New-comparability plans target employer's 401 contributions - k

HR Magazine, Oct, 1998 by Roger Thompson

Profit-sharing plans used to come in two bland flavors. The "plain vanilla" variety was served up as the same percentage of salary to all participants. Some employers provided a "topping" in which highly compensated employees got a bonus calculated on earnings above the Social Security wage base.

In case you haven't noticed, profit sharing's bland days are over. Recently, the standard profit-sharing fare is giving way to more flexible - and tantalizing - plan designs that allow employers to target contributions to individuals or groups. In fact, so-called new-comparability profit-sharing plans permit employers to whip up almost any formula to allocate retirement benefits - as long as the outcome passes IRS nondiscrimination tests.

For small, closely held firms, new-comparability plans permit owners and other key employees to receive the maximum allowable contribution under a defined-contribution plan (the lesser of 25 percent of pay or $30,000), while the rank and file receive lower contributions, generally 3 percent to 10 percent of pay. For midsized companies, different percentages may be contributed to employees divided into three, four or more groups based on job classification, salary level, age, seniority or any combination off similar criteria.

New-comparability plans are the functional equivalent of a defined-benefit pension plan because you can contribute more for certain individuals or groups, says Louis Kravitz, president of Louis Kravitz and Associates, an actuarial consulting firm in Encino, Calif. "The principal difference is that new-comparability plans have a contribution limit of $30,000 [annually]," says Kravitz, who coined the term "new comparability." In contrast, defined-benefit plans allow contributions up to $100,000 or more annually, depending on the ages of participants.

Employers frequently use new-comparability plans in tandem with a tax-deferred 40 l(k) plan. The profit-sharing distribution may represent the employer's entire contribution to the 401(k) plan; or the distribution may be made in addition to an employer match of employee deferrals. "Instead of being limited to a maximum of $10,000 a year in a 401(k) plan, a company owner can go all the way up to $30,000" with a new-comparability plan, explains Stephen J. Butler, president of Pension Dynamics Corp. in Lafayette, Calif.

WHAT GOES IN OR COMES OUT

New-comparability plans aren't a new idea. But they recently gained new credibility when the IRS finally relented in its attempts to kill them. At issue was an approach to passing nondiscrimination regulations called "cross-testing." It's a simple but powerful concept.

The cardinal rule of pension plans is that they may not discriminate in favor of owners or the highly compensated. A highly compensated employee is one who owns more than 5 percent of a company or who earns more than an indexed figure, set in 1998 at $80,000. In the past, defined-benefit plans passed the test by showing that future retirement benefits were not discriminatory. Defined-contribution plans passed by showing that current contributions were not discriminatory.

Cross-testing allows a firm to pass nondiscrimination tests based on either current contributions or future benefits.

Complex formulas convert current contributions made on behalf of each worker into retirement annuity benefits. These benefits are then expressed as a percentage of current pay. These percentages are called Equivalent Benefit Accrual Rates, or EBARs. To pass the nondiscrimination test, the EBARs of highly compensated employees must bear a reasonably close relationship to those who are not highly compensated.

Patrick Byrnes, president of Actuarial Consultants Inc. in Torrance, Calif., explains it this way: "You can look at what's going into a defined-contribution plan or look at what's coming out [the benefit]. That's cross-testing; the logic is perfect."

Maybe so, but unequivocal official acceptance of that logic was a long time in coming. A 1981 IRS revenue ruling established the rules for converting contributions into benefits but did not explain how the results were to be used to prove nondiscrimination. Congress reaffirmed its commitment to nondiscrimination in pension benefits with the 1986 overhaul of the tax code. But the testing issue remained unresolved.

In 1993, the IRS issued 80 pages of final nondiscrimination rules, effective Jan. 1, 1994. The rules detailed the mathematical formulas for cross-testing. The formulas recognize that younger employees have more time to accumulate benefits and therefore may be given smaller contributions. Conversely, owners and managers, typically among the oldest and highest paid, may receive higher contributions because they have fewer years to retirement. The disparity in current contributions is not discriminatory when the amount each person gets today buys roughly the same retirement benefit tomorrow, calculated as a percentage of pay.

The new regulations triggered a spate of articles criticizing cross-tested plans as unfair to the rank and file. The Clinton administration concurred and attacked cross-testing for its failure to allocate benefits equally. Congress attempted to ban cross-testing in 1993 and 1994, but both attempts met stiff-and ultimately fatal-resistance from business, insurance and benefits groups.