Many employers have modified their traditional defined benefit (DB) plans by moving to a soft frozen plan (or closed plan), where the existing participants continue to accrue benefits, but plan participation is closed to new employees. One common design is to maintain the DB plan for a closed group of employees and to establish or enhance a defined contribution (DC) plan for newer (and future) employees. In Part 2 of our earlier series on nondiscrimination testing, we explored the issues faced by a typical plan sponsor electing this route.

As an example of how circumstances change, many years ago Employer F permitted a grandfathered group of longer-service employees to continue accruals under its DB plan, and established a profit-sharing plan for all of the remaining employees. New employees joined the profit-sharing plan when eligible. At the time of the program change, the plans met the three main nondiscrimination tests, which are:

Participation (only applicable to the DB plan)
Coverage
Benefits

A number of years have passed since the change, and the DB plan population has now declined and become more heavily weighted toward highly compensated employees (HCEs). The DB plan is no longer passing the 70% ratio percentage test, and is currently meeting the coverage requirement via the more complex average benefits test. Employer F is concerned that the average benefits test is in danger of failing in the near future, and is now looking for alternative ways to ensure that the DB plan continues to meet the coverage requirements.

In many circumstances, the nondiscrimination rules will currently allow plan sponsors to consider two or more plans to be a single combined (or aggregated) plan for purposes of meeting the coverage and benefit requirements (but not the participation requirements). If this is done for a DB plan and a DC plan, the combined plan is known as a DB/DC plan.

It is possible to combine DB plans with certain types of DC plans for this purpose, such as money purchase or profit-sharing plans. However, if the DC plan provides for employee deferrals, under IRC Section 401(k), or employer matching contributions, under IRC Section 401(m), then these benefits may not be combined for a DB/DC plan, because these types of benefits are required to be disaggregated for testing purposes.

Trap #5: Employer G sponsors a DB plan and also a DC plan, which is a 401(k) plan with a matching employer contribution feature under 401(m). Employer G wants to make use of the DB/DC rules to help meet nondiscrimination requirements. In this case, Employer G will not be able to do so, because all of the benefits provided under the DC plan are 401(k) and 401(m) benefits.

Employer F established a profit-sharing plan many years ago, and is therefore permitted to establish a DB/DC plan for testing purposes. If this was done, all new employees would continue to be eligible for the DC plan, and therefore the resulting DB/DC plan would meet the coverage requirements because employees will be provided with either DB or DC benefits. However, one of the side effects of electing a DB/DC plan is that the combined plan now needs to be reviewed to ensure that it meets the nondiscrimination requirements in benefits.

Employer F must demonstrate that the benefits provided under the DB/DC plan are nondiscriminatory, because the combined plan provides both defined contribution benefits and defined benefit accruals. The testing requires a comparison of all benefits earned by the participants in the combined plan. In order to compare DB plan accruals with DC plan contributions, all benefits must be mathematically converted to one form or the other either an equivalent contribution rate ( DC basis), or an accrual rate ( DB basis).

It is generally easier to pass the nondiscrimination testing requirements if all benefits are converted to a DB basis. Plan sponsors may test plans on either basis; however, if a plan sponsor wishes to test the plan on the more favorable DB basis, the plans must meet certain restrictions imposed by the Internal Revenue Service (IRS). Under the current law, it can become more difficult to meet these restrictions as time passes and the DB population ages and shifts toward a higher concentration of HCEs. As a result, plan sponsors can be faced with the possibility of needing to modify their programs to remain in compliance.

In response to these concerns, the IRS released proposed regulations in 2016 that were designed to help these programs meet the nondiscrimination requirements. The proposed regulations would relax some of the restrictions noted above, so that more of these types of programs would be permitted to use the DB accrual rate testing basis, and therefore meet the benefits requirements.

One area of concern for many plan sponsors continues to be the participation requirement. In order for a DB plan to remain in compliance with the participation requirements, the plan must generally provide benefit accruals to the lesser of 50 employees or 40% of all employees. There is an exception that permits a DB plan to provide accruals to fewer than 50 employees, if none of the participants are HCEs.

The participation requirements apply to individual DB plans, and plan sponsors are not permitted to combine DB and DC plans into a DB/DC plan to meet this requirement. The proposed regulations did not address the participation issue. Because of these restrictions, a plan sponsor that is maintaining a DB plan for a closed, shrinking group of participants may be forced to eliminate the benefits for the HCE participants or otherwise modify the benefit program.

The current DB/DC plan rules and the proposed regulations provide plan sponsors with tools to help keep their plans in compliance with the coverage and benefit rules, but compliance with the participation rules remains a challenge for many plan sponsors.

It should be noted that the regulations described above are proposed and are subject to modification or retraction by the IRS at any time. For further information on this or other nondiscrimination topics, please contact your Milliman consultant.