Retirement Plan Comparison

A defined contribution pension plan is an individual account plan. Annual additions to a participant’s account are based on the formula contained in the plan. Retirement benefits are based on the value of the accumulation in the account and investment performance directly affects the value of retirement benefits. The employer’s commitment is to make annual contributions, not to provide benefits. The following are examples of different types of Defined Contribution Plans:

This represents a pro rata allocation based on compensation. Unless a budget for a lesser amount has been requested, this is illustrated at 25% of compensation, the legal maximum.

Integrated Profit Sharing Plan

Integration of profit sharing plan contribution allocations is a process of correlating the benefits or contributions under a plan with those under a government program. Plans can be integrated with various federal and state programs, the most common being Federal Social Security Benefits.

This study illustrates the integration level at the Taxable Wage Base (TWB). The TWB is the base salary amount, indexed annually by the Social Security administration, upon which the employer’s Social Security obligation is determined. If the integration level is equal to the TWB, the disparity can be no more than 5.7%.

Current regulation allows defined contribution plans to be tested for nondiscrimination by reference to the benefits their allocated contribution represent. Accordingly, there is procedure for converting these allocations in equivalent life annuity benefit amounts. The general test is then performed using benefit accrual rates based on those annuity amounts expressed as a percentage of compensation.

The conversion procedure translates, for each participant, the amount allocated under the plan to an equivalent annuity amount. This is accomplished by advancing the allocation to a selected retirement age at an assumed rate of interest, compounded annually, and the dividing the result by a straight life annuity factor appropriate to that age. The testing age definition, the assumed rate of interest, and the assumptions implicit in the life annuity factor must be the same for all participants. For the interest rate assumption there is a mandated rate of 7.5% to 8.5% inclusive (the higher the interest rate, the more biased the allocation to the older employees’ favor).

New Comparability Profit Sharing Plan

Because this plan allocation is the most complex in the profit sharing illustration, much jargon is used to describe the testing. We have therefore determined that along with the brief description, we should provide you with the actual testing methodology.

1. Determine Equivalent Benefit Accrual Rates (EBAR’s) of all employees. This projected annual benefit at age 65 as a percentage of current salary assuming the current year’s allocation for each employee is projected to retirement using acceptable IRS interest and mortality assumptions.

2. Determine if the plan passes the "average benefits percentage" test. This is done by finding the ratio of the average benefit (EBAR) of the Non-Highly Compensated Employees (NHCEs) to the average benefit of the Highly Compensated Employees (HCEs). This ratio must be equal to or greater than 70% for the plan to pass. If the plan does not pass the test, it must be redesigned or it will be considered discriminatory. If the plan passes, the system proceeds to Step 3.

3. Determine the concentration of NHCEs for the plan. This is found by dividing the number of NHCEs in the plan by the total number of employees in the plan. Once this concentration percentage is found, determine the midpoint of the safe and unsafe harbors per the chart in IRC Section 410(b).

4. Divide the plan into rate groups. The number of rate groups is equal to the number of HCEs. A rate group exists for each HCE in the plan and consists of that HCE and all other employees (both HCE and NHCEs) in the plan who have an EBAR equal to or greater than the HCE’s EBAR.

5. Determine if each rate group passes the ratio percentage test. The ratio percentage compares the number of participants rather than the amount of benefits. The test is performed by dividing the ratio of NHCEs (number of NHCEs in rate group divided by the number of NHCEs in the plan) by the ratio of HCEs (number of HCEs in the rate group divided by the number of HCEs in the plan). To pass the test, the ratio of NHCEs to the ratio of HCEs in each group must be a percentage equal to or exceeding the midpoint of the safe and unsafe harbor percentages found in Step 3.

6. If all rate groups pass the ratio percentage test, the plan as a whole passes the nondiscrimination testing of the regulations for IRC Section 401(a)(4). If one or more of the rate groups fail the ratio percentage test, the plan will be considered discriminatory and must be redesigned.

A 401(k) plan may be stand-alone or a feature of a profit sharing or employer stock ownership plan. A 401(k) feature allows eligible employees the choice between receiving certain amounts in cash or directing the sponsoring employer to contribute these amounts to the qualified plan. Once contributed to the plan, these amounts are fully vested. The employer may also make a matching contribution based on the amount that the employees contribute and/or a profit sharing contribution. Distributions or withdrawals are strictly regulated. The 401(k) must operate in a non-discriminatory manner, not favoring the Highly Compensated Employees.