Cross-Tested Plans Shoot for Similar Benefits at Retirement

For sponsors with 50 or fewer employees, particularly professional services firms like doctors’ offices or law firms, cross-testing is a way for them to ensure their older, highly paid employees, as well as rank-and-file employees, are saving for income replacement goals in retirement, while at the same time meeting non-discrimination requirements.

It combines profit-sharing contributions with defined contribution plans—and, by projecting the benefits afforded to employees at retirement, rather than allocations made along the way—it allows sponsors to fulfill non-discrimination requirements.

“A company that already has a traditional 401(k) can overlay cross testing on top of that,” explains Jay Well, a financial adviser with Foresight Wealth Management in Sandy, Utah. “It changes the way the 401(k) is tested for non-discrimination. In typical non-discrimination testing, the Internal Revenue Service (IRS) looks at how much money is being contributed and whether highly compensated employees (HCEs) and non-highly compensated employees (NHCEs) are benefitting equally. Cross-testing looks at the benefit of those contributions at retirement. Because younger employees have a longer time horizon to grow their assets, it permits employers to contribute more for their older employees.”

Cross-testing allows the profit-sharing component to be tested as a defined benefit would be tested—what the contributions will produce as a benefit at retirement, adds Ted Sarenski, CEO and president of Blue Ocean Strategic Capital in Syracuse, New York. Essentially, cross-testing focuses on extended benefits at retirement, says Tom Foster, national spokesperson for MassMutual Retirement Services in Enfield, Connecticut.

The 2016 IRS limits for employee 401(k) contributions of $18,000 and the $6,000 catch-up for those age 50 and older still apply. However, the employer contributions are considered profit sharing and may be added on top of each employee’s 401(k) contributions up to $53,000 or 100% of compensation, whichever is less, Foster says.

Cross-testing makes sense for companies that want to reward a select group of employees, particularly those “deemed the most important to the company’s success,” says Paula Calimafde, a principal with Paley Rothman in Washington, D.C. and chair of the law firm’s Retirement Plans, Employee Benefits and Government Relations practice groups. “It is not unusual for these plans to give higher contribution amounts, expressed as either a percentage of compensation or a dollar amount, to older employees, employees with more years of service and/or employees who are performing the most important functions for the business.”

While cross-testing tends to benefit HCEs the most, “there is a formula that dictates that a minimum percentage allocation must be made to NHCEs to comply with the Employee Retirement Security Act (ERISA) non-discrimination requirements,” thereby benefitting all employees, says Thomas Cote, senior vice president, retirement plan solutions at EQUIS Capital Management in San Francisco.

Those contributions to the NHCEs, also known as “gateways,” must be at least 5% of their salary or one-third of the highest percentage being given to the HCEs, Foster says. While the HCEs do receive higher amounts, a 5% contribution for NHCEs is still sizeable, Foster says. Plus, he says, the objective of cross-testing is for all employees to have similar benefits at retirement. As Well puts it, whether the employee is in the highly compensated or non-highly compensated camp, cross testing is “a true win, win.”

Sponsors of cross-tested plans divide their employees into multiple groups and have the ability to change their contributions each year, and this flexibility “could be considered an advantage over traditional 401(k) plans,” says Keith Baker, personal finance professor at North Lake College in Irving, Texas. As company profits vary from year to year, employers retain the right to adjust their contributions, or even make no contribution at all, he says.

PNC Financial Services Group has found that cross-testing is “more successful when the average age of NHCEs is younger than the HCEs and when the NHCEs are not deferring enough into the plan to allow HCEs to take advantage of the plan,” says Sherri Painter, senior vice president and director of PNC Retirement Solutions. It is also wise to limit the number of employee groups to no more than 10 due to the contribution calculations and cross-testing, Painter adds.

And because the ratio of owners to rank-and-file employees is so much lower at large companies, cross-testing typically only makes sense for companies with 50 or fewer employees, Well says.

Calculations are determined every year, typically by a third-party administrator or an actuary, Well says. Every cross-testing plan will have its own individually designed formula, which is why it is important for a sponsor to ensure that they partner with a TPA, and, possibly a retirement plan adviser, conversant in the practice, Foster says.

“These are complicated calculations that we leave to actuaries to perform,” says Joanne Youn, an attorney with Caplin & Drysdale in Washington, D.C. “They will tell you what groups to establish and what allocation rates to use,” Youn says. “My role is to ensure the plan design and the documents match up, that the cross-testing design conforms to the law and what the plan document can accommodate. Some plans have limitations on how creative you can be in your plan design.”

Thus, a sponsor using cross-testing needs to periodically “revisit their goals and objectives to confirm the plan design still meets the desired outcomes and adjusts to any changes in employee demographics,” Painter says. Sponsors also need to be aware that the additional cross-testing and customized employee communications to the various groups adds to plan administration costs. However, compared to the benefits that cross-testing affords the highly paid cohort, these costs are minimal, according to Foster.

Sponsors may also want to consider certain proposed changes to retirement plan non-discrimination requirements that the IRS put forth on January 29, 2016. “They would make it more difficult for plans trying to provide qualified supplemental retirement plan benefits to HCEs,” Youn says. Plan sponsors whose plan designs require cross-testing or combined testing under Code 401(a)(4) for their profit-sharing contributions will want to consult their benefit experts about these proposed amendments, she advises.

The proposed regulation would require that groupings of employees be “reasonable” and established under “objective business criteria,” Calimafade says. Further, while the IRS currently permits sponsors to list each employee as their own individual group, which makes administration and cross-testing of plans easier, the proposed amendment would eliminate this practice, she says. “There has already been a tremendous outcry from the plan administration community since so many of the cross-tested plans have been designed this way,” she says.

Putting the administration, costs and the proposed amendments to cross-testing aside, Well still believes cross-testing is a valuable tool for plan sponsors interested in offering profit sharing to their employees, and that if they find a TPA well versed in cross-testing, it is easy to administer. “It’s a great way to go,” he says, “and if more advisers and sponsors knew about it, it would be used more often.”