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Cross-Tested Plans in the Crosshairs (Again)

Small business retirement plans are under attack again. Buried in a Treasury Department proposal to make it easier for large corporations to close their defined benefit plans to new entrants is a provision that will make it harder for small businesses to form new retirement plans or maintain their current ones.

The proposal imposes a new “reasonable classification” requirement on highly compensated employee rate groups that will make it significantly harder for plans that allocate these rate groups on an individual or specific basis to pass the general nondiscrimination test used for cross-tested defined contribution plans under Section 401(a)(4) of the Internal Revenue Code.

There are major problems with this new requirement. First, determining “reasonable classification” is inherently a subjective process based on the facts and circumstances of each business in question. This subjective test removes the objective purely numerical nondiscrimination testing regime that has been in place for more than two decades. The result is to increase the uncertainty and complexity of an already complicated process.

Second, the new requirement unfairly burdens small businesses because they will likely have very small rate groups. So Treasury is in essence forcing small businesses to test on a ratio percentage basis rather than an average benefits basis, which would impose new costs on the small businesses that have these plans and scare away small businesses that are considering adopting these plans.

These cross-tested plans are some of the most popular defined contribution plan designs being used today in the small plan market. Needlessly damaging this effective plan design ultimately hurts the rank-and-file employees that have access to these plans. Remember, rank-and-file workers enjoy meaningful benefits under the current nondiscrimination rules — which have been in place for more than 10 years — since cross-tested plans need to satisfy the minimum allocation gateway rules.

The gateway allocation rules require that non-highly compensated employees get an annual contribution of 5% of pay in a defined contribution plan (or one-third of the allocation rate of highly compensated employees).

Additionally, if a company has a defined benefit plan in combination with a defined contribution plan, this minimum rate increases on a sliding scale up to 7.5% of pay (also depending on the allocation rate of highly compensated employees). Therefore, rank-and-file workers get more employer cash under these widely used arrangements — which are now seriously at risk — than they do under the common safe harbor plan designs that are not subject to nondiscrimination testing.

The Treasury proposal flies in the face of the Obama administration’s effort to increase retirement plan coverage in the private sector workforce. It’s jarring that this proposal was unveiled the very same week that the Obama administration publicly came out in support of another proposal to open up private multiple employer plans to any unrelated employer, ostensibly to encourage small businesses to adopt retirement plans and increase retirement plan coverage in the private workforce.

As the Obama administration notes, millions of private sector workers do not have access to a retirement savings plans provided through the workplace. And moderate-income workers without access to a workplace based retirement savings plan rarely save for retirement. Small businesses employ many of these workers.

We need to do everything we can to increase access to retirement plans at work, especially among small businesses. The Treasury proposal is a classic case of the left hand of the federal government not knowing what the right hand is doing. This proposal is a step in the wrong direction — and needs to be rejected.

Brian H. Graff, Esq., APM, is the Executive Director of NAPA.