Transitioning from a Defined Benefit to a Defined Contribution Program | Part IV: Enhanced Benefit Testing and Other Considerations

After numerous discussions and modeling of the alternatives, sponsors may still be left with a formula that leaves a lot to be desired.  While the projected costs fall within budget, the numbers may also highlight the fact that many employees will be hurt by the changeover.  Many sponsors elect to institute a soft freeze or delay the freeze altogether in order to give those nearest to retirement enough time to plan ahead and make any necessary changes.

Other sponsors (those with the funds available) decide to provide enhanced contributions to a subset of their employees who are negatively impacted and who unfortunately don't have enough time on their side to make up for the shortfalls.

In the case study reviewed in Part 3, a 45-year-old participant with 10 years of service can potentially make up for the lost benefit by increasing their deferrals by 4.4% under the first DC plan alternative (flat 5.5% employer contributions), or by 3.5% under the graded DC plan alternative presented.  A 60-year-old with 20 years of service, however, would need to increase his contributions by 10.9% under the flat 5.5% DC plan alternative, and 8.9% under the graded DC alternative, due to their shorter time horizon.

Providing a select group of participants nearing retirement with an additional 5% contribution, for example, would erase a significant portion of the shortfall.  How much exactly will vary based on the individual’s lost benefit, as well as the number of years left until retirement.

However, in order do to this, you must be reasonably sure that the plan will satisfy nondiscrimination requirements under Internal Revenue Code Section 401(a)(4).  The demographics of the select and overall employee group will determine the amount of enhanced benefits you are able to provide.

We typically establish an enhanced DC contribution that will satisfy the Minimum Allocation Gateway in order to cross-test the DC program.  Cross-testing enables sponsors to show that the general test passes by testing a DC plan on a benefits basis, which is typically easier than satisfying the general test on a DC contribution basis.  The minimum allocation gateway is satisfied when all non-highly compensated employees (NHCEs) receive an allocation at least as large as 1/3rd of the greatest allocation provided to all highly compensated employee (HCEs).  So if the sponsor establishes a DC program that provides a 4% base contribution to all employees, it is possible to establish a select group of employees who will receive enhanced contributions of 8% on top of the 4% base contribution.  If we find that there exists a fairly larger representation of highly compensated employees in the select group as compared to the overall employee population, such a program may fail the general test under nondiscrimination testing for 401(a)(4).  However, because the program satisfies the minimum allocation gateway test (all NHCEs are receiving at least 4% compared to the 12% maximum contribution any HCE may receive), we may-cross test the plan by converting the DC allocations into benefit accruals, which produces higher rates for younger employees, and lower rates for older employees.  This typically translates into higher rates for NHCEs and lower rates for HCEs, thereby enabling the program to satisfy the general test.

We find that this strategy enables many sponsors to provide significant enhanced contributions to a select group of employees before running afoul of 401(a)(4).  In fact, more often than not the additional benefit is more likely to be capped by budgetary constraints rather than realizing a testing failure.

Looking back at the second alternative DC plan, which provided graded employer contributions based on employee age as follows:

We see that if the sponsor wanted to establish a select group of employees, say those who are 55 with 10 years of service as of the freeze date of 1/1/2016, and provide them each with enhanced contributions, one easy way to do so would be to provide an additional 3% contribution.  Although the plan may satisfy the general test on its own basis, because the highest total employer contribution of 10.5% received by any employee (HCE or NHCE) is exactly 3 times the allocation of 3.5% received by all other employees, this plan would satisfy the Minimum Allocation Gateway and may therefore be cross-tested, likely satisfying the general test with comfortable margins.

Ensuring that the Plan will continue to satisfy the general test while the select group of employees gets smaller and smaller (as they retire or leave employment), this may prove difficult in later years.  One potential solution is to only provide enhanced contributions for a limited time (say 5 years), while the select group's ratio of HCEs to NHCEs is still fairly representative of the ratio for the overall employer group.

Looking at a sample employee who just made the age 55 cutoff, we see that although providing an additional 3% in annual contribution does not fully make up the shortfall, it does make a dent in his losses.

The Value of Employee Communications

Another consideration sponsors should analyze is initiating a formula that includes a matching component.  Unless employees themselves commit to retirement savings, even generous DC plans will fall short of providing employees with a retirement income replacement ratio of 80%, or an annual savings rate of 12% that many use as a rule of thumb as the required level of savings needed for most employees to retire comfortably. Sponsors often struggle with communicating the fact that in addition to taking away the beloved DB plan, there is also an expectation that employees must begin paying into the new DC program to realize a full benefit.

Undoubtedly employees will be upset, but this point underlines the fact that any successful DB to DC transition requires sponsors to effectively communicate the changes to its employees.  The key to success is often the sponsor's ability to explain what has led to the changes and making it evident that all the options have been carefully deliberated.  We find that sponsors that are straightforward and take the time to explain the "why," are met with understanding rather than skepticism.

Even participants who aren't actively paying attention to retirement industry trends have seen the headlines and heard the rumblings.  Submitting the facts of increasing volatility and funding requirements is well understood, even if participants are not aware of the intricacies of plan funding.

We also advise sponsors to highlight the very real problem of low participation rates leading to insufficient retirement savings that many Americans will face.  The level of savings needed to achieve a comfortable retirement will require participants to "put skin in the game."  Sponsors must find a way to incentivize and encourage employees to participate and make the commitment needed to achieve security in old age, including participant auto-enrollment and offering matching contributions.

Moreover, sponsors undergoing a transition must explain the many differences between DB and DC programs and highlight the ways in which DC plans require more participant involvement.  Employees must be engaged throughout the process, as they will be responsible for a number of decisions long after the DC plan is installed.  DC plans require participants to act as their own advocates. This will require employees to make investment decisions they may not be equipped to make without the help of professionals, who should be made available to participants throughout the transition and initiation of the new DC program.

Communicating these issues can be tricky, but they cannot be ignored.  They must be an area of focus in ensuring not only a successful transition, but also ensuring high participation and long-term success of the DC program.

Series Wrap-up

There are a number of issues and factors that have not been sufficiently covered, but the hope is that this series of articles will provide sponsors with a general resource of what should be looked at when undertaking a DB to DC plan transition.  As in life, perfect solutions, if they exist at all, are rare and hard to come by.  But by performing a defined benefit to defined contribution study, Plan sponsors may yet establish a cost-effective retirement program that will provide employees with a path to a secure retirement.

Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Opinions expressed are those of the author, and do not necessarily represent the opinions of Cammack Retirement Group.

Investment products available through Cammack LaRhette Brokerage, Inc.
Investment advisory services available through Cammack LaRhette Advisors, LLC.
Both located at 100 William Street, Suite 215, Wellesley, MA 02481 | p 781-237-2291