Is the New Combined Defined Contribution/Defined ... - Plante Moran

September 15, 2009
Is the New Combined Defined
Contribution/Defined Benefit Plan
Worth Considering?
One of the many potential changes brought by the Pension Protection Act of
2006 was Internal Revenue Code (IRC) section 414(x). This new addition allows
employers to combine defined benefit and defined contribution retirement plans,
with the combined plan automatically satisfying the top heavy and certain
nondiscrimination rules of IRC sections 416, 401(k) and 401(m); however, plan
sponsors must pay a price.
Starting in 2010, plan sponsors with 500 or fewer participants are permitted to
combine defined benefit and defined contribution plans into one plan with the
assets held in a single trust. In exchange for meeting requirements with respect
to benefit levels, employer paid contributions, accelerated vesting and
nondiscrimination, the plan sponsor avoids having to test the plan for top heavy
status and certain nondiscrimination requirements related to employee
contributions and employer matching. The question is whether the inflexibility
and magnitude of the requirements make it worthwhile.
Top-Heavy Plan
Generally, a qualified retirement plan fails top-heavy testing if 60% or more of the
benefits are for key employees. The consequences of such failure are:
a) Application of certain vesting to participants – 100% after 3 years of service
or 20% grading of vesting with 2 years of service up to 100% after 6 years,
and
b) Minimum contributions or benefits – 3% of compensation for defined
contribution plan participants and 2% of average compensation times years
of service (not to exceed 20%) for defined benefit plan participants. For
employers with both types of plans, the top-heavy benefit need only apply to
one plan.
Failure of IRC Sections 401(k) and 401(m)
Defined contribution plans that fail the nondiscrimination testing associated with
employee contributions under IRC section 401(k) and the employer matching
contribution component of 401(m) generally are able to either a) make additional
employer contributions or b) refund monies to highly compensated employees.
Usually, the most efficient way to pass otherwise failed tests is to refund monies
to affected employees.
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IRC Section 414(x) Permits Combined Defined Contribution/Defined Benefit Plan
Implementing a Combined Defined Contribution/Defined Benefit Plan
Generally, for automatic compliance with the aforementioned top-heavy and nondiscrimination rules IRC
section 414(x) requires:
a) Application of certain minimum vesting standards – 100% after 3 years of service for defined benefit
contributions and immediate vesting in employer matching contributions,
b) Minimum contributions or benefits – matching contributions of 50% of the first 4% of employee elective
contributions (not to exceed 2% of compensation) for defined contribution plan participants AND 1% of
average compensation times years of service (not to exceed 20%) for defined benefit plan participants
(cash balance defined benefit plans have different contribution rules), and
c) Automatic contributions of 4% of eligible compensation must be withheld from employee payroll unless
they have elected otherwise.
Considerations for Adopting a 414(x) Plan
Under 414(x), benefits may be required to vest over a shorter period than they would otherwise be required
to under the terms of the plan. Likewise, the contributions required may or may not be greater than the
current contribution requirements depending on many factors, including the plan’s current top-heavy status,
defined benefit plan formulas, actual employee turnover, etc. While there are many things to consider when
adopting any type of retirement plan, the major considerations include:
• Required Funding. Given the volatility of the stock market and the inflexible funding requirements
mandated by the Pension Protection Act, by utilizing 414(x), a plan sponsor gives up the flexibility of
discretionary matching contributions found in the 401(k) world and the defined benefit plan contribution
must be funded no matter what the magnitude.
• Cash Flow. Consistent and positive cash flow is a must for this type of plan.
• Company Size. Small, owner-dominated companies that have both types of retirement plans are the
most likely candidates.
• Impact of Current Testing. The more the plans are already affected by the top-heavy and
nondiscrimination rules, the more preferable this sort of arrangement becomes.
The following table lists some high-level considerations and comments on whether a 414(x) plan merits
consideration:
Employer Type
Current
Defined
Benefit Plan
Consistent and
Positive Company
Cash Flow
Refunds in
401(k)
Plan
Already Top
Heavy
414(x) Worthy of Consideration
Small, 25
Employees
Medium, 250
Employees
Large, 500
Employees
Any (with 500 or
fewer employees)
Any (with 500 or
fewer employees)
Yes Yes Yes Yes Yes – this type of arrangement may be less expensive
than a safe harbor defined contribution plan (for the
defined contribution plan).
Yes Yes Yes Yes Maybe – this is an efficiency issue, providing the
minimum benefits may be much more expensive than
making the refunds.
Yes Yes Yes Yes No – if the employee base is growing then this option
may not be available for long: 500 employees is the
limit.
No Yes Yes Yes Maybe – careful consideration is necessary: adding a
defined benefit plan is not a benefit that allows
flexibility in funding.
Yes or No No Yes Yes Maybe – again, careful consideration is necessary;
adding a defined benefit plan is not a benefit that
allows flexibility in funding; if the goal is to reduce the
current level of benefits provided in the defined benefit
plan, this kind of plan might be useful
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There are many other variables that affect retirement plan design such as benefit accumulation and
administration efficiency as well as participant communication.
The Employee Benefits Consulting group is well equipped to address the design considerations associated
with clients who would like consider adopting this sort of combined plan arrangement. Feel free to contact
Joe Rankin at 248.375.7361 with any questions.
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