Kent Mason said companies are looking to Congress for some kind of solution to the discrimination problem.

Employers that thought closing their defined benefit plans to new employees would simplify their pension decisions could be in for a rude surprise as they increasingly risk flunking non-discrimination tests.

“When sponsors do a soft freeze, it's not a question of "if', it's a question of "when' you will run into a compliance problem,” said Scott Jarboe, partner with Mercer's Washington office.

The problems arise most often when defined benefit plans are closed to new hires. As the earnings of participants in the closed plans grow, so does the disparity between the richness of their benefits and those of other employees for whom a defined contribution plan is their only choice.

So, more participants in the closed plan are moving into the highly compensated employee category, while newer employees and turnover keep overall benefit values lower in other plans.

When that gap gets wide enough, sponsors can fail the Internal Revenue Service's non-discrimination rules test.

Employers are now hoping the federal government will allow plans that passed the test when first closed to new hires to be considered to have passed permanently, unless plan enhancements are made. They are pushing for either a legislative or regulatory change as soon as possible.

“More and more companies are going to (Capitol Hill) to talk about this issue with members of Congress,” said Kent Mason, an attorney with Davis & Harman LLP. Mr. Mason is outside counsel to the American Benefits Council in Washington, which is leading the charge.

“They're telling them that if this issue does not get addressed, many of the grandfathered employees will have to be removed from the plan. The potential tragedy is that they would lose the best years.”

Rep. Richard Neal, D-Mass., hopes to re-introduce legislation that idled in the last Congress. That bill would allow grandfathering of closed plans at some point, but the timing for getting anything through a distracted Congress is unknown.

A more likely approach is through regulatory channels at the Treasury Department. Although officials there declined to comment, “they are very aware of this issue, and we have had very constructive discussions,” said Mr. Mason. “I think we have an opportunity to fix it.”

Rules to prevent benefit abuses favoring highly paid plan participants seemed like a good idea when passed decades ago. But now, “we're starting to see the results of not letting anyone else in” to the closed DB plan,said David Driscoll, a principal with Buck Consultants, Boston.

'Extremely complex'

Those non-discrimination rules “are extremely complex,” noted Stewart Lawrence, senior vice president and retirement practice leader for The Segal Co. and its Sibson Consulting division in New York, who leads the national retirement practice. “With the testing for coverage and benefits you are permitted disparity, but at some point they (get too far apart). It's all about the demographics.”

Maria Sarli, a retirement resource actuary in Towers Watson & Co.'s Atlanta office who works with large company plans, said she thinks the problem is going to hit critical mass in the next two to 10 years, depending on each plan's demographics.

Officials at one large pension fund client of Towers Watson are struggling to decipher the complex regulations and tinker with changes as the demographics in the various plans shift, Ms. Sarli said. But getting that older group of employees through the pipeline and into retirement could take several decades. “It involves an awful lot of modeling and uncertainty,” she said. “It is entering the debate more than they expected.”

An internal survey by Aon Hewitt, Lincolnshire, Ill., of 78 closed plans found that while half had five or more years before non-discrimination rules become an urgent problem, 16% had already failed the discrimination test and another 14% were headed toward failure within two years.

“Sometimes you can fail without realizing it,” said Ms. Sarli.

IRS holds all the cards

While many consultants noted that IRS officials will work with sponsors, they also said the agency holds all the cards and has the power to disqualify plans, which would subject employers to taxes on benefits and investment earnings.

“The IRS takes no pleasure in disqualifying a plan, and they give fairly ample opportunity to catch up, (but) they are conscientious about it,” said Buck's Mr. Driscoll.

The options for an immediate fix are few and unappealing to employers, employees or both. Sponsors can freeze the defined benefit plan so no more benefits accrue, continually cull some highly paid employees from it, increase benefits to other employees, or allow more people into the closed plan.

“Either way, it's telling the employer to expand (its) pension liability,” said Rob Austin, senior retirement consultant with Aon Hewitt in Charlotte, N.C. “Fixing a defined benefit plan is extremely difficult. None of these is really great news from a plan sponsor's perspective ...”

“There is no silver bullet,” agreed Mr. Jarboe of Mercer. “There are the costs and financial impact on the company (to consider), and then there's the competitive impact” of changing benefits.

He and his counterparts at other firms spend more time these days redesigning plans to avoid the problem in the first place. “We don't want to put something in that would blindside them down the road,” he said.

Said Rich Martin, a senior retirement plan consultant with The Principal Group in Des Moines, Iowa: “The longer you've had your plan in place, you have a higher probability of not passing. As the DB group shrinks, it's going to get worse.”

This article originally appeared in the February 18, 2013 print issue as, "Closed plans face non-discrimination peril".

— Contact Hazel Bradford at hbradford@pionline.com | @Bradford_PI