This is the second in a series of articles designed to inform our readers of the significance of the so-called "coverage rules" and "minimum participation rules" applicable to qualified retirement plans, (please see link to other installments, right). In this article we will examine: (a) the basic coverage test, also called the "ratio percentage test"; (b) how the ratio percentage test can be satisfied; and (c) situations in which coverage testing can be avoided. We'll also revisit our Profiles In Coverage (from our last installment) to see how everyone made out.
The Ratio Percentage Test
As we discussed in our last installment, the purpose of the coverage rules is to ensure that each group of employees subject to discrimination testing includes at least a minimum number of lower-paid employees (NHCEs) relative to the number of higher-paid employees (or owners) (HCEs) in the group. Although there are two methods available, the vast majority of retirement plans satisfy the coverage rules by complying with the ratio percentage test.
The coverage testing rules allow us to ignore any employees who are excluded under the plan's statutory exclusions (e.g., those collectively bargained, nonresident alien, or not yet qualified by service or age). The remaining employees are the "non-excludable" employees who constitute the coverage-testing group.
A plan (or a portion of a plan subject to coverage testing) will pass the ratio percentage test if the plan's NHCE ratio divided by the HCE ratio is least 70%.
The WHCE ratio is the percentage of non-excludable NHCEs who are benefiting under the plan. The HCE ratio is the percentage of non-excludable HCEs who are benefiting. Arithmetically the ratio percentage test would look like this:
# of NHCEs Benefiting ÷ # of HCEs Benefiting = Ratio Percentage
# of Non-excludable NHCEs # of Non-excludable HCEs
What does this formula tell us? If your plan is having trouble with its discrimination testing (including 401(k) tests), you may want to review your plan's statutory exclusions - particularly its eligibility requirements - in order to exclude ineligible employees from the testing.
Another thing it tells us is that a plan does not have to benefit 100% of an employer's eligible employees or even 100% of its eligible NHCEs. Remember, the ratio percentage test is based on relative percentages. Whatever the HCE ratio is, if the NHCE ratio is at least 70% of that HCE ratio, then the plan meets the coverage requirements. If all of the employer's Non-excludable HCEs are benefiting under the plan, then at least 70% of its Non-excludable NHCEs must also benefit. However, if a plan is designed so that only 80% of the employer's Non-excludable HCEs are benefiting under the plan, then at least 56% (70% of 80%) of its Non-excludable NHCEs must also benefit. Since it is often possible to provide comparable benefits to certain HCEs as part of a non-qualified deferred compensation plan, the intentional exclusion of a few executives from a company's qualified retirement plan may be one way to reduce the number of HCEs who must be covered under the plan, or increase the plan's chances of passing certain discrimination tests, such as the 401(k) deferral percentage test. Conversely, an employer may want to confer a special or additional plan benefit on a small percentage of its HCEs. The ratio percentage test will be satisfied if this special plan benefit also is provided to a percentage of NHCEs, which is at least 70% of that small percentage of HCEs.
Later on in this article we will examine specific cases of how this formula works.
Getting A Free Pass From Coverage Testing
For those of you familiar with the trials and tribulations associated with certain annual coverage and discrimination tests (particularly for 401(k) plans, plans designed on a cross-tested basis, and multiple plans within an employer group), it is helpful to know about a few exemptions from the coverage rules which may provide a plan (or plans) with a permanent free ride, or in some cases a limited time exemption. Due to the direct link between the coverage rules and the nondiscrimination rules mentioned in our last installment, plans that qualify for a permanent free ride from coverage testing do not have to worry about discrimination testing either! Would you like us to tell you more?
There are four categories of plans entitled to a permanent, free ride from coverage testing:
- Plans of an employer that employs only HCEs (e.g., a plan of a small hospital-based medical group that employs no NHCEs, either on a direct basis or on a leased basis).
- Plans that benefit only NHCEs
- Plans, or the portions of a plan, that benefit collectively bargained employees only.
- Plans that are considered "governmental plans" under the Code.
As we will see later, the second exemption can be a very useful tool when designing or redesigning a company's overall retirement program.
Time Well Spent
We also mentioned a limited time exemption from having to satisfy the coverage rules. This limited time exemption applies to the plans of businesses that have been involved in an asset or stock acquisition, disposition, merger or similar transaction. Provided that the plans of the parties to the transaction satisfied the coverage rules prior to the transaction, and there has been no significant change in either the terms of the plans or the coverage of the plans following the transaction (other than the inevitable transfer, hiring, or termination of employees as part of the transaction), the affected plans are deemed to comply with the coverage rules for a limited time period. This limited-time, free ride extends from the effective date of the transaction until the last day of the first plan year beginning after the date of the transaction. In order to take advantage of this rule, businesses that are contemplating an acquisition, disposition, or merger should consider the employee benefits ramifications of the deal before the terms of the deal become too settled.
Profiles In Coverage Redux
As promised, we rejoin our stories from the first installment involving the coverage problems of fairly typical businesses.
The Gander Gets His
In our last installment we left our group of physicians wanting in the worst way to add yet another preeminent colleague to their numbers. They were even willing to waive the one-year eligibility requirement of their retirement plan to induce him to join (provided their employee benefits attorney gave them the green light to do so).
A careful analysis of this proposed waiver of the eligibility rules revealed that the group was essentially willing to confer a premature or early contribution upon this colleague. Obviously, such a special benefit would be subject to the usual discrimination testing. But how could this special benefit possibly be considered nondiscriminatory if it was only being provided to a lone very highly compensated physician? The answer: It couldn't be in this case.
However, we've yet to meet a discrimination failure which couldn't eventually be cured by the inclusion of some NHCEs. What we found was, if the group also was willing to confer immediate eligibility (the special benefit) to at least two of the nurses who were joining the group as part of this physician's practice team, the ratio percentage test with respect to the immediate eligibility benefit would be satisfied. Therefore, it was not discriminatory to provide immediate eligibility to the physician and two of his staff. Needless to say, the group took no time at all to decide that the addition of this physician more than justified the additional cost of providing benefits to his staff.
For NHCEs Only, Almost Anything Goes!
In the third of our Profiles In Coverage, a company's management wanted to know what could be done to protect a group of loyal employees from losing benefits as part of a change in plans. The new plan that the company had decided to implement was ideal (and provided greater benefits) for the vast majority of the company's relatively young work force. However, for a small number of older and long-serving employees the switch to a new plan could cause them to lose a significant amount of retirement benefits. Was there any way to provide these employees with an additional employer contribution under the new plan?
You bet! As it turns out, the entire group of affected older employees were NHCEs. Therefore, the additional benefit (the additional contribution) that the company wanted to provide them was not subject to either the coverage or nondiscrimination rules. The total employer contributions for each of the affected employees, however, remained subject to the overall limits of Code section 415. The moral of this story is that it is almost always possible to confer additional or special benefits to a group of employees consisting solely of NHCEs.
What To Do
Keep your number two pencil sharpened and stay tuned for the next installment in this gripping series. Now that you have mastered the basics of coverage, we'll be moving on to the minimum participation rules, as well as an examination of some of the less well understood (read that as arcane) rules of coverage testing.