Execs hope for less burdensome non-discrimination rules

Will Hansen
Will Hansen thinks the IRS should focus more on supporting the defined benefit system.

As Internal Revenue Service officials grapple with how to prevent employers from providing lopsided retirement benefits that discriminate in favor of higher-paid employees, plan sponsor advocates are holding their collective breath that regulators won't make it so complicated plan sponsors simply give up.

At issue are non-discrimination testing rules originally written for open defined benefit plans. As more sponsors close plans, they move closer to violating non-discrimination rules. That's because the salaries of people in the closed plan continue to rise, leading to a higher retirement benefit, while other employees are enrolled in a defined contribution plan.

Running afoul of the IRS is not a risk that sponsors are willing to take for themselves or their employees, with benefits and tax advantages for both at stake.

“Instead of focusing on one or two (defined benefit plans) that might take advantage, we'd like to see the IRS focus on the bigger picture and on the plans that aren't going to be able to pass,” said Will Hansen, senior vice president of retirement policy with the ERISA Industry Committee in Washington. “The DB system is still a valid system that we need to support. There's just too much at risk here.”

Plan sponsors have been urging IRS officials for years to issue non-discrimination testing relief for plans that are closed to new entrants instead of using rules intended for ongoing plans. In January 2014, IRS officials responded with temporary relief for three years that allowed plans to be considered in compliance if they were at the time the plan closed.

In the Jan. 29 Federal Register, the IRS proposed new rules aimed at making it easier for closed DB plans to comply, but attached several strings and put in more wrinkles for how sponsors would test all types of plans to ensure the system isn't being gamed at the expense of lower-paid employees.

A 2016 Aon Hewitt survey of 165 plans found that 85% of those closed to new entrants would need more relief under the IRS proposal to be compliant, and 39% of plans with frozen accruals would need more relief than the proposed rules related to contributions provided by employers.

Maria Sarli, U.S. retirement resource actuary with Willis Towers Watson PLC in Atlanta, told IRS officials at a May 19 hearing that while about one-third of their clients would benefit, “a lot of clients would not be helped. Some pension plans are very, very close to failing.”

Kent Mason, an attorney at law firm Davis & Harman who is outside counsel for the American Benefits Council, estimates that as many as 1 million plan participants could be negatively affected.

“All of these plans are going to have an issue. It's just a question of timing,” said Eric Keener, Aon Hewitt partner and chief actuary.

As proposed, the new rules allow some plans to satisfy non-discrimination rules in certain situations, but only after they've been closed for at least five years, with no significant changes made in that time, along with other tests. But because plan administrators often make routine amendments on early retirement factors or options such as lump sums, consultants say few plans can pass that hurdle. It also rules out companies with plans affected by any corporate mergers or acquisitions.

Complex steps

The proposed rules do allow sponsors to cross-test DB and DC plans when it comes to favorable benefits, but those steps are seen as complex and do not allow the employer's DC match to be factored in. “It would make a big difference if you could count matches,” said Ms. Sarli of Willis Towers Watson.

Plans that closed five or more years ago “didn't see this coming,” said Paul Strella, Mercer senior partner in Washington. “Certainly, deserving cases will fail to qualify. Companies don't want to be in that position.”

Part of the problem is that when companies move from defined benefit plans to cash balance or defined contribution plans, they try to “make whole” those employees caught in between by allowing them to continue accruing DB benefits, contributing to a DC plan with an employer match or non-elective contribution, or through a stock ownership plan. As the DB group ages and incomes increase, those transition choices also will eventually fail IRS tests, experts said.

Between Aon Hewitt's 2013 and 2016 surveys, the number of employers able to continue providing make-whole contributions dropped 40%.

“The way the rules are right now, a company is rewarded for not doing anything to make up that difference,” said Janice Harbold, Aon Hewitt senior consultant who often cautions clients to prepare participants for possible freezing of benefits. “It's painful, knowing how hard they've been trying to keep those benefits for employees,” said Ms. Harbold.

The corrective options are few and unappealing to employers and employees, including freezing the defined benefit plan so no more benefits accrue, continually culling some highly paid employees from the plan, increasing benefits to other employees or allowing more people into the closed plan.

In the face of that much complexity and uncertainty, many employers just stop trying. That uncertainty was a deciding factor for Lockheed Martin Corp., Bethesda, Md., which in 2016 froze the $32 billion U.S. DB plan that it closed to new entrants in 2006 and shifted workers to an enhanced defined contribution program. “If we don't freeze the pension plan by 2020, current regulations would impose a significant tax penalty on our employees and the company. By proactively making this decision now, it gives our employees time to plan for the changes,” Lockheed Martin spokesman Gordon Johndroe said in 2014 when the plan was announced.

Plan sponsors don't want any last-minute surprises either, like discovering after the fact that their plans don't qualify. “Until this lack of clarity gets fixed, the issue is going to continue and more plans are going to close,” said Jarred Wilson, consulting actuary at Sibson Consulting in New York, a subsidiary of The Segal Group.

Companies with active pension plans are also watching and wondering if it is better to close now, said Mr. Strella of Mercer. “You certainly see that conversation.”

No one envies the IRS' challenge of designing a rule to capture many possible scenarios, but “the hope is that the IRS will come out with rules that are more flexible and that more closed plans can satisfy. The relief is important for real people,” said Mr. Strella. The tests still need to be passed, agreed Mr. Wilson of Sibson Consulting, “but let's not be so restrictive.”

Ready for legislation

Advocates for testing relief, including plan sponsors, are keeping members of Congress primed to advance legislation that would allow plans that qualified at the time of closure to be considered in compliance, and offer other relief for smaller plans.

For now, there is some cautious optimism following the May hearing at IRS headquarters in Washington, where “the discussions were very constructive,” said Mr. Mason. “Treasury and the IRS seemed quite concerned about the small number of plans that would be helped by the proposed regulations, and very interested in ideas to improve the proposed regulations, so we are hopeful that there will be major changes.”

This article originally appeared in the May 30, 2016 print issue as, "Execs hope for less-burdensome non-discrimination rules".