United States: Executives May Be Eligible To Receive Larger 401(K) Plan Benefits With A New Comparability Formula

Business Considerations

Defined contribution retirement plans have become so common-place that most employers do not consider the specific terms of their 401(k) plans when designing and touting their executive compensation packages. Cookie-cutter 401(k) plan designs, seemingly incomprehensible non-discrimination rules and the drive to keep plan expenses as low as possible converge to make this approach understandable.

However, employers looking for a competitive advantage to attract and retain executive talent should consider a "new comparability plan." While nondiscrimination rules limit the permissible bias in the benefits/contribution provided to highly-compensated employees ("HCEs") (e.g., executives) vis a vis non-highly compensated employees ("NHCEs") (e.g., rank-and-file employees), these rules do not preclude providing more generous benefits for select groups of employees on a cost-effective basis. 

Profit sharing plans (which include almost every 401(k) plan) with a "new comparability" design segregate employees into various categories (called "allocation groups") and provide a separate contribution formula for the members of each allocation group. Under a well-designed new comparability plan, certain allocation groups will receive larger profit-sharing contributions than others, thus keeping costs down, without violating non-discrimination tests.

Designing and operating a new comparability plan includes the careful assignment of employees to the allocation groups, the design of the benefit formula for each allocation group, satisfaction of the "gateway" requirements, and good actuarial and legal support. Each allocation group will typically have eligibility requirements based on objective business criteria, such as job classification; however, allocation groups can also be structured so that individual employees, or certain select employees, are each assigned to an individual allocation group, giving considerable flexibility in allocation formulas.

The chart below provides a simple example of structuring profit-sharing contributions based on a uniform fixed percentage of compensation for participants versus based on the new comparability plan rules. Please note, this is only an example.

1. Maximum permissible compensation for qualified defined contribution plan purposes in 2017 for HCEs #1 and 2.

2. Maximum permissible contribution for qualified defined contribution plan purposes in 2017 (excluding catch-ups).

3. Required 5% "gateway" contribution for cross-testing purposes for NHCEs #1, 2 and 3.

Technical Considerations

The non-discrimination test for employer contributions in a defined contribution plan compares the contributions provided to HCEs as a group versus those provided to NHCEs as a group. There are, however, a variety of ways in which this comparison can be performed, each with its own set of conditions and requirements. For example, a profit sharing plan that provides for employer contributions equal to a single given percentage of each employee's annual compensation would pass the non-discrimination tests, even though the HCEs (with greater compensation) would receive larger dollar-amount contributions than NHCEs (with less compensation). A plan that provided for the same fixed dollar contribution (e.g., $100) for each participant would satisfy the nondiscrimination tests because, on a percentage-of-compensation-basis, the HCEs are receiving a contribution that is a smaller percentage of compensation than are the NHCE. These designs have the advantage of being easy to administer and test, but they typically do not provide executives with any enhanced incentives because in order to provide an executive with the maximum benefit allowed by law, a correspondingly large (and expensive) benefit would have to be provided to rank-and-file employees.

With a new comparability plan, the non-discrimination test instead looks to the benefit each contribution would generate if future valued to the employee's expected retirement date (e.g., age 65) and converted to a life annuity at that retirement date. The annual benefit each participant would receive under that hypothetical annuity, expressed as a percentage of the employee's current compensation, is used as the basis for determining whether the benefits to HCEs impermissible discriminates against the NHCEs. The testing on a benefits basis at retirement, rather on a contribution basis at the time of the contribution, is sometimes referred to as "cross-testing" (because the effect is to test a defined contribution plan as if it were a defined benefit plan). Thus, a larger contribution can be given to an older employee because the hypothetical future value of that contribution will be relatively smaller (since it has less time to grow in value to that older participant's retirement date), whereas a smaller contribution for a younger employee will have a relatively larger hypothetical future value (since it has more time to grow until the younger employee's expected retirement date). In populations of employees where the executives to be benefitted are relatively older than the average rank-and-file NHCEs, cross testing may allow a new comparability design to provide substantially larger contributions for executives, while minimizing the cost of contributions for NHCEs.

Cross-testing profit sharing contributions is a very complex undertaking. If your company wants to explore such a possibility, it should contact its third-party administrator or similar service provider to inquire, keeping in mind that setting up and cross-testing a new comparability plan will likely increase administrative fees for the plan.

The attorneys at Andrews Kurth Kenyon are also available to discuss the new comparability plan rules in more detail.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.