Download Articles Executives May Be Eligible to Receive Larger 401(k) Plan

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Executives May Be Eligible to Receive Larger 401(k) Plan Benefits with a New
Comparability For mula
Matthew B. Grunert, L. Lee McMurtry III and Kelly A. Ultis
Executive Compensation Practical Pointers
May 2017
Business Considerations
Defined contribution retirement plans have become so common-place that most employers do not consider the specific
terms of their 401(k) plans when designing and touting their executive compensation packages. Cookie-cutter 401(k) plan
designs, seemingly incomprehensible non-discrimination rules and the drive to keep plan expenses as low as possible
converge to make this approach understandable.
However, employers looking for a competitive advantage to attract and retain executive talent should consider a “new
comparability plan.” While nondiscrimination rules limit the permissible bias in the benefits/contribution provided to
highly-compensated employees (“HCEs”) (e.g., executives) vis a vis non-highly compensated employees (“NHCEs”) (e.g.,
rank-and-file employees), these rules do not preclude providing more generous benefits for select groups of employees on a
cost-effective basis.
Profit sharing plans (which include almost every 401(k) plan) with a “new comparability” design segregate employees into
various categories (called “allocation groups”) and provide a separate contribution formula for the members of each
allocation group. Under a well-designed new comparability plan, certain allocation groups will receive larger profit-sharing
contributions than others, thus keeping costs down, without violating non-discrimination tests.
Designing and operating a new comparability plan includes the careful assignment of employees to the allocation groups,
the design of the benefit formula for each allocation group, satisfaction of the “gateway” requirements, and good actuarial
and legal support. Each allocation group will typically have eligibility requirements based on objective business criteria, such
as job classification; however, allocation groups can also be structured so that individual employees, or certain select
employees, are each assigned to an individual allocation group, giving considerable flexibility in allocation formulas.
The chart below provides a simple example of structuring profit-sharing contributions based on a uniform fixed percentage
of compensation for participants versus based on the new comparability plan rules. Please note, this is only an example.
Technical Considerations
The non-discrimination test for employer contributions in a defined contribution plan compares the contributions provided to
HCEs as a group versus those provided to NHCEs as a group. There are, however, a variety of ways in which this
comparison can be performed, each with its own set of conditions and requirements. For example, a profit sharing plan that
provides for employer contributions equal to a single given percentage of each employee’s annual compensation would pass
the non-discrimination tests, even though the HCEs (with greater compensation) would receive larger dollar-amount
contributions than NHCEs (with less compensation). A plan that provided for the same fixed dollar contribution (e.g., $100)
for each participant would satisfy the nondiscrimination tests because, on a percentage-of-compensation-basis, the HCEs
are receiving a contribution that is a smaller percentage of compensation than are the NHCE. These designs have the
advantage of being easy to administer and test, but they typically do not provide executives with any enhanced incentives
because in order to provide an executive with the maximum benefit allowed by law, a correspondingly large (and expensive)
benefit would have to be provided to rank-and-file employees.
With a new comparability plan, the non-discrimination test instead looks to the benefit each contribution would generate if
future valued to the employee’s expected retirement date (e.g., age 65) and converted to a life annuity at that retirement
date. The annual benefit each participant would receive under that hypothetical annuity, expressed as a percentage of the
employee’s current compensation, is used as the basis for determining whether the benefits to HCEs impermissible
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discriminates against the NHCEs. The testing on a benefits basis at retirement, rather on a contribution basis at the time of
the contribution, is sometimes referred to as “cross-testing” (because the effect is to test a defined contribution plan as if it
were a defined benefit plan). Thus, a larger contribution can be given to an older employee because the hypothetical future
value of that contribution will be relatively smaller (since it has less time to grow in value to that older participant’s retirement
date), whereas a smaller contribution for a younger employee will have a relatively larger hypothetical future value (since it
has more time to grow until the younger employee’s expected retirement date). In populations of employees where the
executives to be benefitted are relatively older than the average rank-and-file NHCEs, cross testing may allow a new
comparability design to provide substantially larger contributions for executives, while minimizing the cost of contributions for
NHCEs.
Cross-testing profit sharing contributions is a very complex undertaking. If your company wants to explore such a possibility,
it should contact its third-party administrator or similar service provider to inquire, keeping in mind that setting up and
cross-testing a new comparability plan will likely increase administrative fees for the plan.
The attorneys at Andrews Kurth Kenyon are also available to discuss the new comparability plan rules in more detail.
1. Maximum permissible compensation for qualified defined contribution plan purposes in 2017 for HCEs #1 and 2.
2. Maximum permissible contribution for qualified defined contribution plan purposes in 2017 (excluding catch-ups).
3. Required 5% “gateway” contribution for cross-testing purposes for NHCEs #1, 2 and 3.
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