1. Nondiscrimination Requirements: Part Three
Fundamentals I of Retirement Plan Issues
Chapter Eight, Part Three/Week 12

2. Permitted Disparity Rules of IRC §§401(a)(5) and 401(l)
Social Security mandates a 7.65% FICA tax rate for both ERs and employees – 5.7% for Social Security retirement benefits and 1.45% for Medicare benefits
Due to the maximum wage ceiling on Social Security benefits and FICA taxes, the ER paid 5.7% of the employee’s wages up to the FICA wage ceiling
If the ER’s privately provided retirement plan contribution % could be “integrated” with Social Security, the ER could provide 0% under its private plan for wages up to the maximum wage ceiling + 5.7% for wages over the maximum wage ceiling. The end result was that the ER contributed a total of 5.7% of all compensation for retirement benefits (either through Social Security or the employer’s private plan).
Most employers are required to pay taxes to support the Social Security System – both its retirement benefits and its Medicare benefits. However, there is a cap on the maximum wages that the Social Security system will consider for benefits and tax purposes – known as the maximum taxable wage base – which for 2010 is $106,800. If the theory is that the employer should contribute a uniform % of total compensation for covered employees for retirement purposes, the argument arose that the employer was already contributing a fixed % of total compensation for employees under the maximum taxable wage base to Social Security. Therefore, the employer should be able to contribute less than or equal to a fixed % of total compensation for employee over the maximum taxable wage base under a privately maintained employer plan – if the two plans were considered together, the employer would be contributing a uniform % of total compensation under both plans and therefore such contributions would be nondiscriminatory.
Presently the portion of the FICA tax attributable to retirement benefits is 5.7% and is subject to a maximum taxable wage base (presently $106,800 for 2010). The other portion of the FICA tax of 1.45% is attributable to Medicare benefits, and that portion of the tax is not subject to a maximum taxable wage base.
Under the original integration rules, an employer could provide a current year’s DC allocation of 5.7% of wages in excess of the current maximum taxable wage. This is known as the excess approach. If the ER maintained a DB plan, two approaches developed – an excess approach and an offset approach.

3. Original Integration Rules
Concepts that existed under the original integration rules:
Integration level: the plan’s cutoff for compensation purposes – compensation below such level would receive $0 or a lesser allocation as compared to compensation above such level
Maximum taxable wage base: Social Security’s maximum taxable wage base for the current year
Covered compensation: the average of the maximum taxable wage bases that a hypothetical employee always at that wage base earned over his/her 35-year career average
OASDI rate: portion of the FICA tax attributable to retirement benefits (5.7%) and to health benefits (1.45%).
While the original integration rules have been altered, remnants of the original rules still remain today:
Integration level: the plan’s cutoff for compensation purposes – compensation below such level would receive $0 or a lesser allocation as compared to compensation above such level
Maximum taxable wage base: Social Security’s maximum taxable wage base for the current year
Covered compensation: the average of the maximum taxable wage bases that a hypothetical employee always at that wage base earned over his/her 35-year career average
OASDI rate: portion of the FICA tax attributable to retirement benefits (5.7%) and to health benefits (1.45%).

4. TRA ’86 Revisions to the Rules
TRA ‘86 totally modified the integration rules and replaced them with the permitted disparity rules
The notion of not providing any benefits/allocations for wages below the maximum taxable wage base (MTWB) was expelled
Instead, a “two for one” comparison was adopted whereby the allocation rate applied to wages above MTWB was dependent upon the allocation rate applied to wages below the MTWB
TRA ‘86 took a totally fresh look at the integration rules and dismissed the thought that there could be no allocations for wages below the maximum taxable wage base (MTWB). Instead the new integration rules (labeled the permitted disparity rules) conditioned the amount to be allocated on wages in excess of the MTWB on what was being allocated on wages below the MTWB, via a two-for-one rule.
Via the two-for-one rule, the allocation rate applied to wages below the MTWB dictated the maximum that could be provided on wages in excess of the MTWB. Using a two-for-one ratio, if the allocation was 1% on wages below the MTWB, the maximum permitted disparity was an allocation of 2% on wages in excess of the MTWB. So to replicate the prior 5.7% allocation on wages in excess of the MTWB, the employer would have to provide an allocation of 5.7% on wages up to the MTWB in order to provide an allocation of 5.7% on wages in excess of the MTWB. Since this drastically escalated the costs of integration, any employers chose not to integrate their plans.
Example: DC with immediately eligibility for all ees of ER and allocation formula of 2% × total pay up to MTWB + 4% × total pay in excess of MTWB. All NHCEs at or below MTWB and all HCEs above MTWB. Each NHCE’s allocation rate = 2% and each HCE’s allocation rate is 4%. Under general test, no NHCEs in any HCE rate group, and plan would fail. But the permitted disparity rules permit such a formula.
For defined benefit plans, the excess approach continued whereby the AB could condition one accrual rate for wages below the integration level and a higher accrual rate for wages above the integration level but it too was subject to a 2-to-1 comparison and the maximum disparity between the two rates of .75% per year (capped at 35 years).

5. Comparability Testing
The TRA ‘86 Act ‘s ABP coverage test requires that all allocations and accruals for NHCEs and HCEs be aggregated and tested under the 70% test – as such DC plan allocations must be aggregated with DB accruals to accomplish this test – this brought about the cross-testing rules.
For most employees, it would be difficult to ascertain which would be more profitable -- a 5% of compensation as a current year DC allocation or a accrual of 5% of compensation, payable at age 65 as a life only, under a DB plan. In fact, one would have to be an actuary to advise a client which would be more advantageous. Under conservative actuarial assumptions, the break-even age is generally age 42 – a 5% of compensation contributed annually and cumulated until age 65 and then annuitized is roughly equivalent to a promise of 5% of compensation payable at age 65 as a life annuity. For employees younger than age 42, a 5% of compensation allocated under a DC plan has a longer time horizon for investment and accumulation, and therefore is expected to produce an annuity at age 65 in excess of 5% of compensation annually.
For purposes of the ABP test, allocations and accruals under all qualified plans maintained by the employer are required to be aggregated. Hence, the regulations (via the cross testing rules) had to create some way to create a DC allocation into a DB accrual and vice versa. Since the value to an individual employee of an allocation or accrual, under a DC or DB plan, is so unique dependent on the employee’s age, the cross testing rules create unexpected allocation/accrual rates where expressed as a DC or DB rate. For example, a DC plan may provide a 5% uniform allocation rate for all participants; however, when that 5% allocation is expressed as a DB accrual rate, it may result in an accrual rate of 20% for an older participant and a 1% rate for a younger participant.

6. Cross Testing Rules Byproduct of ABT of the ABP coverage test
Method to convert a DB plan to a DC plan to aggregate with other DC plans/to convert a DC plan to a DB plan to aggregate with other DB plans
When you convert, age becomes a determinative factor, not salary
Because the third prong of the ABP test requires the plan administrator to compare the average benefits % that the NHCEs attain from all qualified plans with the employer with the average benefits % that the HCEs attain from all qualified plans with the employer, the IRS had to issue regs that permitted a DC allocation to be converted into a DB accrual rate and vice versa. Employers then asked to perform IRC §401(a)(4) nondiscrimination testing on either basis: thus, DC plan could test allocation rates or benefits’ accrual rates, and vice versa for DB plans.

7. Cross Testing Rules
Two ees: ages 30 and 50, $10,000, covered under both plans
DC allocation = 5% of pay = $500
DB benefit = 5% of pay/65/life only = $500/65/life
If both plans were viewed as DB plans:
Take current allocation, project to NRA, determine EBAR (equivalent benefit accrual rate)
Age 30: DC 5% allocation is worth 24% of pay as a DB, so combined rates are 5% + 24% = 29%
Age 50: DC 5% allocation is worth 2% of pay as a DB, so combined rates re 5% + 2% = 7%
If both plans were viewed as DC plans:
Age 30: DB 5% benefit is worth 2% of pay as a DC, so combined rates are 5% + 2% = 7%
Age 50: DB 5% benefit is worth 12% of pay as a DC, so combined rates are 5% + 12% = 17%
We have two employees, both earning the same pay of $10,000, but one is 30 and one is 50. DC allocation rate is 5% and the DB annual accrual rate (under the AB formula) is 5% at 65 as a life annuity.
If the DC plan was viewed as a DB plan (thus ignoring allocation rates), we would take the current 5% of pay allocation amount (5% × $10,000 = $500) and project it with interest for the age 30 year old until he reached 65 and then used that amount to purchase an annual annuity at 65 as a life annuity. Because there are 35 years of compounding of interest for the 30-year old, it purchases an annual accrual of 29% of pay at 65 as a life annuity. Then we have two DB accrual rates for the 30-year old, 29% and 5%, which produces an annual accrual rates of 34% for both plans.
In contrast, if we take the current 5% of pay allocation amount (5% × $10,000 = $500), we would project this with interest for the age 50 old until he reached 65 and then used that amount to purchase an annual annuity as a life annuity. Because there are only 15 years of compounding of interest for the 50-year old, it does purchase as large an annual accrual (only 2% at 65 as a life annuity). Then we have two DB accrual rates for the 50-year old, 5% and 2%, which produces an annual accrual rate of 7% for both plans. Depending on the interest rate and mortality table used, usually an age 42 old’s 5% allocation under the DC plan produces an annual accrual rate of 5% in the DB plan.
If the DB plan was viewed as a DC plan (thus ignoring accrual rates), we would take the current 5% of pay life annuity payable at age 65, and discount it back to the current year and ask what dollar amount would be required to purchase such annuity. That dollar amount would be divided by the ee’s total pay to produce an allocation rate for the DB plan. The reverse now occurs: the 30-year old’s annual accrual when discounted back 35 years isn’t worth very much and thus produces a lower allocation rate, whereas the 50-year old’s annual accrual when discounted back only 15 years is worth more and thus produces a higher allocation rate.

8. Design Considerations
Intent of the owner/employee
Maximizes the owner’s % more efficiently
Demographics of the employer
Ages
Turnover
Size of the employer
Family members working for employer
HCE status of one may result in HCE status for younger family member
Small employers typically use cross tested plans as a very large allocation amount for an older owner purchases a small DB annual accrual since he/she is so close to NRA. If the NHCEs are younger, a smaller allocation amount results in a large DB annual accrual since it’s compounding with interest over a longer period (current year to projected NRA of 65). Thus, instead of giving every one 5% of total pay, the owner can be given a much larger x% of total pay as an allocation, because it translates to a much smaller DB annual accrual rate.
Obviously, the demographics of the employer are critical, both age and turnover. Also the numbers can become unpredictable if the size of the employer is small. An employer with 5 NHCEs and 2 HCEs can have tremendous changes in the rate groups if one NHCE terminates during the year.
Also which family members work for the employer is also determinative. An older HCE (who is a 5% owner) will deem the spouse and children to be deemed HCEs.

9. Computing EBAR
Actuarial Assumptions: 8.5% and UP-84 Mortality Table and NRA =65 and monthly annuity purchase rate is Owner: age 52 with $245,000 comp Profit sharing allocation % = $22,050÷ $245k = 9% EBAR = [$22,050 × (1.085)13]÷ × 12 = $8, – annual annuity at 65 EBAR accrual rate = $8, ÷ $245,000 = 3.27%
Here’s an example as to how the actuary would make the computation.
We have a DC allocation of 9% for an owner-employee, age 52, with comp limited by the IRS §401(a)(17) limit of $245k. The 9% allocation on $245k produces an allocation of $22,050. The actuary takes that allocation of $22,050 and projects it to NRA of 65 using an interest rate of 8.5%, and then uses that amount to purchase a monthly life annuity at age 65. The annuity produced is an annual dollar amount of $8, This amount divided by the owner’s total pay of $245k produces an accrual rate of 3.27%. We call that rate the EBAR (equivalent benefit accrual rate).

10. New Comparability Rules
Minimum Gateway Allocations
Broadly Available Allocation Rates
Age-Based Allocations
Still have to satisfy RP or ABP for rate groups on either a DC or DB analysis
Using a very simple example, a DC plan with two participants affording two different allocation rates – 20% for participant A (an HCE) and 5% for participant B (a NHCE) – may result in DB accrual rates, because of A’s and B’s respective ages, of 5% for each. Hence, if the plan were cross-tested as a DB plan and not a DC plan, the uniform 5% accrual rates would meet the IRC §401(a)(4) general test.
Thus, the regulations under IRC §401(a)(4) were amended to permit cross-testing but subject to three different tests.
The Gateway Test requires that the minimum NHCE allocation rate be the lesser of 5% or 1/3 of the highest HCE allocation rate. So using the example in the textbook, the DC allocation formula provides a 40% allocation rate to the single HCE and an allocation rate of 6.25% to the remaining four NHCEs. Clearly under the general test, this would fail. However, if the allocation rates are converted to accrual rates (which are dependent on the participants’ ages), the HCE’s AB rate is now 17%, whereas the NHCEs’ AB rates are 20%, 17%, 10% and 3%. Even if these rates could satisfy the general test under IRC §401(a)(4), the gateway test requires that the minimum NHCE allocation rate of 5% be the lesser of [5% or 1/3 of 17%, which is 5.7%], which is met. Hence now test the EBARs under IRC §401(a)(4).

11. IRS LRM 94 Listing of Required Modifications
The plan document must set forth each allocation group used in the cross tested comparability design.
The plan document must set forth which gateway minimum is being used.
The employer must provide annual written notification the contributions to each allocation group.
The plan document must define the Allocation Groups used in the cross testing; no required disclosure in the plan of the allocation percentages, but employer must disclose % each year.
According to the IRS’ Required Modifications, plans relying on cross testing must satisfy the following requirements:
- The plan document must set forth each allocation group used in the cross tested comparability design;
The plan document must set forth which gateway minimum is being used to satisfy the definitely determinable requirement;
The employer must provide annual written notice of the contributions being allocated to each allocation group; and
- The plan document must define the allocation group used in the cross testing design; whereas the allocation percentages don’t have to be defined in the plan document, the employer must disclose the percentages allocated each year.

12. Minimum Gateway Allocation
Minimum gateway allocation must be made for every NHCE
Provided to any employee who benefits as an employee for the PY
Minimum gateway is most commonly used (e.g., NHCEs get at least 5% of 414(s) pay)
These rules presume that the plan’s allocation rates were converted to DB annual accrual rates, which satisfied the general test of IRC §401(a)(4). Despite meeting that general test, the actual DC allocation rates must, in addition, satisfy one of the three cross tested minimum requirements.
Minimum gateway requires the allocation for the NHCEs to be at least 5% unless 1/3 of the highest HCE rate was less. Example: HCE’s allocation rate = 12%, then NHCEs’ allocation rates must be at least 4%. Once this minimum gateway is satisfied, the plan can then test EBARs under rate group analysis under IRC §401(a)(4).

13. Broadly Available Allocation Rate
This test is utilized when there are a wide range of allocation rates attributable to HCEs and NHCEs alike
Each allocation rate is treated as a benefit, right or features and thus tested as if available to a valid 410(b) coverage group
Least utilized method
This test is available when there is a wide variety of allocation rates available to HCEs and NHCEs alike. The different allocation rates are treated as a benefit, right or feature, and therefore each different allocation rate for the HCE tested to be a valid 410(b) coverage group.
. Not utilized very often because it was designed to be used in plans with different allocation rates for HCEs and NHCEs. For example, if HCEs get 16% of pay and NHCEs get 4% of pay, it fails the broadly available test because 16% is not available to NHCEs. Also would fail minimum gateway as 4% is less than 1/3 of 16% or 5%.

14. Age-Based Allocations
Plans that explicitly use graded age or service conditions for allocation purposes are subject to a separate test to assure that the bands used are “smooth and regular”
The spreads between the bands are subject to the following constraints:
The allocation rate for each band cannot exceed the rate for the preceding band by more the 5%;
The ratio of the allocation rate for the band compared to its immediately preceding band cannot exceed 2%; and
The ratio of the allocation rate for the band compared to its immediately preceding band may not exceed the ratio of the allocation rates between the two immediately preceding bands.
This test assumes that the plan uses graded age or service bands to bifurcate the allocation rates provided to participants. For example, the plan’s allocation rates provide that participants under age 25 receive an allocation of 3%; between ages 25 and 34, an allocation of 6%; between ages 35 and 44, an allocation of 9%; between ages 45 and 54, an allocation of 12%; between ages 55 and 64, an allocation of 16%; and over ages 64, an allocation of 21%.
Here employees are groups into either age or service brackets. Changes in allocation rates can’t be more than 5% between adjacent bands and the ratio of one band to the next can’t be greater than 2, nor can the ratios increase.
The purpose of the brackets is to avoid designing a plan that backloads the allocation rates
Thus the differences between each band is as follows:
Rate Difference Ratio to prior band
Under 25 3% -- --
% 3% 200%
35 – 44 9% 3% 150%
45 – % 3% 133⅓%
55 – % 4% 133⅓%
Over % 5% 131%
Test 1: the allocation rate between bands cannot exceed 5% -- which is met.
Test 2: the ratios of the allocation band to its immediate preceding band doesn’t exceed 200% -- which is met
Test 3: the ratios of the allocation band to its immediately preceding band doesn’t exceed the ratio of the allocation rates between the two immediately preceding bands; as the ratios decrease over time, this test is met.

15. Cross Tested PS Plan
Name Age 2010 Pay PS Allocation Alloc % EBAR % % of Total ER $ HCE K 22,500 9% 3.27% 84.29% HCE 2* 46 50K 1,500 3% 1.78% 5.73% NHCE K 1,350 3% 4.02% 5.16% NHCE K 480 3% 1.93% 1.84% NHCE K 780 3% 6.56% 2.98% 382K 26,160 Results of RP? Results of ABP? Cross testing rules? * Spouse of HCE 1
Results of RP:
Test group = 5 – 3 NHCEs and 2 HCEs
Benefiting under plan = 5 % – 3 NHCEs and 2 HCEs
Two rate groups: 3.27% or more and 1.78% or more
6.56% NHCE 3
4.02% NHCE 1
Rate group # % HCE 1
1.93% HCE 2
Rate group # % HCE 2
Rate group #1: 3/3 versus 2/2 = 100% coverage – meets RP
Rate group #2: 2/3 versus ½ = 133⅓% -- meets RP
Under cross-testing rules, does the allocation formula meet minimum gateway?
Yes, since all NHCEs eligible to benefit receive 3% which is the lesser of [5% or 1/3 of 9%]