Cross tested plans - how-to & examples

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cross tested plans

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Cross tested plans - how-to & examples

  1. 1. Cross-Tested Plans James A . van I waarden, F S A , E A Con s u l t i ng A c t u a r y Van I wa a rde n A s s o c i a tes Minneapo l is, MN ISCEBS Sympo s ium, B o s ton Sep tember 2 5 , 2 013
  2. 2. Today’s Menu y What are cross-tested plans? y History y Cross-testing “recipe” y Plan designs y Other uses y What works, what to avoid y How to use cross-tested plans with 401(k)’s
  3. 3. What are Cross-Tested Plans? y Plans that don’t fit into IRS pre-approved designs y Or...a group of non-identical plans y Show nondiscrimination by converting contributions into benefits (cross) and testing the benefits (testing!)
  4. 4. History of Cross-Testing – Part I §401(a)(4) •...benefits or contributions do not discriminate in favor of HCEs... RR 81- 202 •comparability of plans 410(b) & 401(a)(4) regs •200+ pages, early 1990’s
  5. 5. History of Cross-Testing – Part II New Comparability •a.k.a. class allocation plans, based on the new regulations Threats to outlaw • led to “gateways” effective 2002 Stable for 10+ years •now, even prototype plans include class allocation option
  6. 6. Cross-Testing “Recipe” for DC Plans Step 1: pass thru any of three “gateways” Go! Broadly available allocation rates Gradual age or service schedule Minimum alloc rate: 5% or 1/3 top HCE
  7. 7. Cross-Testing “Recipe” for DC Plans y Step 2: prepare the ingredients @ 8½% interest Contribution for each ee To age 65 ÷ annuity factor (we’ll use 10) to get annual benefit ÷ pay = accrual rate
  8. 8. Cross-Testing “Recipe” for DC Plans y Step 3: mix it all together There’s a rate group for each HCE; it includes the HCE & everyone (HCE or NHCE) with a higher accrual rate: ees w/ rate >=HCE#1 HCE#1 Test each rate group to see if it passes the §410(b) coverage test: • 70% ratio percentage test, or • average benefit percentage test Ratio % below is 75% ÷ 50% = 150% %/HCEs 2/4=50% %/NHCEs 3/4=75%
  9. 9. Cross-Tested Plan Designs y Common designs include: { Age-weighted: guaranteed to pass { Service-weighted { Class allocation (aka “new comparability”) { DB/DC, usually cash balance & profit sharing { Examples for Dr. F & his faithful servants...
  10. 10. Cross-Tested Plan Designs y Age-weighted profit sharing plan { Always passes §401(a)(4) test, but not very flexible { Gateway is gradual age or service schedule { One rate group covers HCE (Dr. F) & both NHCEs, ratio % = 100% Age Service Pay PS % PS $ Benefit Accrual Rate Dr. Frankenstein 60 40 $255,000 20% $51,000 3.01% Igor 40 10 50,000 3.91% 1,955 3.01% Inga 30 5 30,000 3%* 900 5.22% * Age-weighted formula produces 1.73%, but 3% top-heavy minimum applies.
  11. 11. Cross-Tested Plan Designs y Service-weighted profit sharing plan { Rewards loyalty, not very common { PS in this example is ½% of pay per year of service { Gateway is gradual age or service schedule { One rate group covers HCE (Dr. F) & both NHCEs, ratio % = 100% Age Service Pay PS % PS $ Benefit Accrual Rate Dr. Frankenstein 60 40 $255,000 20% $51,000 3.01% Igor 40 10 50,000 5% 2,500 3.85% Inga 30 5 30,000 3%* 900 5.22% * Service-weighted formula produces 2.5%, but 3% top-heavy minimum applies.
  12. 12. Cross-Tested Plan Designs y Class allocation (aka “new comparability”) profit sharing { Very common, even prototype documents include this option { Gateway is minimum allocation 5% or 1/3 of highest HCE rate { One rate group covers HCE (Dr. F) & both NHCEs, ratio % = 100% Age Service Pay PS % PS $ Benefit Accrual Rate Dr. Frankenstein 60 40 $255,000 20% $51,000 3.01% Igor 40 10 50,000 5% 2,500 3.85% Inga 30 5 30,000 5% 1,500 8.69%
  13. 13. Cross-Tested Plan Designs y DB/DC combo: cash balance & profit sharing { Common for professional firms { Enables large deductible contributions for owners { Gateway here is 7½% DC; Igor & Inga get 3% cash balance credits { This example is for a PBGC-covered plan, Frankenstein Mfg. Inc. Ù A PBGC-exempt professional firm may need to limit DC er contrs to 6% Age Pay Cash Balance Credit PS & 3% Safe Harbor 401(k) & Catchup Total Dr. F’stein 60 $255,000 $230,000 $33,500 $23,000 $286,500 Igor 40 50,000 1,500 3,750 whatever 5,250+401k Inga 30 30,000 900 2,250 whatever 3,150+401k
  14. 14. Other Uses for Cross-Testing y Can structure retirement plans by business unit y Could be all DB, all DC or a combination y It’s a lifesaver for mergers & acquisitions
  15. 15. Other Uses for Cross-Testing y Case study: parent & acquisitions, 25,000 total ees DB/DC DB only DC only y Combine all the plans and test on a benefits basis y Can apply this for any group of non-identical plans
  16. 16. Cross-Testing – What Works, What to Avoid y What works great { Profit sharing / cash balance combination Ù PS projected at 8½% interest Ù Cash balance at interest crediting rate (usually much lower) Ù Better results than pure DB or pure DC Ù Effect is known as
  17. 17. Cross-Testing – What Works, What to Avoid y What works great { 401(k) 3% safe harbor { You get a triple dip Ù Free pass for ADP & ACP tests Ù Covers DC top-heavy requirement Ù Counts for cross-testing base & gateway { A few issues Ù Notice required >30 days before plan year starts Ù 100% vesting Ù Can’t impute “permitted disparity” (FICA recognition) for testing { Add profit sharing, if needed to meet gateway
  18. 18. Cross-Testing – What Works, What to Avoid y What to avoid { Unfavorable demographics Ù HCEs younger than others Ù Usually a solution, but it’s tricky { Inflexible plan designs Ù Contribution rates specified in plan document Ù Even prototypes now allow each participant in own class
  19. 19. Cross-Testing – What Works, What to Avoid y What to avoid { Failing the §401(a)(4) test! { Causes Ù Demographic changes, especially new young HCEs Ù Inflexible plan designs { Prevention Ù Test before contributing Ù Flexible plan designs { Cure Ù §1.401(a)(4)-11(g) corrective amendment Ù Can provide extra contributions for a targeted group of NHCEs Ù Must be done within 9½ months after end of year
  20. 20. Cross-Testing – What Works, What to Avoid y What to avoid { 401(k) matching contributions (even safe harbor) { Really? { Deferrals & match don’t count for 1st stage of §401(a)(4) test { You can still match, but it’s an extra expense { What can you do? Ù Convert match to 3% safe harbor, with advance notice Ù Add profit sharing for gateway & cross-testing base
  21. 21. Using Cross-Tested Plans with 401(k)’s y Get top people within deferral range of §415 DC maximum { In 2013, that’s $51,000 - $17,500 = $33,500 (13.14% of max pay) y Cover the gateway for NHCEs { If HCEs are at 13.14%, NHCEs need to be at 1/3 of that: 4.38% y Use 3% non-matching safe harbor { That leaves only 1.38% needed for NHCE profit sharing { Frees HCEs to maximize 401(k) deferrals y Still need to run the test { But gateway is often enough to pass 20% 15% 10% 5% 0% NHCE HCE Def PS SH
  22. 22. Take-Out Menu y Cross-testing is the most powerful testing tool there is! y You can structure plans to fit business needs y It makes some amazing plan designs possible

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