Did IRS inaction prompt some to freeze DB plans?

Those bumping against non-discrimination rules didn't get needed help

More closed corporate defined benefit plans may have been frozen this year because the IRS has not released guidance on how employers could avoid failing non-discrimination testing in closed plans.

While it is too soon to know how many employers have opted to do so, officials of Washington-based trade groups say in the absence of long-sought guidance, employers seeking to avoid failing the test have few options but to freeze their plans, halting any additional benefit accruals.

Information on the number of plans frozen in 2013 won't be available until companies file their 5500 forms sometime next year.

The issue is that the IRS' non-discrimination test is harder to pass when companies have closed DB plans to new entrants. That's because a salary gap occurs over time, as salaries of people in the closed plan continue to rise, while lower-paid and new employees are enrolled in a defined contribution plan. To avoid failing the test, some employers opt to freeze the DB plan.

For an employer to freeze a closed plan beginning Jan. 1, it would have had to provide plan participants notice of the move by Nov. 15.

Groups representing plan executives have stepped up the pressure on Treasury Department officials to figure out a solution before more plan sponsors run out of options.

“It's very difficult for employers to say, "let's take out our crystal ball.' Congress did a great job of making this very complicated,” said Rob Austin, director of retirement research with Aon Hewitt in Charlotte, N.C.

A Nov. 21 letter from Sens. Rob Portman, R-Ohio, and Ben Cardin, D-Md. tried to speed things along, urging Treasury Secretary Jacob Lew to take “a practical, non-regulatory action” before more companies are affected. Mr. Lew also heard from 28 bipartisan House members in a June letter warning the rule could “directly cause a substantial number of companies to no longer provide pension benefits.”

Now, Senate Education, Labor and Pensions Committee Chairman Tom Harkin, D-Iowa “is confident that the Treasury Department is taking it seriously,” said his spokeswoman Allison Preiss.

With the added attention from Capitol Hill, “we're optimistic that the IRS will be responsive to these companies that are trying to do the right thing and not freeze their pensions,” agreed an aide to Mr. Portman, who declined to be identified.

Looking into the matter

Treasury and IRS officials declined to comment beyond saying they are looking into the matter. Skeptics point to the IRS list of 2013-2014 regulatory priorities, which includes guidance on closed defined benefit plans as one of 40 retirement projects, and to the fact that negotiations with the IRS and industry groups are reaching the two-year mark.

“These are companies that made a conscious choice to retain the plan and they're not looking to change that, but they may be forced to because of these rules,” said Paul Strella, a senior partner in Mercer's Washington resource group. “Every year there's another group pulling the trigger” to freeze accruals in their plans.

“They'd love to keep their plans open, but feel they have no option,” said Mr. Austin of Aon Hewitt. “Discrimination testing contributes to the phenomenon of DB plans going away.”

The problem has become acute in recent years as more defined benefit plans closed to new employees; the non-discrimination testing rules, which were intended to prevent lopsided benefits in ongoing plans, did not address that shift.

According to an internal Aon Hewitt survey of 78 plans that are closed to new employees, 16% already were in a failing situation in regards to non-discrimination tests, and another 14% expected to fail within two years, while a mere 4% did not expect to fail discrimination testing. The remainder had at least five years before non-discrimination rules became an issue. “Half the population is already failing or going to fail within five years,” said Mr. Austin.

“The number of affected plans is increasing every year. In terms of the scope of the issue and the benefits at risk, this is one of the biggest retirement plan issues that the American Benefits Council is working on,” said Kent Mason, a partner in Davis & Harman LLP's Washington office and outside counsel to the ABC.

Failing the test and risking disqualification of the plan is not an option, said pension consultants. But fixes to offset the imbalances, such as reducing benefits for some or increasing them for others, can be cumbersome, disruptive and expensive, and are only short-term solutions.

“We're running up against the wall,” said Althea Day, a partner in the employee benefits and executive compensation practice of Morgan Lewis & Bockius LLP's Washington office. “The way the non-discrimination rules work puts our clients in a very difficult situation. It requires them to take actions that would create a lot of friction, and it gets expensive.”

Creative ways

Stewart Lawrence, senior vice president and retirement practice leader for The Segal Group and its Sibson Consulting division in New York, said there are creative ways to help plans pass the test “but at some point it does break.”

Mr. Lawrence has two clients dealing with testing failure now. One is giving more benefits to lesser-compensated employees, while the other has chosen “the nuclear option” of freezing the defined benefit plan, “which is the opposite of what was intended,” said Mr. Lawrence.

“The options aren't very attractive,” agreed Mr. Strella of Mercer. “It is one of the most complex areas of pensions. Once the (defined benefit) pension plan starts to fail on its own, in most cases the rules don't allow it to be tested with the defined contribution plan,” which guarantees failure.

“Companies are watching those test results get closer to the failing line. If you're close, you don't want to risk failing the next year. It doesn't make sense to make these arbitrary choices, just for a few years. The trick is to freeze the plan before you fail,” said Mr. Strella.

While the intricacies of complying with the IRS rules are complex, defined benefit plan advocates say it boils down to a simple solution: Consider employers who closed their plans to new hires to be in compliance if they were at the time of closing, as long as there have been no enhancements. Another way to comply is by being allowed to test all employer contributions together.

Pension experts understand concern by IRS officials that grandfathering plans that would pass the test at the time they closed to new participants could provide an opening for smaller employers to game the system by opening, and then closing, plans that benefit top executives.

But the unpredictability faced each year by companies almost guarantees more closed defined benefit plans.

“Many thousands of participants are losing benefits effective Jan. 1, 2014, because this problem has not been solved,” said Mr. Mason. “A far greater number of participants will lose benefits in the future if the issue is not addressed. This problem is already widespread, and it is still growing.”

This article originally appeared in the December 9, 2013 print issue as, "Did IRS inaction prompt some to freeze DB plans?".