a letter to Treasury Secretary Jack Lew asking that the Treasury Department review pension nondiscrimination regulations, specifically with regard to so-called soft frozen plans. They did this under the guise of retirement security for working Americans.

I have mixed feelings about what they write and I will come back to that later. First, however, it is necessary to give some background on pension nondiscrimination and soft freezes.

ERISA, signed into law on Labor Day, 1974, generally prohibited companies from providing nondiscriminatory pension benefits. While the rules perhaps had more teeth than I am going to see, this was generally achieved by showing three things about the pension benefits that were offered:

• That they were properly integrated (with Social Security) under Revenue Ruling 71-446
• That they covered a reasonable cross-section of employees (this was difficult to not satisfy in my experience)
• That they were comparable within the meaning of Revenue Ruling 81-202

Along came the Tax Reform Act of 1986 (TRA). It added some more specific rules to the Internal Revenue Code (Code) among them sections 410(b) and 401(a)(4). Together with a few related provisions, this suite of rules became known generally as the nondiscrimination rules. Regulations were long and cumbersome. But, unlike previous rules, they prescribed objective tests to determine whether the retirement benefits offered by a company were nondiscriminatory.

Objective tests are good and they are bad. From a practitioner's standpoint, they give us a set of bright line rules to follow. Exceed the thresholds and you pass. Fall short and you fail. It's pretty simple.

These sections of the Code were regulated fairly early in my career and I became somewhat expert at dealing with them. What I learned, somewhat oversimplified, is that it is quite rare that a tester, highly knowledgeable with respect to the rules, cannot force a company's plans through the tests to prove them nondiscriminatory. In fact, I worked with some situations that on their faces were very discriminatory in favor of highly compensated employees (HCEs) and proved that they were not.

There is one situation, however, that has always proven to be troublesome -- that of soft frozen plans. Generally, a defined benefit (DB) plan is soft frozen when participation (and benefit accrual) continues for employees who were in the plan on the soft freeze date and never happens for those who were not. In a variation on the theme, future participation is sometimes limited to those who have met some age and service threshold with the company as of the soft freeze date. 

What frequently happens is that over time, the population that remains in the DB plan becomes more predominantly composed of HCEs. And, as this happens, the DB plan on its own is not nondiscriminatory. What companies would like to do is to look at the total retirement program and show that it is nondiscriminatory. But, as many of these companies have only a 401(k) plan going forward (401(k) plans cannot be aggregated with DB plans for most testing purposes), the math just doesn't work.

So, companies wind up taking the only alternative that they can see and eventually totally (hard) freeze the DB plan. When they do so, the grandfathered employees, as a group, are often just at the point in their careers that their pension accruals are largest. These are the years that were going to allow them to retire securely.

This is the problem that Portman and Cardin seek to address. They tell us that the nondiscrimination rules were meant to enhance retirement security, not to detract from it. To me, this is where the difference in views that often occurs between legislators and businesspeople comes to the fore. 

Legislators, when developing retirement rules have often preached that if we force companies to provide similar benefits to nonhighly compensated employees (NHCEs) as to HCEs that the companies would increase NHCE benefits to meet that bogey. To paraphrase President Kennedy (who used the slogan of the New England Council (Chamber of Commerce)), they assume that a rising tide will lift all boats.

Historically, it hasn't worked that way. Faced with that situation, companies have opted to provide smaller benefits across the board, thereby lessening retirement security for most, and have found other ways to provide for their key employees.

Senators Portman and Cardin have a worthy goal. They seek to find a way to allow companies to continue to provide meaningful benefits to those people who have an expectation of those benefits. But, even if they do, they cannot solve the whole problem.

For years, Congress has passed bills designed to enhance retirement security only to see that each one in turn has caused more and more companies to get out of the business of providing retirement benefits to their employees. Oftentimes, these rules, such as the Pension Protection Act of 2006, have been poorly thought through, and actually decrease retirement security for workers. In fact, during my career, each time a major piece of pension legislation has become law, a swath of companies seek ways to get out of the business of providing pensions. But, no law over that period has caused companies to start up new plans.

If we want to restore a sense of retirement security for typical working Americans, we need to start anew from the beginning, not simply apply another band-aid to the problem. That said, I applaud the senators for making far more of a constructive effort than any of their colleagues.

Ruling Affects ERISA Compliance Issues for Private Equity Funds

Just last week, the First Circuit Court of Appeals ruled in New England Teamsters v. Scott Brass Holding Corp. So, what's the big deal and why am I writing about it here? Well, Scott Brass Inc. was wholly owned by a combination of Sun Capital Partners III and Sun Capital Partners IV, a pair of private equity funds under the Sun Capital Partners umbrella. Scott Brass participated in the New England Teamsters & Trucking Industry Pension Fund. When Scott Brass went into bankruptcy protection, it was assessed a withdrawal liability.

The District Court accepted the argument of Sun Capital Partners that their funds were not "trades or businesses" and were therefore not liable for withdrawal liability payments. But, the Appeals Court held that the Sun funds invested in Scott Brass "with the principal purpose of making profit." Further, although Sun argued that it had no employees, the Court noted that the partners of the Sun funds had and exercised the authority to hire, fire, and compensate employees of Scott Brass. Additionally, partners of the Sun funds were "actively involved in management and operation" of the company.

The implications of this ruling are potentially far more significant than just this withdrawal liability case. Diligent readers (I certainly hope I have a few) may recall that nearly two years ago, I wrote on retirement compliance issues for private equity funds. At least a few readers wrote to me to tell me that private equity funds were exempt because they were not, in fact, businesses.

Pshaw!

While I am not an attorney and am therefore not technically qualified to opine on what the Appeals Court said, I can read. This seems to make clear to me that at least in the states of Maine, Massachusetts, New Hampshire, and Rhode Island as well as the Commonwealth of Puerto Rico, private equity funds can be businesses. Since there primary purpose generally is to make a profit and since they tend to exercise some management authority over the companies in their portfolios, it strikes me that this ruling can be construed to make them (where they have 80% common ownership) a controlled group of companies.

So, private equity funds beware. This means that:

• you and your partners might be jointly and severally liable for funding of qualified retirement plans in the controlled group
• all those retirement plans in the controlled group are subject to the nondiscrimination, coverage and minimum participation rules of ERISA and the Internal Revenue Code
• we could say the same about welfare benefit plans and their nondiscrimination requirements

Of course, there are other requirements and pitfalls, but I thought it worth it to point out a few. The effect here could be significant. How many companies that are owned by private equity funds, for example, do their nondiscrimination testing on a controlled group? Or, conversely, how many do not? 

Somebody out there is going to latch onto this and stir up some trouble. The question to me is will other circuits follow the first?

MAP-21 and SERP Funding, Now May be the Time

If you work with US defined benefit (DB) pensions and you haven't been living under a rock, then you are probably familiar with MAP-21, the law passed this summer whose more formal name is Moving Ahead for Progress in the 21st Century. It was positioned as a highway bill, but you are too smart for all that and know all about positioning. Where building highways costs money, lowering corporate deductions for pension plans raises money (or gets scored that way by the Congressional Budget Office). So, MAP-21 included pension funding relief.

In a nutshell, MAP-21 allows plan sponsors to use significantly above-market discount rates in the determination of funding requirements for their qualified pension plans. The trade-off comes in increases in PBGC premiums. But, while the first of these items is optional, the second is required.

So, where am I going with this? If you read the title of this post, you may be wondering.

Flashback to late 2004. Congress passed and a different president signed into law another act supposedly designed to create jobs. This one had a much more in-your-face title, the American Jobs Creation Act of 2004. With that innocuous name, however, came a new section of the Internal Revenue Code, Section 409A that among other things removed distribution and funding flexibility for DB SERPs. Since that time, many executives have wondered how to get their benefits, or at least portions of them, out from under the dark veil of 409A.

For some companies, MAP-21 may have provided an answer.

WARNING: before considering an option such as what I am about to describe, plan sponsors should very carefully consider the underlying risks.

The time may be right to consider a QSERP. Briefly, a QSERP is a means to transfer certain nonqualified benefits to a qualified plan. You can read about them in more detail here.

So, why might now be the right time. MAP-21 has given companies the ability to use higher discount rates in funding their pension plans. This means that any restrictions that might have arisen due to low funded statuses have likely disappeared. So, companies have the opportunity to fund this obligation in a qualified plan without having to fund it all at once.

Risk managers might tell you not to do this and there are good reasons. Paramount among them is that temporary use of above-market discount rates does not change the "true" funded status of a plan.

Other risk managers might tell you that you should do this and you should do it now. Why? Let's consider a simple example. Suppose you have agreed to pay your CEO an additional $100,000 per year (for life starting at age 65) from the SERP. This is over and above what he will get from the qualified DB plan. The present value of that obligation is the same whether that benefit is in the qualified plan or in the SERP. But, in the qualified plan, you get these advantages and many others:

• The benefit will not be subject to 409A
• You could efficiently fund the benefit immediately and generally get an immediate tax deduction for that funding
• That tax deduction may be taken at a higher corporate tax rate than it will be in the future
• When the CEO retires, his benefit can be paid out of a large pool of assets rather than creating a cash flow crunch

This is a complex process and there is much to consider. But, for the right company, now is the time. You'll only know if you are the right company after careful analysis. Ask an expert.

Nondiscrimination Testing Revisited

Yesterday, I read an article written by David Godofsky of Alston & Bird (a large law firm headquartered in Atlanta) on nondiscrimination testing in 401(k) plans. If you are interested in this topic, I would commend you to read it. It is very well written. It's almost interesting. And, like very few pieces that I have seen on this topic that has been written by an attorney, David gets it right, even the math.

You see, David has an unfair advantage. I'm not sure when he became an attorney, but I do know that he has been an actuary for a really long time. So, unlike most attorneys that I know, he gets the numbers. And, unlike many actuaries, he gets the law.

So much for praise of an attorney. While he gets the technical stuff right and keeps it interesting, I am going to explain to you where David goes wrong. He compares testing to a peanut butter and jelly sandwich, and puts that sandwich in a positive light. I know this will be anathema to many, but peanut butter is the single worst food ever created. It smells bad, it tastes bad, and it has a bad texture. That, by the way, is either opinion or fact, and the early voting returns say it is fact, although I am afraid that opinion may come on strong. In any event, to add to the problem, he doesn't even serve anything to drink with his abomination.

Retirement plan nondiscrimination is clearly more elegant than that which applies only to 401(k) and similar plans. If Mr. Godofsky is serving PB&J with his testing, the testing that I refer to is more suited to foie gras served with sauternes.

You get the picture? His is packed in a metal lunchbox with Fred and Wilma staring at you. Mine is presented by a trained server and is only for the most discriminating among us. And, oh yeah, mine costs more than his.

Before I move forward, though, I need to warn you that just like foie gras and sauternes, neither most actuaries nor most attorneys understand nondiscrimination testing. I taught this lovely topic for more than ten years, so I saw the misconceptions.

Now, we get technical and explain to you why this process should not be left to the sous chef and the apprentice sommelier, but rather to the masters. While I am not going to go into the really gory details, this is probably about to become the single most technical topic (although I prefer to think of it as elegant) that has ever appeared in this blog.

It all started with Internal Revenue Code Section 401(a)(4) which spells out one of the requirements that a trust that forms part of a retirement plan be qualified (exempt from tax): "[I]f the contributions or benefit provided under the plan do not discriminate in favor of highly compensated employees (within the meaning of section 414(q)). For purposes of this paragraph, there shall be excluded from consideration employees described in section 410(b)(3)(A) and (C)."

That sounds pretty simple doesn't it? You wonder what nondiscriminatory means in this context, don't you?

I'm so glad you asked. You see, without explaining everything, there are two ways that a plan can be nondiscriminatory in the amount of benefits or contributions that are provided:

1. Have a safe harbor design
2. Prove it

Let's suppose that we choose to prove it. In the simple case, we will consider each employee in the controlled group. And, then for each one, we will calculate both that employee's normal and most valuable rate of accrual. Normal generally means life annuity at normal retirement age. Most valuable generally means qualified joint and survivor at the age at which it has the greatest actuarial value. This is not a simple determination. 

Then we take the employees and we put every one of them on a grid defined by his or her normal and most valuable accrual rates (by the way, if you think this is too easy so far, there are multiple measurement periods that can be used to do these calculations, and we can choose to impute permitted disparity or not). Let's assume that in our grid, the highest rates are in the upper left or northwest corner. We get to take people with similar accrual rates and group them. Then, we define a rate group for every highly compensated employee (or group of highly compensated employees). A rate group consists of every employee who sits neither south nor east in our grid of the rate group in question. Once we have done that, we determine a ration percentage for that rate group defined loosely as the ratio of 1 to 2 divided by the ratio of 3 to 4 where 1, 2, 3, and 4 are as defined here:

1. the number of nonhighly compensated employees (NHCE) in the rate group
2. the number of nonexcludable nonhighly compensated employees in the controlled group
3. the number of highly compensated employees (HCE) in the rate group
4. the number of nonexcludable highly compensated employees in the controlled group

So, now we have a percentage for a rate group. We need to get a percentage for every rate group. And, then we need to take the minimum of all those percentages. And, after that, we need to compare that minimum to the threshold percentage for the coverage test that we used and if our minimum is above that threshold percentage, then we pass.

Hold on, what's all this about coverage percentages?

Well, you see, a plan also needs to satisfy the minimum coverage requirements of Internal Revenue Code Section 410(b). And, this section has two tests (you only need to pass one). But, the tests have different threshold percentages.

Let's look at them. Under the ratio percentage test, you again take the ratio of 1 to 2 and divide it by the ratio of 3 to 4 like we did above, except that now in the numerators, we have numbers benefiting under the plan. To pass the ratio percentage test, your threshold is generally 70%, unless you are using snapshot data which is a subject for a comparison of restaurants rather than foods (snapshot data looks like fast food while complete data looks like fine dining). But, suppose you fail the ratio percentage test, or when you are doing your nondiscrimination testing, your rate groups don't clear the 70% hurdle. Then, you will want to use the average benefit test.

It's a nice little test. It has two parts, the average benefit percentage test (ABPT) and the nondiscriminatory classification test (NDCT). And, the NDCT has two parts. To run the ABPT, you combine generally all plans of the employer and determine an accrual rate (or contribution rate) much like we did above for each employee in the controlled group. Then, you take the average over all the NHCEs and divide it by the average over all the HCEs and take the average for the NHCEs and divide it by the average for the HCEs. If it's at least 70%, you pass this part.

On to the NDCT. One part of it is that the group of people covered by the plan has to be a nondiscriminatory classification. It's hard to know exactly what this means, but two examples may help. A plan that covers all the employees working in Grand Fenwick probably has a nondiscriminatory classification. A plan that covers all the employees with purple hair and orange eyes may fail to be nondiscriminatory.

The other part is a version of the ratio percentage test, but with a lower passing threshold. What is that threshold? I'm so glad you asked because you have to figure it out. Just follow these simple steps:

1. Determine the percentage of employees in your controlled group who are NHCEs. Call this the NHCE Concentration Percentage (NHCECP). 
2. Round down to the next lower integral percentage unless you are already at an integral percentage.
3. Subtract that answer from 100.
4. Multiply that answer by 0.75.
5. Add that answer to 20, but don't let your new answer go above 50.
6. This is your safe harbor percentage.
7. Subract 10, but don't let this answer go below 20.
8. This is your unsafe harbor percentage.
9. Halfway in between the two is your midpoint.
10. If your ratio percentage is at least equal to the safe harbor percentage, you pass.
11. If your ratio percentage is less than your unsafe harbor percentage, you fail.
12. If you are between the two harbors, you are in the Sea of Facts and Circumstances and only the IRS can tell you if you pass or fail.
13. The midpoint is generally the threshold for your rate groups.

That sure was fun, wasn't it?

Well, sometimes after you have done all that, you still don't pass. And, that's when you really need to rely on tricks of the trade.

Don't do it yourself. This is dangerous stuff. Talk to the master.

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