Guest Article (3/13/2000)

Small Business Retirement Plans Will Terminate Due to Potential Treasury Changes to Qualified Plan Regulations

More Time is Needed to Study the Issue

By Brian Graff
Executive Director
American Society of Pension Actuaries

Introduction

There are significant tax benefits associated with qualified retirement plans. Contributions made to the plan are deductible to the employer, and the benefits accrued by employees (and any earnings on such benefits) are excludable from income until distributed. However, these tax benefits come with a price. Qualified retirement plans have stringent administrative and nondiscrimination requirements.

Internal Revenue Code Section 401(a)(4) states that contributions or benefits provided in a qualified retirement plan must not discriminate in favor of highly compensated employees. This one sentence in the Code has spawned hundreds of pages of regulations. There is some reason for this. The concept of nondiscrimination in qualified retirement plans is extremely complex. A contribution of a dollar to the retirement account of one employee could be worth significantly more than the same dollar contribution to the account of another employee. For example, a $1,000 contribution to the account of a 25-year old employee is worth over 11 times as much upon retirement than the same $1,000 contribution to the account of a 55-year old employee. Consequently, in order to compare the relative value of these contributions in terms of real worth, the nondiscrimination regulations contain a complex methodology that permits consideration of the participants' ages. In general terms, this is accomplished by comparing contributions under a defined contribution plan to the benefits that would be received under a defined benefit plan. This methodology for satisfying the nondiscrimination rules is sometimes referred to as "cross-testing" or "new comparability." These are not new concepts. Concepts such as "cross-testing" and "new comparability" were first sanctioned by the IRS in 1981 and were recognized by Congress in 1996.

Treasury has recently announced that it is reviewing its nondiscrimination regulations. Particularly, they are focusing on the "cross-testing" and "new comparability" methodologies used to satisfy the nondiscrimination requirements. They are concerned with the disparities in contribution rates between highly and nonhighly compensated employees which may be allowed by these methodologies due to differences in ages.

Many small business retirement plans utilize these methodologies to satisfy the nondiscrimination rules. Unfortunately, one alternative approach already suggested by Treasury would discriminate against small business on a mathematical basis merely for having a small number of employees. There is great concern that any material change to these regulations could lead to the termination of small business retirement plans leaving small business employees without any retirement benefits.

The Small Business Retirement Plan Challenge

Small business employees already have few opportunities to save adequately for retirement. Presently, only 20 percent of small business employees are covered by a retirement plan. Meanwhile, over 70 percent of employees at larger companies have access to a retirement plan. This coverage gap is significant given that over 75 percent of the new jobs created in recent years were small business jobs. Small business now employs over half of the nation's workforce.

Surveys of small businesses reveal why so few small businesses offer retirement plans to their employees. Small businesses are faced with unique challenges which make offering such benefits to their employees difficult. At first, a small business struggles to survive, so naturally all of its resources are devoted to keeping the small business in business. When the small business finally believes it has the resources to offer a retirement plan to its employees, it is faced with burdensome administrative requirements and nondiscrimination rules that mandate that the small business must make a certain level of contributions on behalf of its employees. The contributions required by the nondiscrimination rules can be expensive. Although the owners of a small business would like to offer a plan to their employees, in many cases the small business simply cannot afford them. Simply put, the owners of the small business will not offer retirement plans to their employees if offering such a plan does not make economic sense as compared to other retirement savings alternatives that are available.

"Cross-testing" and "New Comparability"

Since 1981, Treasury and IRS guidance has permitted qualified plans to satisfy the Code's nondiscrimination requirements by effectively comparing contributions under a defined contribution plan to the benefits that would be received under a defined benefit plan. Under methodologies known as "cross-testing" and "new comparability," the real value of contributions to a defined contribution plan are compared in terms of the retirement benefits they provide which takes into account the ages of the participants.

An age-weighted profit-sharing plan is a basic example of these methodologies. A real company example is the best way to demonstrate how this works.

Bob runs a small manufacturing firm in Southeastern Wisconsin. He was laid off from an engineering job at a large Fortune 500 manufacturing firm which downsized in the late eighties. Since that time, he has been able to build his business so that he now has four employees. In the mid-nineties, Bob became very concerned about retirement. He had invested his life savings in the business and had just finished putting his kids through school. He had no retirement savings to speak of.

Bob felt that the business could afford about $26,000 a year for retirement savings. His financial advisor suggested that he pay himself a bonus and invest the after-tax proceeds in a mutual fund. However, Bob felt he would like to do something to also help his employees, but only if it made financial sense.

Bob met with a pension consultant who first suggested an age-weighted profit-sharing plan. Under an age-weighted profit-sharing plan, the value of each of the employees' contribution on a present value basis would be equivalent. However, the actual dollar contribution as a percentage of pay for each employee would be different. Here is how it would look.

The plan satisfies the nondiscrimination regulations because the equivalent benefit percentages (i.e., the real value of the contributions on a future value basis) for all employees are the same. Unfortunately, this plan design was unacceptable to Bob. He was extremely concerned that his employees would be upset by the fact that their gross contribution percentages were different. In a small business, employees do talk to one another about these things. He was particularly concerned about Alice, his most valuable employee, because she was in charge of the computer system. A defined benefit plan was not an option because Bob was afraid, given the uncertainties of his small business, to commit to pension contributions every year as required with defined benefit plans. He wanted a defined contribution plan design where his employees would get the same percentage of pay contribution. He was even willing to lower his own contribution to achieve that, provided having a plan still made economic sense as opposed to simply investing the money in a mutual fund.

Fortunately, the current nondiscrimination rules allow for such a design. Under "new comparability," the employees can receive the same gross contribution as a percentage of pay. Here is how it works.

A new comparability plan design will satisfy the nondiscrimination rules if each of the "rate groups" satisfies the "ratio percentage test." A rate group consists of each highly compensated employee (in this case Bob) and all other employees whose equivalent benefit percentages are equal to or higher than the highly compensated employee's equivalent benefit percentage. The ratio percentage test requires the percentage of nonhighly compensated employees in the rate group as compared to the percentage of highly compensated employees in the rate group to be equal to at least 70 percent. In this case, Dave, Joan, and Alice (or 75 percent of the nonhighly compensated employees) have equivalent benefit percentages equal to or higher than Bob's. Consequently, the plan design satisfies the nondiscrimination rules.

Changes to Regulations Being Considered

Treasury is considering changes to the nondiscrimination rules that would prohibit the "new comparability" plan design described above. Ironically, Treasury suggests that it would still allow the age-weighted profit-sharing plan design described above, even though it results in a higher contribution for the highly compensated employee. Unfortunately, as discussed earlier, an age-weighted profit-sharing plan will not meet the needs of Bob's small business. An alternative would be a straight profit sharing plan that is not age weighted. However, as demonstrated below such a plan would not make economic sense for the small business owner.

Under a straight profit sharing plan, the $26,000 pension contribution would be divided equally on a percentage basis among Bob and all of his employees. Here is how it would breakdown:

As you can see, Bob's equivalent benefit percentage (i.e., the real value of his contribution on a future value basis) is significantly lower than those of his employees. Further, this plan design does not make economic sense for Bob as compared to Bob simply investing the pension contribution in a long-term growth mutual fund, which distributes minimal taxable capital gain distributions on an annual basis, and is taxed at capital gains rates upon distribution

Assume that Bob instead pays himself a bonus equal to the $26,000 pension contribution. Assuming he is currently in a 33 percent tax bracket (federal and state), the after-tax amount available for him to invest is 17,300. How well would Bob fare in 10 years if he chose the bonus alternative as compared to the straight profit-sharing plan or the new comparability plan design?

The straight profit-sharing plan as compared to the after-tax bonus simply does not make economic sense to Bob. However, as the chart demonstrates, the new comparability plan design does make economic sense and has the added feature of allowing Bob to provide valuable benefits to his small business employees.

Unfortunately, changes being considered by Treasury would make the new comparability plan design no longer available to Bob's small business. When told of this possible development by his pension consultant, Bob said he would have to seriously consider terminating his retirement plan in favor of the bonus approach. He said he was getting tired of the administrative requirements and expenses anyway. Further, he could give his employees a small bonus as a substitute and probably still come out ahead.

Does this result make sense from a retirement policy perspective?

More Time is Needed to Study the Issue

Any material changes to the nondiscrimination regulations relating to "cross-testing" and "new comparability" could result in the termination of small business retirement plans, thus denying small business employees a meaningful opportunity to save for retirement. Given the current lack of retirement plan coverage among small business employees, the last thing needed is any further reason for small businesses to not adopt a retirement plan or terminate their existing plans.

Given the pressing need to expand small business retirement plan coverage, and the great complexity of this issue, great care must be taken to ensure that even the most minor of changes to the regulations do not inadvertently result in small business plan terminations. However, the notice recently issued by Treasury suggests that, despite their requests for industry comments, they have already concluded that changes to the regulations are needed. The notice states that changes to the regulations will be made prospectively and suggests a possible approach they are considering. Unfortunately, this approach would discriminate against small businesses on a mathematical basis merely for having a small number of employees.

Further, the timing of this review will be particularly burdensome to small businesses. Currently, small businesses are redesigning and amending their plans to comply with several law changes affecting qualified retirement plans enacted since 1994. Under Treasury and IRS rules, these changes must be accomplished by the end of the 2000 plan year. In many cases, small businesses will incur thousands of dollars to make these changes.

Many of these plans legitimately rely on "cross-tested" or "new comparability" plan designs. As stated earlier, such designs are based on nondiscrimination testing concepts permitted since 1981, confirmed in Treasury regulations finalized in 1993, and acknowledged by Congress in 1996. Now, without any previous indication, Treasury and IRS have issued a notice indicating they are seriously considering changes to these rules and asking for comments in 75 days. If, as it appears, they rush to propose new regulations in this area, it will force thousands of small businesses to once again incur the significant cost of redesigning and amending their retirement plans next year. This gives small businesses one more reason to terminate their plan.

It is also peculiar that Treasury believes it has the authority to make changes to these rules by regulation as opposed to legislation given their longstanding existence. In 1994, Treasury made a legislative proposal to prohibit "cross-testing" which was soundly defeated. It appears that they now believe they have the regulatory authority to make changes in an area they previously had to change through legislation. This is particularly curious given that, as noted before, Congress acknowledged the existence of cross-tested plans in 1996.

Changes to the qualified retirement plan nondiscrimination rules could have serious implications for small business retirement plan coverage. Such changes should be considered extremely carefully. Studies should be conducted by independent agencies, like the General Accounting Office, to obtain an objective view on the potential impact of any changes on small business retirement plans. An open and honest dialogue on this issue should be conducted with groups representing small business and the retirement industry. However, a 75-day comment period is wholly insufficient to adequately accomplish all of this and does not allow for measured consideration.

For these reasons, we believe there should be a moratorium on any further guidance in this area until 2002. In the mean time, the issues in this area can be carefully reviewed to ensure that any changes do not detrimentally effect small business retirement plan coverage. Small businesses are struggling enough to maintain retirement plans for their employees. It is certainly reasonable to relieve them of the burden of having to incur the cost of redesigning the plans two years in a row.

Brian Graff is the Executive Director of the American Society of Pension Actuaries, www.asppa.org

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