If you love baseball, the Spring Training season is a great time of year. For the die-hard fan, it’s an ideal environment to scout your team, meet the players and get autographs. Spring Training is also a reason, if you live in a colder climate, to trade mounds of snow for the warm sunshine and time at the ballpark. For Arizona and Florida natives, a game also is an excuse to pack up early at work, enjoy the weather, eat a hot dog and sip a cold drink. Regardless, it’s great to spend the day at the ballpark!
So what does Spring Training have to do with nondiscrimination testing in a Defined Benefit Plan (“DB Plan”)? Well, as you know, in baseball, a run is scored whenever a player makes it around all four bases. In our analogy, the four elements of nondiscrimination requirements are like the four bases in baseball. For an employer to “score a run” (pass nondiscrimination testing), they must “round all four bases” (satisfy all four requirements).
Nondiscrimination requirements ensure that an employer does not provide retirement benefits that discriminate “too much” in favor of its owners and highest-paid employees.
Thus, if an employer wants to enjoy the tax advantages of a Defined Benefit Plan, they must provide reasonable benefits to non-owners and “lower-paid” employees relative to owners and “higher-paid employees”.
As mentioned, we will compare the four elements of nondiscrimination testing to the four bases in baseball. Since these requirements are complex, we will cover each item at a high level.
Again, the object of nondiscrimination testing is to provide non-owners and “lower-paid” employees reasonable benefits relative to owners and “higher-paid” employees.
To test this, employees are divided into two groups: highly compensated employees (“HCEs”) and non-highly compensated employees (“NHCEs”).
At a high level, an HCE is someone who owns more than 5% of the business or whose prior year’s compensation exceeded a specified threshold. For this purpose, ownership is attributed to certain family members. Attribution of ownership ensures that benefits given to the business owner’s spouse, for example, are classified as HCE benefits (it’s not hard to see the loophole if this were not the case). Regarding compensation, if an employee received more than $135,000 in 2022, they are an HCE for 2023. This threshold is indexed for inflation.
As you may have guessed, an NHCE is anybody who is not an HCE.
In some cases, the business owner must include employees in all his or her businesses to determine if the Defined Benefit Plan meets nondiscrimination requirements. This generally would be true for someone that has 100% ownership of two businesses. Otherwise, a business owner would be able to create a second business with no employees that provided retirement benefits to just the owner and not employees in the first business.
There are a number of reasons an employee may be excluded from nondiscrimination testing, so that they do not “count” for testing purposes. Specifically, someone under age 21 or who has less than a year of service may be excluded from testing. In some instances, the employer may exclude those who terminate with fewer than 501 hours for testing purposes.
With that foundation laid, let’s get back to our analogy. Specifically, how nondiscrimination testing in a Defined Benefit Plan is like a baseball diamond. A Defined Benefit Plan must be nondiscriminatory in terms of the following items:
Minimum coverage is the first requirement or “base” of nondiscrimination testing in a Defined Benefit Plan. It measures the percentage of NHCEs who “benefit” relative to the percentage of HCEs who “benefit”. If the ratio between the two percentages is at least 70%, then minimum coverage is passed. If the ratio is less than 70%, a lower threshold may be allowable if other conditions are met. Note that, with some exceptions, an employee “benefits” in the Defined Benefit Plan when their DB benefit increases for the year being tested.
Here is an example of how coverage testing works. Assume a business owner has 10 NHCE employees. Of the 10 employees, only 8 benefit under the Defined Benefit Plan. In this case, 80% of NHCEs benefit in the Plan (8 / 10). Assuming the owner benefits, 100% of HCEs benefit in the Plan (1 / 1). Therefore, the ratio of the percentages of NHCEs and HCEs who benefit is 80% (80% / 100%). Since this percentage is at least 70%, minimum coverage is passed.
In addition to minimum coverage, the Defined Benefit Plan must demonstrate nondiscrimination in the amount of benefits.
To satisfy this requirement, a DB Plan may use a safe harbor design. For example, if all employees in the Plan receive the same benefit formula (along with some other conditions), minimum benefit testing is satisfied.
If a safe harbor design is not used, testing is required. To do this, the benefit as a percentage of compensation is calculated for all employees who may not be excluded. This percentage is called an accrual rate.
Next, for each HCE, the percentage of NHCEs whose accrual rate is at least as much as that particular HCE is divided by the percentage of HCEs whose accrual rate is at least as much as that particular HCE. If the ratio of the percentages is at least 70% for all HCE rate groups, nondiscrimination testing for the amount of benefits is satisfied. If any HCE rate group is less than 70%, testing still may be satisfied if certain other conditions are met.
As an example, assume an owner has 4 NHCE employees. Further, assume the owner’s accrual rate is 10% and the 4 employees have accrual rates of 5%, 8%, 10%, and 12%. In this example, 2 of the 4 NHCEs, or 50%, have accrual rates that equal or exceed the HCE owner’s accrual rate of 10%. Since there is only one HCE, the HCE percentage is 100%. Therefore, the applicable ratio for this HCE rate group is 50% (50% of NHCEs / 100% of HCEs). If there were more than one HCE, a similar ratio would be computed for each HCE’s rate group. Since the ratio for the only HCE is less than 70%, other conditions would have to be met for this test to be satisfied.
Note that in practice there are two types of accrual rates to be considered. We have simplified the example to illustrate the concept.
A Defined Benefit Plan must also be nondiscriminatory in the Benefits, Rights, and Features (“BRFs”) that it provides. Examples of BRFs may include death benefits, loan provisions, and alternative payment options.
To test nondiscrimination in BRFs, each BRF is tested separately. To test this, the percentage of NHCEs to whom the BRF is available is divided by the percentage of HCEs to whom the BRF is available. If this ratio exceeds a certain threshold, that particular BRF passes testing. Each BRF is tested to ensure compliance.
Note that the threshold will vary depending on the demographics of the Defined Benefit Plan. In addition, age and service conditions are ignored for determining if a BRF is available unless the BRF is time-limited. For example, if an enhanced early retirement benefit requires at least 20 years of service, this BRF is considered available to all employees unless they are excluded from this benefit for another reason (e.g., job classification). However, if the enhanced early retirement benefit were only available for a 6-month period, age and service conditions would be considered for determining availability.
Again, the explanation regarding BRF testing is simplified to demonstrate the concept.
Finally, the timing of Plan amendments cannot discriminate in favor of HCEs. This test is based on facts and circumstances.
For example, assume a Defined Benefit Plan covered both HCEs and NHCEs during most of its existence. Moreover, as a part of closing its doors, the employer lays off all NHCEs. Subsequently, the employer amends the DB Plan to significantly increase benefits for remaining employees, all of whom are HCEs. This amendment would have the effect of discriminating in favor of HCEs.
Nondiscrimination testing is one of the most complex aspects of administering a Defined Benefit Plan. We have provided simplified explanations and examples to provide a high-level understanding. That said, the details and nuances cannot be ignored in practical applications; they must be reflected for nondiscrimination testing in Defined Benefit Plans.