IRS Proposal Would Change Rules for QSERPs

The Internal Revenue Service’s (IRS) proposed rules from January that would offer nondiscrimination testing relief for closed defined benefit (DB) plans include a proposal that could limit plan sponsors’ ability to offer enhanced executive benefits under their qualified retirement plans.

A blog post from Morgan, Lewis & Bockius LLP explains that employers often provide highly compensated executives additional retirement benefits outside of qualified plans using nonqualified deferred compensation plans (NQDCs), often called supplemental executive retirement plans (SERPs). To offer tax-deferred benefits under SERPs and other NQDCs, amounts set aside to fund the benefits must remain at risk to an employer’s creditors in the event of the employer’s insolvency. Additionally, benefits payable under a SERP (or any NQDC) generally are subject to the stringent limitations of section 409A on when and in what form a benefit may be paid.

According to the blog post, because of these disadvantages to using SERPs and other NQDCs, some employers have instead capitalized on flexibility built into the qualified plan nondiscrimination rules to provide enhanced benefits for executives. Under the nondiscrimination rules, qualified plan benefit accruals need not be uniform among participants. So long as there are a sufficient number of non–highly compensated employees (NHCEs) who accrue benefits at a rate equal to or greater than the accrual rate for each HCE designated for an enhanced benefit, the designated HCEs can accrue benefits under a different or additional formula. Plans that use this qualified supplemental executive retirement plan (QSERP) approach typically identify each QSERP participant and his or her benefit or accrual rate by name or employee identification number in the plan document.

The IRS proposal explains that under the general test in the existing regulations, if a plan satisfies the minimum coverage requirements of section 410(b) using the average benefit percentage test, then the rate group for each highly compensated employee is treated as satisfying the minimum coverage requirements if the ratio percentage for the rate group is equal to the midpoint between the safe harbor and the unsafe harbor percentages (or the ratio percentage for the plan as a whole, if less). This rule recognizes that the composition of a rate group may be unpredictable and so the rate group should not be subject to a reasonable business classification standard.

However, that same consideration is not relevant if the group of employees to whom the allocation formula under a defined contribution plan (or benefit formula under a defined benefit plan) applies is not a reasonable business classification. The proposed regulations limit the existing rule under which a rate group with respect to a highly compensated employee is treated as satisfying the average benefit percentage test to those situations in which the allocation formula (or benefit formula) that applies to the highly compensated employee also applies to a reasonable business classification. For example, if a benefit formula applies solely to a highly compensated employee who is identified by name, it does not apply to a reasonable business classification. In such a case, the proposed regulations would require that the rate group with respect to that individual satisfy the ratio percentage test.

Sponsors of QSERPs may want to consult with counsel about what the proposed rule would mean for their plans.