This is the first of a series of three articles designed to inform our readers of the significance of the so-called "coverage rules" and "minimum participation rules" applicable to qualified retirement plans. In this article we will explain the basic terms of the rules and show how employers may: (a) avoid testing and reporting problems related to plan coverage, and (b) design their plans to take advantage of the limited flexibility available under these rules.
The Coverage And Nondiscrimination Rules Go Hand-In-Hand
Simply put, the coverage rules of Code section 410(b) define whether the group of employees benefiting under a retirement plan (or a particular feature of a retirement plan or a combination of retirement plans) satisfies the nondiscrimination rules for qualified plans. The nondiscrimination rules generally require that certain plan participants be treated alike. The coverage rules tell us which participants or groups of participants must be treated in the same nondiscriminatory manner. These rules operate by comparing the rights of certain highly compensated employees to the rights of non-highly compensated employees. As we shall see, the coverage rules require that each group of employees subject to discrimination testing includes a minimum number of lower paid employees relative to the number of higher-paid employees (or owners) in the group. Thus, it makes little sense to discuss whether a particular plan benefit is discriminatory without knowing which participants are benefiting under the plan.
Many employers incorrectly assume that they must treat all of their employees alike for retirement plan purposes. Not so! Although there may be overriding business or employee-relations reasons for establishing retirement benefits on a uniform company-wide basis, the coverage rules provide employers with a certain amount of flexibility to custom-tailor their retirement plans and to discriminate between their employees. However, before we can discuss the more useful aspects of these rules, as well as difficulties in complying with them, we need to review some terminology.
HCEs, NHCEs, Etc., Etc.
It is practically impossible to discuss either the coverage rules or the nondiscrimination rules without starting with two definitions: highly compensated employees (HCEs) and non-highly compensated employees (NHCEs). Since 1997, an HCE has been defined as any employee who:
- Was a 5% owner (i.e., owned more than 5% directly or by attribution) at any time during the current or preceding year; or
- Received compensation in excess of $80,000 in the preceding year and, if the employer elects for a plan year, was in the top-paid group (the top 20%) of employees for the preceding year.
Conversely, an NHCE is any employee who is not an HCE.
The $80,000 figure is subject to cost of living adjustments and for purposes of determining HCE status for either 2007 or 2008, the applicable "look back" compensation level is $100,000. As you can imagine, it generally makes sense for an employer to include the "top-paid group" requirement in its definition of an HCE only if considerably more than 20% of its participating workforce is making more than the qualifying figure (now, $100,000).
You also need to be able to determine how many of your company's employees are "benefiting" under your plan(s) and, of those who are not benefiting, how many are "statutory exclusions" and how many are "nonstatutory exclusions." For our purposes, an employee may be treated as "benefiting" if the employee receives an allocation under a defined contribution plan, accrues a benefit under a defined benefit plan, or is eligible to make deferrals under a 401(k).
Statutory exclusions are employees who fit within certain categories listed in the Code and which your plan document excludes from participation. Statutory exclusions may include employees who:
- Are covered by a collective bargaining agreement.
- Are nonresident aliens without U.S. source earned income; and
- Have not met the plan's minimum age and service requirements (generally, one year of service and age 21).
Non-statutory exclusions generally refer to categories of employees who are excluded from participation by your plan document only. These might include: leased employees, employees compensated on a commissions-only basis, or certain hourly employees.
Armed with these definitions you should be able to determine the number of employees who are:
- Employed by the "employer" (keep in mind that in determining who are the employees of an employer for retirement plan purposes, you must first determine who the employer is by applying the controlled group rules, affiliated service group rules, and leased employee rules).
- Statutory exclusions.
- Non-statutory exclusions.
Those employees who are subject to the plan's non-statutory exclusions are included along with "benefiting" employees in coverage testing and so are referred to as "nonexcludable employees" for testing purposes. If the number of employees who are benefiting under your plan is less than the number of nonexcludable employees, it is likely that your plan excludes various employees from participation based on the plan's non-statutory exclusions.
Among both of these latter groups, the "non-statutory exclusions" and the "benefiting" employees, a further distinction is made between those who are HCEs and those who are NHCEs.
The following diagram illustrates how these definitions fit together.
Having worked through these definitions, and done a bit of subtraction, you are probably raring to go to apply these concepts to test the coverage of your company's plan(s). Unfortunately, we need to stick with our script and first explain why it is advantageous for you to understand these concepts and do a little coverage testing on your own (something we will definitely get into in our next installment).
Profiles In Coverage
Here are a couple of stories describing fairly common problems involving retirement plan coverage.
What's Good For the Goose . . . .
There once was a very successful group of physicians. This group had two rather generous retirement plans for its eligible employees. In order to participate in these plans, however, new employees had to complete a one-year waiting period. From time to time, the group would seek to recruit other successful practitioners to join it. One such practitioner agreed to combine his practice with that of the group, provided that he might be granted immediate participation in the group's retirement plans. The group really wanted to add this physician to their ranks. But, was it possible to grant him such special treatment? Wouldn't a waiver of the plans' eligibility rules result in impermissible discrimination?
Almost Anything Goes!
Once there was an employer with many loyal and long-serving employees. For various reasons we will not go into here, the employer was compelled to switch from the defined benefit pension plan, which it had maintained for many years, to a defined contribution plan. In analyzing the conversion from one plan to the other, the employer determined that a group of older employees with considerable years of benefit service would "lose out" in the switch from a defined benefit program to a defined contribution program. In a few cases, the difference in projected retirement benefits for these individuals was quite substantial. Management of the company came to us wanting to know what could be done to protect these loyal employees from losing out as part of the change in plans.
The answer will be revealed in our next installment. (Hint: if you are dealing with the right group of employees, the coverage rules provide you with a tremendous degree of flexibility in terms of plan design.)
What To Do
Stay tuned and start counting your HCEs and NHCEs. In the next article of this series, we will examine a number of ways to satisfy the coverage rules, or even avoid having to deal with coverage issues at all!