Nondiscrimination Rules for Public Pension Funds (Posted on June 30, 1997 by )

Carol V. Calhoun, Counsel
Venable LLP
600 Massachusetts Avenue, NW
Washington, DC 20001
Phone: (202) 344-4715
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Carol V. Calhoun

  1. What Are the Nondiscrimination Rules?

    1. Immediate Concerns

      1. Universal Availability of Salary Reduction Contributions to Internal Revenue Code ("Code") section 403(b) plans (e.g. tax-deferred annuities for employees of public schools) are already in effect:

        1. Basic rule: if any employee of the employer can make a contribution, all must be permitted to make one.

        2. Issues:

          1. Since statewide university system is treated as constituting one employer, this rule creates problems if any individual university does not have a 403(b) plan or does not allow all employees to make contributions to it.

          2. How can rules be applied in cases of casual employees, such as substitute teachers, whose compensation cannot be calculated in advance?

          3. Can employer limit contributions more than is required by statute, e.g., in order to simplify calculations or payroll operations, without creating problems under this rule?

      2. Compensation Taken Into Account. (Code section 401(a)(17). Imposes $150,000 cap on compensation taken into account for purposes of contributions or benefit accruals.

        1. Applicable to public plans, effective for the first plan year beginning on or after January 1, 1996, or 90 days after the opening of the first legislative session beginning on or after January 1, 1996 of the governing body with authority to amend the plan, if that body does not meet continuously (the "1996 legislative date").

        2. A transitional rule permits a public plan to apply 401(a)(17) only to persons who become plan participants after the effective date, if certain conditions are met. One of those conditions is that the plan must be amended before the beginning of the first plan year beginning on or after January 1, 1996.

        3. Issues:

          1. To what extent can excess benefit plan make up for benefits lost due to compensation cap? This is particularly likely to be a concern for statewide plans, inasmuch as excess benefit plan assets must be subject to claims of the creditors of the "employer" in order to avoid onerous tax consequences to employees. How can this be arranged if there is more than one employer in the plan?

          2. One of the conditions for the transitional rule is that the plan incorporate by reference the federal cap on compensation taken into account. This may be treated under some state laws as an impermissible delegation of legislative functions.

      3. Code section 415 rules. Problems not resolved by last year’s legislative relief:

        1. Although maximum percentage of compensation limits have now been eliminated for benefits under defined benefit plans, maximum dollar limits have not. These limits typically affect only a few employees, but applying them can be an issue given typical constitutional restrictions on modifying benefit formulas for existing employees.

        2. Regulations treat employee contributions (e.g., to purchase service credit) as if they were contributions to a defined contribution plan, subject to an annual limit of $30,000 or 25% of compensation.

        3. Very complex aggregate limitations on benefits and contributions also apply. Certain contributions to other plans (including in some circumstances a tax-deferred annuity) count in applying those limits.
        4. Issues:

          1. These rules compare all contributions in one year (even contributions to purchase service credit for many prior years) to compensation for that year. Thus, they can severely impair the ability of employees without much compensation for a particular year (e.g., those who retire in the middle of a year) to purchase service credit.

          2. Rules can in part be avoided through purchasing service credit with contributions treated as "picked up," or with rollovers from other qualified plans. It appears that they may not apply to contributions which represent refunds previously received from the same plan, plus interest. However, these mechanisms are typically not satisfactory for all employees.

          3. See comments on 401(a)(17) concerning problems engendered by attempts to use excess benefit plans to make up benefits limited by the Code.

          4. The issues concerning purchased service credit would be resolved if legislation initiated by NCTR passes.

    2. Effective beginning with the first plan year beginning on or after January 1, 1997, or 90 days after the opening of the first legislative session beginning on or after January 1, 1997 of the governing body with authority to amend the plan, if that body does not meet continuously (the "1997 legislative date"):

      1. Nondiscrimination rules for employee contributions and matching employer contributions. (Code section 401(m).) Limit the degree to which after-tax contributions to a plan by highly compensated employees can exceed after-tax contributions by lower paid employees, even if the differences in contribution rates are entirely attributable to employee elections.

        1. The proposed nondiscrimination regulations do not apply 401(m) to employee contributions unless those contributions are kept in a separate account and credited with actual earnings of the plan trust.

        2. In the case of a typical public defined benefit plan which credits employee contributions only with a nominal rate of interest (e.g., five percent, regardless of trust earnings), the contributions are not subject to Code section 401(m). However, this is a mixed blessing, inasmuch as such contributions will be subject to the much stricter standards of Code section 401(a)(4) (see below).

      2. Average Deferral Percentage Test. (Code section 401(k).) Limit the degree to which contributions to a 401(k) plan by highly compensated employees can exceed contributions by lower paid employees, even if the differences in contribution rates are entirely attributable to employee elections.

        1. The average deferral percentage ("ADP") tests in Code section 401(k) are applicable to grandfathered 401(k) plans,

        2. Applies only to "grandfathered" 401(k) plans, since public employers cannot set up new 401(k) plans.

    3. Effective beginning with the first plan year beginning on or after January 1, 1999, or 90 days after the opening of the first legislative session beginning on or after January 1, 1999 of the governing body with authority to amend the plan, if that body does not meet continuously (the "1999 legislative date").

      1. Minimum Coverage Standards. (Code section 410.) Prohibit coverage of plan from discriminating in favor of highly compensated employees.

        1. Government plans are exempt from present Code section 410(b). Code section 410(c)(1).

        2. Code section 401(a)(3) as in effect prior to the adoption of ERISA is applicable to public plans (Code section 410(c)(2)). Even after Code section 401(a)(3) applies, the following employees may be excluded in determining whether coverage of plan violates minimum coverage rules:
        3. (i) Employees who have been employed five years or less (or any lesser period);

        4. (ii) Employees who customarily work not more than 20 hours in any one week, and

        5. (iii) Employees whose customary employment is for not more than 5 months in any calendar year.

        6. Issues:

          1. Who is the "employer" for testing purposes? For example, in a statewide pension system, must all state and local employees not covered by the system (including employees of nonparticipating localities be looked at to determine whether requirements are met?

          2. What is a "nondiscriminatory classification"? For example, would a teachers’ plan violate these rules if teachers were more likely to be highly compensated than other employees of the same schools?

          3. If a plan covers primarily or exclusively employees who are covered by collective bargaining agreements (or more informal "meet and confer" procedures), but is imposed by statute rather than a collective bargaining agreement, can it use the more liberal rules for collectively bargained plans?

      2. Nondiscrimination in Benefits Rules of Code section 401(a)(4). Prohibit a plan from discriminating in favor of those highly compensated employees who are covered by the plan.

        1. IRS regulations take the position that the current (post-ERISA) version of Code section 401(a)(4) applies.

        2. Given the extensive interaction between the nondiscriminatory benefit rules and the minimum coverage rules (discussed above), it is difficult to understand how plans will be able to apply the post-ERISA nondiscriminatory benefit rules and the pre-ERISA minimum coverage rules.

        3. Issues:

          1. If benefits are calculated based on compensation for period of less than three years, the definition of compensation may be considered to create discriminatory benefits.

          2. Will benefit "tiers" for employees hired before a particular date be discriminatory, as the employees covered by a particular tier become older and presumably more highly compensated?

      3. Integration with Social Security. (Code sections 401(a)(5) and 401(l).)

        1. These rules limit the extent to which a plan can adjust plan contributions or benefits to take account of Social Security contributions or benefits.

        2. Issues:

          1. These rules may prevent a plan from including a full offset for Social Security benefits.

          2. Even if a plan can in practice meet the rules, doing so may require complicated testing, which must be performed regularly even if the plan is not initially discriminatory.

      4. Nondiscrimination in Vesting. (Code section 411(e).)

        1. The vesting standards of Code section 411 are not applicable to public plans. Code section 411(e)(1).

        2. However, beginning with the 1999 legislative date, public plans must satisfy Code sections 401(a)(4) and 401(a)(7) as in effect prior to the enactment of ERISA. Code section 411(e)(2). Prior to ERISA, Code sections 401(a)(4) and 401(a)(7) read as follows:
               (a) Requirements for Qualification.-A trust created or organized in the United States and forming part of a stock bonus, pension, or profit-sharing plan of an employer for the exclusive benefit of his employees or their beneficiaries shall constitute a qualified trust under this section-
          * * *
               (4) if the contributions or benefits provided under the plan do not discriminate in favor of employees who are officers, shareholders, persons whose principal duties consist in supervising the work other employees, or highly compensated employees.
          * * *
               (7) A trust shall not constitute a qualified trust under this section unless the plan of which such trust is a part provides that, upon its termination or upon complete discontinuance of contributions, under the plan, the rights of all employees to benefits accrued to the date of such termination or discontinuance, to the extent then funded, or the amounts credited to the employees’ accounts are nonforfeitable. This paragraph shall not apply to benefits or contributions which, under provisions of the plan adopted pursuant to regulations prescribed by the Secretary or his delegate to preclude the discrimination prohibited by paragraph (4), may not be used for designated employees in the event of early termination of the plan.
        3. Issues:

          1. The IRS takes the position that these rules can be an issue even if a plan has a uniform vesting rule applicable to all employees. For example, an issue could arise under these rules if a plan delays vesting for a long time, and if nonhighly compensated employees tend not to continue their employment for as long as highly compensated employees do.

          2. Again, even if tests can be passed, testing may be administratively complicated.

      5. Minimum Participation Rules. (Code section 401(a)(26).)

        1. Subject to several rules for the exclusion of certain employees, a plan must benefit on each day of the plan year, the lesser of 50 employees of the employer, or 40 percent or more of all employees of the employer.

        2. Applicable to public plans beginning with the 1999 legislative date.

        3. Issues:

          1. This may be a problem for very small plans.

          2. Even if a plan covers all employees of a particular governmental entity, problems in determining whether the "employer" is that entity or some larger entity may create problems in determining whether the 40 percent rule is met.

  2. Effect of Noncompliance with Nondiscrimination Rules.

    1. Tax consequences to participants.

      1. Code section 402(b) and 403(c) tax vested participants currently on each year’s accruals if a plan is disqualified for reasons other than discrimination. This would apply both to accruals based on employer contributions and to those based on contributions intended to be "picked up" under Code section 414(h)(2).

      2. If a private plan is disqualified due to Code section 401(a)(26) or 410(b) problems, Code section 402(b)(2)(B) causes each highly compensated employee to be taxable in the year of disqualification on all vested amounts accrued from the date he or she began participation through the year of disqualification. The IRS has taken the position that this provision applies if a public plan (which is not subject to Code section 410(b)) is disqualified due to problems under the comparable provision for public plans, i.e., Code section 401(a)(4) or pre-ERISA Code section 401(a)(3) as incorporated by reference in Code section 410(c), or under Code section 401(a)(26).

      3. Finally, there is a split of authority as to whether all of the favorable tax provisions in Code section 402 for recipients of lump sum distributions from qualified plans (e.g., rollovers and forward averaging) are unavailable if the plan is disqualified, or whether such favorable tax provisions might still be available as to that portion of the benefit accrued in years in which the plan was qualified.

    2. Tax Consequences to Employers.

      1. Even if IRS would likely be reluctant to penalize employees for being participants in a disqualified plan, it has another avenue of potential attack: collecting additional withholding taxes from the employer.

      2. Under Code section 3401(a)(12), employer and picked-up employee contributions to qualified plans are exempt from withholding, but this rule does not exempt contributions to disqualified plans. Under Code section 3403, the employer is liable for the amount of the tax which should have been withheld, whether or not such amount has been withheld from the employee.

    3. Consequences to Plans.

      1. Plans are required to inform participants who receive distributions of what portion of the distribution is subject to tax, and what portion can be rolled over into another plan.

      2. Thus, the tax consequences of nondiscrimination violations on plan distributions may present plans with difficult reporting obligations.

    4. Amelioration of Penalties.

      1. Some of the harsh results set forth above could be mitigated under the IRS Voluntary Compliance Resolution ("VCR") and Coordinated Appeals Procedure ("CAP") programs.

      2. However, IRS representatives have informally stated that they will be seeking monetary sanctions, not just future compliance, from public plans which seek to remedy their qualification problems under these programs.

  3. Prospects for Legislative Relief.