Nondiscrimination Requirements: Part One Fundamentals I of Retirement Plan Issues Chapter Eight, Part One/Week 9 Chapter 8 has been divided into three parts: Part one will be an orientation on the overall requirements of IRC §401(a)(4); Part two will get more into the details of these requirements; and Part three will discuss the cross-testing and permitted disparity rules. Parts one and two will focus on the rules of IRC §401(a)(4) and its related regulations; Part three will focus on the rules of IRC §§401(a)(5) and 401(l).

Nondiscrimination Requirements Three tests under IRC §401(a)(4) Test 1: Allocations or Benefit Accruals must be nondiscriminatory For DC plans, safe harbor = same % of allocation x Total PY compensation For DB plans, safe harbor = AB provides same % of Total PY compensation for each year of svc The Tax Reform Act of 1986 was designed to afford more predictability to plan sponsors regarding two issues (1) who are the individuals that are deemed to be in the “prohibited group,” and (2) how are the nondiscrimination rules of IRC §401(a) to be interpreted and enforced. Thus, IRC §414(q) was added to define who is a highly compensated employee (HCE) and therefore in the “prohibited group,” and IRC §401(a) was to be interpreted by the Service in more concrete terms. The Service interpreted IRC §401(a)(4) to contain three tests – Test 1 specified that allocations (under a DC plan) and/or accruals (under a DB plan) must be nondiscriminatory. Hence, if the actual allocations and/or accruals expressed as a percentage of the participant’s total compensation were the same uniform %, the plan’s allocation/accrual formula would be nondiscriminatory. Thus, the plan sponsor could design the allocation/accrual formula as a fixed % of total compensation, thereby satisfying the nondiscrimination test on its face. Alternatively, the plan sponsor could design the allocation/accrual formula in a different fashion, but would have to satisfy a general test annually that tests each allocation/accrual formula for discrimination.

Example of Discrimination Safe Harbor: uniform allocation based on total pay DC allocation: pro rata allocation using base pay instead of total pay and ER contribution ÷ Total base pay = 10% for the PY EE Base Pay Total Pay Allocation % of Total Pay A $50,000 $50,000 $5,000 10% B 20,000 40,000 2,000 5% As noted on the prior slide, if the allocation formula under a DC plan is a fixed percentage of the participant’s total compensation (e.g., 5% × total compensation), then the formula satisfies the safe harbor under the regulations, and there is no further testing under Test 1. This would be the case under a prototype plan where the plan sponsor must elect a uniform percentage of the participant’s total compensation as the allocation formula. A very popular allocation formula is the pro rata formula, especially under a discretionary profit sharing plan, where the employer is not obligated to make a fixed contribution every year. A pro rata formula is determined as follows: [participant’s total compensation × {Total ER contribution ÷ Total participants’ compensation}]. This type of formula automatically adjusts the allocation for each participant to be uniform once the total ER contribution and total participants’ compensation base are determined. For example, the total participants’ compensation base for the plan year is determined to be $1,000,000 and thus the employer decides to make a total ER contribution of $100,000. Thus the pro rata formula produces a uniform % of 10% (i.e., $100,000 ÷ $1,000,000) × each participant’s total compensation as the current year’s allocation. If the DC allocation formula is pro rata but based on the participant’s base pay, instead of total compensation, it does not satisfy the safe harbor and therefore has to be tested under the general test. Under the general test, the actual allocation determined by the plan’s allocation formula must be divided by the participant’s actual total compensation to produce a % for each participant. If the highest % for any HCE is greater than the lowest % for any NHCE, the general test requires more testing. In this example, there are two participants – A who is an HCE and B who is a NHCE. Since the plan’s allocation formula uses base pay, A’s actual allocation is 10% × $50,000 = $5,000 and B’s actual allocation is 10% × $20,000 = $2,000. Taking these allocations and dividing them by A’s and B’s total compensation, the general test determines that A’s % is $5,000 ÷ $50,000 = 10% and B’s % is $2,000 ÷ $40,000 = 5%. Since A’s 10% is greater than B’s 5%, the general test requires more testing.

Nondiscrimination Requirements Test 2: Benefits, Rights and Features Current availability & Effective availability Test 3: Amendments & Terminations Facts & circumstances determination Under the regulations for IRC §401(a), there are two other tests: Test 2 requires that any benefit, right or feature (BRF) available under the plan be made available to a nondiscriminatory group and utilized by a nondiscriminatory group. For example, if the lump sum optional form of payment was available only to participants with 20 or more years of service which resulted in its availability to a disproportionate % of HCEs as compared to NHCEs, such feature would be discriminatory. Test 2 has two components: (1) the BRF must be made available to a nondiscriminatory group, i.e., current availability requirement and (2) the BRF must be utilized by a nondiscriminatory group, i.e., effective availability requirement Test 3 requires that allocations (under a DC plan) and accruals (under a DB plan) that are payable under “special circumstances” must also be nondiscriminatory. For example, the plan provides that if a given plant is shutdown, additional benefits will be payable to the participants that were employed by that plant. Other examples include allocations/accruals that are triggered through a plan amendment or plan termination. Test 3 is a facts and circumstances test.

Top Heavy Determination Determination of key employee, not HCE Determination of top heavy status of plan Accelerated vesting schedules Mandated allocations for DC plans and accruals for DB plans As a review, top heavy plans are presumed to be discriminatory as a disproportionate amount of the allocations/accruals (i.e., 60%) are for the benefit of key employees. These top heavy rules are a carryover of the prior H.R. 10 or Keogh rules that were added to the Code when sole proprietorships and partnerships were permitted to establish and maintain qualified retirement plans. Since the presumption was that the key employees (then, the sole proprietor or the partners) would be receiving the lion share of the benefits, and thus, protections should be added to assist the non-key employees. A key employee is defined under IRC §416(g) as an employee, who at any time during the plan year, is (1) an officer having compensation greater than $130,000 ($160,000 for 2010), or (2) a 5% owner (which means having ownership greater than 5%), or (3) a 1% owner (which means having ownership greater than 1%) and having compensation greater than $150,000 (which is fixed and doesn’t have a COLA attached to it). Solely for purposes of (1), no more than 50 employees (or if less, the greater of 3 or 10% of the employees) need to be characterized as key employees. This was an accommodation for banks, as numerous individuals are titled as officers but clearly are not in the position of control. A non-key employee is any employee who is not a key employee for the plan year. A top heavy plan is one in which more than 60% of the accrued benefits (cumulative amounts) are attributable to the key employees. Once a plan is top heavy for a plan year, the vesting schedule is accelerated (e.g., 3 year cliff or 2-to-6 graded schedule). Also increased minimum allocations/accruals required under a top heavy plan for non-key employees. For DC top heavy plans, minimum allocation of 3% × compensation or maximum allocation accrued by any key employee. For DB top heavy plans, cumulative AB for years in which the plan is top heavy equal to the lesser of [ 2% × vesting years × FAE, or 20%], where FAE is average compensation over a 5-year period.

Safe harbor rules for Test 1 – DC Plans Criteria that must exist to use the safe harbors under the IRS regulations: Plan’s definition of compensation for allocation purposes must satisfy the definition in IRC §414(s) Same allocation formula must apply to all participants Safe harbor: Uniform allocation formula Same percentage of compensation or same dollar amount or same amount per year of service applies to all participants Safe harbor: Uniform points formula The IRS regulations set forth two safe harbor formulae for DC plans. However, there are certain criteria that must be satisfied in order to rely on the safe harbors: The plan’s definition of compensation used in the allocation formula must satisfy IRC §414(s), and The same allocation formula must apply to all participants. First safe harbor requires that the allocation formula provides the same percentage of compensation or the same dollar amount or the same dollar amount for each year of service applies to all participants. For example, the plan uses a pro rata allocation formula, using total compensation that meets the definition of IRC §414(s). Second safe harbor allows both compensation and age or service (not both age and service) to be considered in determining the allocation through the use of a uniform points based formula. The same points for service and compensation must be used for all participants. After the points are determined for each individual participant, the points are totaled. The total dollar amount of the ER contribution is then determined and divided by the total points to be allocated, resulting in an individual point value. This point value is then applied to each individual’s points, resulting in a dollar allocation. This dollar allocation is then divided by the participant’s total compensation, resulting in an allocation %. The safe harbor then requires the average of all the allocation %’s for the NHCEs to be computed, as well as the average of all the allocation %’s for the HCEs. If the HCE average % exceeds the NHCE average %, the safe harbor fails.

Safe harbor rules for Test 1 – DB Plans Criteria that must exist to use the safe harbors under the IRS regulations: Plan’s definition of compensation for allocation purposes must satisfy the definition in IRC §414(s) Same allocation formula must apply to all participants Plan’s NRA is uniform Post-NRA accruals must be uniform and each subsidized optional form of payment must be available to substantially all partiicpants No employee contribuitions Safe harbor unit credit AB formula Criteria that must exist in order to use the DB safe harbors: Same two criteria that applies to DC plans (definition of compensation used for AB meets IRC §414(s) and same AB formula applicable to all participants) NRA must be uniform; however, Social Security Retirement Age (SSRA) can be used provided additional coverage tests apply. Post-NRA accruals must be uniform and each subsidized optional form of payment must be available to substantially all participants. No employee contributions are permitted. Safe harbor unit credit AB formula: here the AB is a unit credit, using the participant’s years of participation, with either a career average (CAE) or final average (FAE) permitted. The AB formula must also satisfy the 133⅓% rule.

Safe harbor rules for Test 1 – DB Plans Fractional rule safe harbor: Plan’s AB = fractional rule applied to the NRB, however, no employee’s accrual rate can exceed 133⅓% of another employee’s accrual rate E.g., NRB = 1.6% × CAE × yrs (cap 25)/65/life only or J&S and AB = fractional rule Flat benefit plan (with 25 year minimum) using the fractional rule: The next safe harbor is the fractional rule safe harbor, where the AB = fractional rule; however, no employee can accrue at a rate that exceeds 133⅓% of any other employee’s accrual rate. For example, NRB = 1.6% × CAE × yrs (cap 25) and AB = fractional rule. For all participants with less than 25 years of service, the annual accrual is 1.6% (40% ÷ 25 = 1.6%); for all participants with 33 or fewer years of service, the annual accrual is 1.212% (40% ÷ 33 = 1.212%). As 1.6% is not more than 133⅓% of 1.212%, the plan meets this safe harbor. The next safe harbor has the NRB as a flat or fixed type of formula and the AB = fractional rule, but no HCE can accrue the AB over a period of less than 25 years. For example, NRB = 100% - 4% (for each year of service below 25) × CAE and AB = fractional rule. As long as the AB is conditioned upon using a denominator of at least 25 years for any HCE, the safe harbor is met. The final safe harbor has the NRB as a flat or fixed type of formula and the AB = fractional rule, but not conditioned on using a period of at least 25 years for HCEs. However, an annual numeric test is required whereby the average accrual rate of all NHCEs has to equal 70% of the average accrual rates of all HCEs. Hence, if most of the younger entrants are NHCEs (and thus have lower accrual rates), whereas most of the older entrants are HCEs , this test will not be met.

General Test for DC Plans General Test: if the highest allocation rate for any HCE exceeds the lowest allocation rate for any NHCE, the regulations “restructure” the plan into various rate groups Restructuring is done according to each different allocation rate for all HCEs; the group includes the allocation rate for the HCE and all NHCEs & HCEs with that or a higher allocation rate Each restructured group must be tested under the IRC §410(b) coverage tests If the DC plan is not relying on one of the two safe harbors, the allocation rate (equal to the PY amount of allocation ÷ total compensation) for every NHCE and HCE must be computed and compared to one another. Under the general test, if the highest allocation % of any HCE is greater than the lowest allocation % of any NHCE, the plan must be “restructured” (a term coined under the regulations). Restructuring the allocation rates is done according to the various rate groups that exist. There is a different rate group for every different HCE allocation %. Rate groups are constructed, starting with the lowest HCE allocation % and including all HCEs and NHCEs with the same or higher allocation %. For example, if there are 2 HCEs with allocation % of 8% and 10% and 3 NHCEs with allocation % of 5%, 9% and 11% -- there are 2 rate groups as there are two different HCE allocation %. Rate group #1 includes the HCE with the 8% rate and all other HCEs and NHCEs with 8% or greater rates (which would include NHCE’s 9% and 11% and HCE with 10%). Rate group #2 includes the HCE with the 10% rate and all other HCEs and NHCEs with 10% or greater rates (which would include NHCE with 11%). Each of the rate groups must be tested under the coverage rules of IRC §410(b) (as modified); if any of the rate groups fails the coverage rules, the general test is not met and the plan faces disqualification.