Senators Call for Discrimination Test Fix

Two United States senators are calling on the U.S. Treasury to address nondiscrimination challenges facing employers that enact soft freezes on qualified defined benefit (DB) retirement plans.

In an open letter sent to Jacob Lew, Secretary of the Treasury, Senators Rob Portman (R-Ohio) and Benjamin Cardin (D-Maryland) warn nondiscrimination testing requirements designed to ensure retirement benefit parity between higher- and lower-compensated participants can actually hurt retirement readiness figures in certain pension freeze cases. 

In short, a soft pension freeze occurs when a company grandfathers current employees into an existing DB plan in order to minimize disruptions and to prevent employees from having to build savings in a new retirement model mid-career. The company then starts a defined contribution (DC) plan for new hires and proceeds to operate both plans simultaneously.

The letter points out that nondiscrimination testing required to qualify a DB plan for tax deferred status under the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (IRC) makes it difficult for companies to enact soft freezes on pension plans—even though soft freezes can result in better retirement outcomes for employees than simply closing a pension plan outright.

The problem is that, over time, grandfathered employees in the old system typically build seniority and become more highly compensated than younger workers entering the DC plan. This widens the income gap between the two groups and inadvertently increases the likelihood that the DB plan will fail to meet nondiscrimination standards.

Such a split between having mostly higher-compensated employees in a DB plan and mostly lower-paid employees in a DC plan may trigger the nondiscrimination rules even if the level of pension benefits between the two groups is comparable. The senators say this is because current nondiscrimination rules do not allow for adequate comparison between DB and DC benefits in these circumstances.

A company failing nondiscrimination tests risk losing its pension's qualified status, which can in turn result in immediate taxation of employee benefits and, therefore, poorer retirement readiness.

According to the senators’ letter, many companies have felt compelled to instead implement hard pension freezes that completely close DB plans and force all employees into the DC structure. 

“This is clearly not the intended effect of the nondiscrimination rules,” the senators argue, “which were written to strengthen retirement security rather than to force many older employees into new pension plans that may not provide enough time to accumulate sufficient benefits before retirement.”

A copy of the senators’ letter can be read here.