Pension
Trends Volume IV, No. 1, February 2003
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Pension
Trends Volume IV, No. 1, February 2003
printer friendly
In this issue...
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Choosing the Right Allocation Method for Your Profit Sharing/401(k) Plan
Author Profile: This article was written by Alan J. Stonewall, FSPA, EA, MAAA. Mr. Stonewall is the former president of the American Society of Pension Actuaries, former chairman and board member of the Actuarial Standards Board. Mr. Stonewall also founded Stonewall Pension Service in 1979, and prior to his current position as Consulting Actuary at IAI, he was Director of Employee Benefits at Deloitte & Touche. If you would like to contact Mr. Stonewall or any of the Consulting Actuaries at IAI, please call 1.888.643.5179.
The allocation method used to allocate the employer contribution in a profit sharing or 401(k) plan will have a huge impact on how much of the contribution is credited to the owner-employees, to management, and to staff. Where not long ago there were only two options, now there are many options and the difference in results is dramatic. It is not uncommon to find plans where the contribution for the owner-employees can be increased to 15%, 20% or even 25% of pay while the contribution rate for staff is kept to only 5%.
What has come to our attention is that many plan sponsors are simply doing what they have always done without an eye toward choosing the allocation method that best meets their objectives. Here is an overview of the general allocation methods available and their implications:
Traditional Comp-to-Comp. Under this method, the employer contribution is allocated in proportion to compensation. All eligible employees receive the same allocation, e.g., 5% of pay, 8.27% of pay, or whatever percentage is developed by dividing the total contribution by the eligible payroll. This method treats everyone alike. It is most appropriate when the employer does not have one or more groups it wants to treat differently than others.
Permitted Disparity. An allocation method that uses permitted disparity works much like the traditional comp-to-comp method except it weights the allocation somewhat toward higher paid employees - specifically, those who earn above the social security wage base. This method factors into the allocation an adjustment to reflect the fact that these higher paid employees are earning wages for which they are not receiving credit toward their social security retirement benefits. The pension laws allow the employer to give them a somewhat higher share of the employer contribution. For example, if under the traditional comp-to-comp method, the allocation for all employees would have been 5% of pay, with permitted disparity the allocation might be something like 4.2% for pay below the social security wage base and 8.4% for that portion of an employee’s pay above the social security wage base.
Age or Service Weighted. It is possible to weight the allocation of the employer contribution by employee age or years of service, or both. This method will favor older employees, long service employees, or some combination thereof. For example, under an age weighted allocation, the contribution for two employees, one age 25 and one age 45 who are otherwise identically situated might result in an allocation of 5% of pay for the 25 year old and 20% of pay for the 45 year old. Clearly age or service weighting is an effective way to provide greater allocations to older or longer serviced employees.
Cross Testing. Cross testing is the most recent innovation for allocating employer contributions in a profit sharing or 401(k) plan. It has replaced age or service weighting as the method of choice for targeting different contribution rates for different employee groups. Using a cross testing methodology, an employer can designate multiple groups using employment related criteria and make differing discretionary contributions for each group each year. For example, Group 1 may be partners with 10 or more years of service. Group 2 may be all other partners and the senior support staff. Group 3 may be all other staff. The employer could decide to contribute 25% of pay for Group 1, 15% for Group 2 and 5% for Group 3. Next year the corresponding contribution rates may be 22%, 5% and 5%. All of this is possible AS LONG AS the contributions satisfy the nondiscrimination requirements of IRC 401(a)(4). The testing necessary to insure compliance with 401(a)(4) is complex. Designing a plan that satisfies both the employer’s goals for allocating the contribution and the standards set by 401(a)(4) is often a challenge, but most employers have found it worth the effort.
The allocation method that is appropriate for your plan or your client’s plan is tied to the goals of the employer. Does the employer want to gear the plan as much toward management as possible, or is the plan part of the broad-based compensation package for all employees? How does this contribution coordinate with the matching contribution the employer makes to the 401(k) part of the plan? Once these types of questions are addressed, it is relatively straightforward to model how the various allocation methods work toward the employer’s goals and evaluate their options, especially the more complex cross testing options.
Let us know if we can help. We have the expertise and modeling capabilities to help employers evaluate their options, especially the more complex cross testing options.
This newsletter has been published in order to share general
information with our professional contacts. The information presented in this
newsletter should not be relied upon without first seeking the advice of a CPA,
Attorney or other benefit professional.