The three main nondiscrimination tests are:
- Participation
- Coverage
- Benefits
Participation testing is designed to ensure that a defined benefit (DB) plan is not excessively small for the size of the organization (the testing is not required for defined contribution [DC] plans). Defined benefit plans that are currently providing accruals must generally provide them to (at a minimum) the lesser of 50 employees or 40% of all employees.
Trap #1: Employer A freezes accruals under their defined benefit plan for 120 of its 200 employees. These 120 employees (and all new employees in the future) will participate in a new defined contribution plan that provides for salary deferrals with a company match.
At the time of the freeze, the pension plan passes the participation testing, since 80 employees continue to benefit under the plan. However, over time the number of employees receiving benefits will decline because of terminations and/or retirements. The pension plan needs to be monitored carefully, as it will fail the participation test at some point in the future if the number of benefiting employees falls below 50.
Coverage testing ensures that plans do not provide benefits to a disproportionate number of highly compensated employees (HCEs).
To pass coverage testing, plan sponsors will perform the ratio percentage test, also known as the 70% test.
The ratio percentage test is satisfied if the percentage of non-highly compensated employees (NHCEs) who benefit under a plan is at least 70% of the percentage of HCEs who benefit under that plan. As an example, assume that 40 of Employer A's employees are HCEs, and that 20 of these employees are continuing to benefit under the defined benefit plan. The ratio percentage test is performed as follows:
Total NHCEs:? 160????????? NHCEs Benefitting:??? 60
Total HCEs:?? 40????????? HCEs Benefitting:???? 20
The percentage of NHCEs benefiting under the plan is 60 divided by 160, or 37.50%.
The percentage of HCEs benefiting under the plan is 20 divided by 40, or 50.00%.
The ratio percentage test result for the defined benefit plan is 37.50% divided by 50.00%, or 75.00%. Because this exceeds 70%, the test is passed. If a plan does not pass the ratio percentage test, it may still be able to pass the coverage testing through an alternative testing method known as the average benefits test. In order to pass the average benefits test, the plan sponsor must obtain data on all benefit plans sponsored by the controlled group, which can complicate the testing procedure.
The ratio percentage test result for the defined contribution plan is performed in a similar manner, resulting in a final test result of 125.00%. Because this exceeds 70%, the defined contribution plan also passes the coverage test.
Trap #2: Now that Employer A has changed the benefit plan structure by establishing two separate plans, the coverage testing results will need to be closely monitored. For the defined benefit plan, the ratio percentage test result of 75% is likely to decrease, because of factors such as a) higher turnover in the NHCE population and b) higher-paid NHCEs in the plan moving to HCE status. If the testing result decreases below 70%, the plan will need to use an alternative compliance method (such as the average benefits test), or additional changes will need to be made to the benefit program.