This post marks the third in a three-part series on nondiscrimination testing.

Benefits testing demonstrates that the level of benefits provided by a plan does not discriminate in favor of highly-compensated employees (HCEs). Certain benefit structures that make use of a safe harbor design (such as a defined benefit [DB] plan that provides 1% of final average pay for each year of service, or a defined contribution [DC] plan with an employer contribution of 4% of compensation) are exempt from benefit testing.

If the safe harbor design is not met, then detailed testing is required. ??401(k) deferrals are subject to the average deferral percentage (ADP) test, and ??401(m) matching contributions are subject to the average contribution percentage (ACP) test. All other types of benefits (such as DB plan accruals or DC profit-sharing allocations) will be subject to a numerical test known as the general nondiscrimination test (GNT). Catch-up deferrals are exempt from testing requirements.

Trap #3: Employers B, C, and D are part of a controlled group. Each of the three employers sponsors a defined contribution plan (Plans B, C, and D). Plan B covers all of the employees of Employer B, Plan C covers all of the employees of Employer C, and Plan D covers all of the employees of Employer D. Plans B, C, and D are all subject to ADP and ACP testing. Separate record-keepers are used for each plan. Each record-keeper performs the ADP and ACP testing for the plan that they are responsible for.

The ADP and ACP testing can be performed correctly by each of the record-keepers. However, if data is not shared between the record-keepers, coverage testing would not be possible, because this testing is based on the data for the entire controlled group. The coverage testing needs to be coordinated to ensure that it is performed properly.

There are other types of testing that may also need to be performed. Plans are permitted to provide certain items (known as benefits, rights and features) as long as they are made available to employees in a nondiscriminatory manner. These items include (but are not limited to) ancillary benefits such as death and/or disability benefits, optional forms of payment (including lump sums), and eligibility for early retirement benefits.

Trap #4: Employer E sponsors a defined benefit plan, which provides unreduced early retirement benefits to employees who retire at age 60. The plan was modified 10 years ago so that new entrants would not be eligible for the unreduced benefit.

As a result of the change, the unreduced benefit became subject to this additional testing, because it was no longer available to all participants. The plan easily passed the testing for the first few years after the change, but the passing margin has deteriorated recently, which is due to decreases in the number of participants eligible for the early retirement benefit.

Plans that provide benefits based on compensation (other than total compensation) need to show that the compensation used in the testing does not discriminate in favor of HCEs (otherwise, detailed benefit testing as described above will be required). For example, consider a plan that uses base pay plus bonus as the compensation definition, and therefore excludes overtime from consideration. If overtime is a significant portion of total compensation for the NHCEs, it is likely that this definition of pay would be considered discriminatory.

Many benefit plans need to be closely monitored to assure that they remain in compliance with the nondiscrimination requirements. This is especially important when contemplating plan changes, as the changes could have an adverse impact on current or future nondiscrimination testing. For further information, please contact your Milliman consultant.