ReDB – a better solution for nondiscrimination problems
In September, we published an article on the nondiscrimination problem presented by some frozen plans. Generally, the problem arises because, as part of a plan freeze or similar transaction, employers create a ‘closed group’ of ‘old’ employees who get a different, ‘better’ benefit than the benefit provided to new employees.
As we discuss in our article, a closed group like this may create a problem under the Tax Code nondiscrimination rules because, over time, the number of highly compensated employees (HCEs) in it will increase, relative to the number of non-highly compensated employees (NHCEs): some NHCEs will, after a pay raise or a promotion, become HCEs; others will terminate (there is generally more turnover among NHCEs than HCEs).
There are a lot of different versions of this problem. In this article we want to focus on a particular, fairly common, closed group ‘fact situation,’ where a DB plan is closed to new entrants. Current participants continue to earn DB benefits, but new hires are only covered by a DC plan. Under this structure, at some point, employers are likely to have a nondiscrimination problem, and, as many are finding out, the problem may crop up several years earlier than anticipated.
The simplest answer is a ‘freeze, DC’ strategy. And it is fairly common. But in these circumstances, a ‘ReDB’ strategy can avoid the nondiscrimination issue, allowing ‘closed’ participants to continue to earning their traditional DB benefits, as explained below.
While a closed group will generally pass the Tax Code nondiscrimination test at the time of the initial freeze, it often becomes discriminatory – ‘HCE-heavy’ – relatively quickly thereafter. Disqualification can be avoided, however, if the old (DB) plan and the new (DC) plan can be tested together, generally on what’s called a ‘benefits basis’ – i.e. comparing the annuity benefit at normal retirement age for both DB and DC participants.
But there’s a catch: there are special rules that don’t allow this sort of ‘testing on a benefits basis’ unless you meet certain minimum requirements. You can meet these minimum requirements in different ways, but most of the alternatives are expensive (e.g., providing a benefit of 7.5% of pay to DC participants).
One of the easier and inexpensive ways to meet this requirement, however, simply requires that at least half of the company’s NHCEs receive at least half of their retirement benefit from a DB plan. For companies that go the ‘freeze, DC’ route, this strategy ceases to be effective once half of the company’s NHCEs are no longer covered by a DB plan.
Instead, employers can avoid this inevitable failure by putting new employees into a ReDB plan. A ReDB plan is a DB plan – so it automatically satisfies that 50% rule. But, from the sponsor’s point of view and risk tolerance, it functions like a DC plan. That is, participants have an account to which contributions and trust earnings are credited, just like a DC plan. We explain how this works in our article The ReDefined Benefit Plan.