How the ‘Cross-Testing’ Pension
Loophole Harms Low- and Moderate-Income Workers
by Peter R. Orszag
Pension coverage in the United States is skewed toward high earners. In 1993, for example, 27 percent of full-time private-sector workers who earned between $10,000 and $15,000 were covered by a pension. In contrast, 81 percent of full-time private-sector workers who earned more than $75,000 were covered by a pension. This unequal distribution of pension coverage also manifests itself in the distribution of pension tax preferences: Two-thirds of the benefits from existing pension tax preferences accrue to the top 20 percent of the income distribution.
The skewed distribution of pension tax benefits arises, at least in part, from various provisions of the tax law that allow firms to provide disproportionate benefits to higher-paid workers. One of those provisions permits so-called "cross-testing" of pension plans, a practice that is apparently spreading rapidly among small businesses.
The first section of this paper explains how the cross-testing provision is essentially a loophole that allows businesses to receive the tax benefits that are provided for qualified pension plans while skewing their pension benefits toward high-income owners and providing little pension coverage to low- and moderate-income workers. It also explores a particularly potent form of cross-tested plans, known as "new comparability" plans, that are even more skewed than the first generation of cross-tested plans. Use of new comparability plans allows firms to direct a still-larger share of pension benefits to highly paid owners and executives — and a smaller share to ordinary employees — than the firm otherwise could do.
The second section of the paper describes how the use of cross-tested plans among small businesses makes several proposed pension reforms - such as weakening the "top-heavy" rules and increasing the limits on amounts that can be contributed to defined contribution plans - particularly dangerous.
The final section of the paper briefly discusses a recent Treasury Department initiative to constrain new comparability plans. On February 24, the Treasury Department and the Internal Revenue Service announced they were reviewing new comparability plans and invited comments on one method of curtailing their use.
Cross-Testing: What It Is and How It Works
Under current law, firms sponsoring pension plans must demonstrate that their plans do not discriminate in favor of highly compensated employees to continue enjoying the tax benefits from a qualified pension plan. There are a number of mechanisms firms can use to show they satisfy this requirement. One troubling mechanism, which effectively dilutes the non-discrimination rules for defined contribution plans, is known as cross-testing. Cross-testing essentially allows firms to treat defined contribution plans as defined benefit plans for the purposes of this non-discrimination test (the plans are thus "cross-tested," since they are defined contribution plans but are tested as though they were defined benefit plans). In so doing, cross-testing allows firms to direct a surprisingly large percentage of benefits toward older, higher-income workers.
To understand the basic idea behind cross-testing, consider a firm with one older, high-earning owner and several younger, lower-paid workers. The firm has a defined contribution pension plan that covers the older owner and all of the younger, lower-paid workers. Under an option that can be used to test the compliance of the firm's pension plan with the non-discrimination rules, the amounts contributed on behalf of the younger employees as a percentage of their incomes are compared to the amount contributed on behalf of the older owner as a percentage of his or her income. Under this method, if the contribution rate for the owner (i.e., the contributions made on behalf of the owner measured as a percentage of his or her income) is not too much higher than the average contribution rate for the younger employees, the plan would pass the non-discrimination test.(1) If, for example, the contribution rate for the older owner equals 10 percent of pay, the plan would pass the non-discrimination test if the average contribution rate for the younger workers is at least 7 percent.(2) This method allows some skewing of benefits to the owner. The firm also could skew benefits to the owner by taking advantage of the Social Security integration (or "permitted disparity") rules, which allow a higher contribution rate for earnings above the maximum Social Security taxable earnings level ($76,200 in 2000) than below it without violating the non-discrimination rules.(3)
Even without cross-testing, the non-discrimination rules thus allow disproportionate contributions for the high-income owner. Under cross-testing, the firm can skew pension contributions significantly further. Cross-testing allows the defined contribution plan to be tested in terms of the hypothetical retirement benefits projected for each worker ( the general non-discrimination test for defined benefit plans) rather than the amount of the actual contribution made on behalf of each worker (the general non-discrimination test for defined contribution plans). The longer the number of years before retirement during which any given contribution earns interest (and benefits from the power of compound interest), the higher the hypothetical retirement benefit from the given contribution would be.
Since younger workers have more years until retirement than older workers, $1 put into the account of a younger worker produces a larger hypothetical retirement benefit than $1 put into the account of an older worker. Therefore, if the testing is done on the basis of the hypothetical retirement benefits that ultimately can be paid from the contributions, rather on the basis of the actual contributions themselves, the contributions the employer makes on behalf of the younger workers can be substantially lower than the contributions the employer makes on behalf of the older workers. For example, if the firm applies a projected return of 8.5 percent per year to compute hypothetical retirement benefits, and if the owner is 60 years old while the younger workers are all 21 years old, the contribution rate for the 60-year old owner can be 20 or more times larger than the average contribution rate for 21-year-old workers without causing the employer to fail the meet the non-discrimination test.(4)
The first generation of cross-tested plans used the relationship between age and projected retirement benefits to skew contributions toward older owners. But the pension industry has recently created new versions of cross-tested plans that allow even more skewing toward high-income workers. These plans, called "new comparability" plans, provide higher benefits only to specific favored older employees (e.g., older owners), while providing much smaller benefits to other older employees.(5) One pension firm, whose web site claims that it pioneered the new comparability approach, advertises that the "plan design allows contributions up to $30,000 for senior executives without raising the contribution for the other employees. In fact, it may be possible to dramatically reduce the contributions for the other employees. We call this plan design 'New Comparability'."(6) Similarly, an article in Physician's News Digest noted that, "When used aggressively, new comparability cross-testing enables physicians to maximize their retirement plan contributions while at the same time reducing the total contribution for the year."(7)
Age |
Compensation |
Contributions equal to 15% of pay |
Integrated with Social Security ("permitted disparity") |
First-generation cross-tested plan |
New comparability plan |
|
Owners |
||||||
55 |
$150,000 |
$22,500 |
$23,993 |
$29,420 |
$30,000 |
|
50 |
$150,000 |
$22,500 |
$23,993 |
$19,566 |
$30,000 |
|
Workers |
||||||
60 |
$40,000 |
$6,000 |
$5,276 |
$11,797 |
$1,200 |
|
50 |
$35,000 |
$5,250 |
$4,617 |
$4,565 |
$1,050 |
|
45 |
$30,000 |
$4,500 |
$3,957 |
$2,602 |
$900 |
|
25 |
$25,000 |
$3,750 |
$3,298 |
$750* |
$750* |
|
21 |
$20,000 |
$3,000 |
$2,638 |
$600* |
$600* |
|
21 |
$15,000 |
$2,250 |
$1,979 |
$450* |
$450* |
|
TOTAL |
$465,000 |
$69,750 |
$69,750 |
$69,750 |
$64,950 |
|
Owners |
$300,000 |
$45,000 |
$47,985 |
$48,986 |
$60,000 |
|
Workers |
$165,000 |
$24,750 |
$21,765 |
$20,764 |
$4,950 |
|
Owners’ % of total |
65% |
65% |
69% |
70% |
92% |
|
| * Reflects 3 percent mandatory contribution for top-heavy plans. | ||||||
Under the first generation of cross-tested plans, all older employees would benefit from the tilting of contributions toward older workers, while a younger owner would get little from the cross-tested pension plan. Under a new comparability plan, the firm can make relatively large contributions on behalf of an older owner and a younger owner, while making relatively small contributions to all other workers (both older and younger). Under these plans, the contributions made on behalf of owners or other highly compensated employees often can account for 90 percent or more of the total pension contributions the firm makes. Fundamentally, the new comparability plans "carve out" older non-owners from the most lucrative components of the plan, and "carve in" younger owners into more attractive pension arrangements.(8)
The table above offers an illustrative example of how the new approaches can tilt benefits toward favored owners. The firm has two co-owners and six workers. The owners are aged 50 and 55, and the workers range in age from 21 to 60. The third column in the table shows the compensation earned by each person in the firm: The owners earn $150,000 each, and the workers earn between $15,000 (for one of the 21-year-old workers) and $40,000 (for the 60-year-old worker). The table shows the pension contributions made on behalf of each person in the firm under different pension arrangements:
- Defined contribution plan with contributions equal to 15 percent of pay: Under the simplest defined contribution plan, each worker receives 15 percent of pay in his or her pension. As shown in the fourth column of the table, total pension payments amount to $69,750, and the owners receive 65 percent of that amount. This pension plan is the simplest to understand: each worker receives a contribution equal to 15 percent of pay.
- Integrated with Social Security: The next column shows one way in which the owners can tilt more of the contributions to themselves while keeping the total contribution amount the same. Even if the pension plan is tested on the basis of contributions, the owners can capture more of the contributions by taking advantage of various ways in which the non-discrimination tests are relaxed. The fifth column shows the results when the firm takes advantage of the Social Security integration rules by contributing a higher percentage of pay above the maximum taxable Social Security earnings level ($76,200). Since the owners are the only ones in the firm with earnings above that level, they enjoy higher contribution rates than the rest of the firm, raising the percentage of contributions that accrue to the owners to 69 percent. By design, the total contributions to the pension plan remain $69,750.
- First-generation cross-tested: The next column of the table shows the results for a cross-tested plan of the first generation, under which the plan's hypothetical retirement benefits rather than actual contributions are examined for non-discrimination testing purposes. Since the two owners are older than the average worker, this approach allows the owners to tilt the benefits further in their direction. Under this traditional cross-tested plan, the owners are able to capture 70 percent of the total contributions while still enjoying the tax advantages enjoyed by qualified pension plans. Note, however, that the 50-year-old owner receives a lower pension contribution than the 55-year-old owner and that the 60-year-old worker receives a relatively large contribution. Total contributions remain $69,750.
- New comparability: The final column of the table shows the results for the new comparability plan. The owners of the firm enjoy an astonishing 92 percent of the contributions under this plan, yet it still qualifies for the substantial tax advantages provided by pension law. Note that relative to the traditional cross-tested plan, the firm has dramatically boosted the contribution for the 50-year-old owner and dramatically reduced the contribution for the 60-year-old worker. Also note that the firm's total contributions have declined, despite the increase in contributions made on behalf of the owners: The total contributions are now $64,950, because the contributions made on behalf of workers are now only one-quarter (or less) of their level under the other plans.
It also is worth noting that the contributions made on behalf of lower-income workers in any of these plans may not ultimately benefit some of those workers. Under current law, if a worker leaves a firm before the pension contribution has vested, the worker is not entitled to any benefit from that contribution.(9) Any such contributions that do not ultimately vest with the low-income worker, however, are still counted for non-discrimination purposes when made.
Cross-Testing and the Dangers of Proposed Pension Reforms
Pension actuaries and consultants have been promoting new comparability plans to company owners and partners as the most effective means of distributing benefits to highly paid employees while still meeting the non-discrimination rules. As a result, pension professionals believe that new comparability plans are spreading.(10)
The spread of cross-tested plans increases the dangers from two sets of pension changes being debated on Capitol Hill.(11) One set of proposed pension legislation would raise the amounts that can be contributed to defined contribution plans on behalf of higher-income workers. Under current law, the combined employer-employee contributions to 401(k)s and other defined contribution pension plans may not exceed $30,000, or 25 percent of pay, whichever is lower. In addition, under current law, tax-favored pension benefits are based on compensation up to a maximum compensation level of $170,000. The maximum considered compensation limit, and the limits on defined contribution amounts, are often the only limiting factors on contributions for older owners and partners under new comparability plans. Bills such as the Portman-Cardin legislation, the Graham-Grassley legislation, the bankruptcy bill the Senate recently approved, and last year's vetoed tax bill would raise the maximum compensation level. Many reform bills also would increase the combined employer-employee contribution limit and eliminate the requirement that such contributions not exceed 25 percent of pay.
Another set of proposed changes would relax the so-called top-heavy protections. These protections apply to pension plans that, while meeting the nondiscrimination rules, nonetheless deliver 60 percent or more of their benefits to a few key employees who control the firm. Top-heavy plans are required to take additional steps to protect middle- and low-income workers in such circumstances, through accelerated vesting and certain minimum contributions or benefits. The top-heavy protections are often important in the cross-testing context, since cross-tested plans are designed to pass the non-discrimination tests while still delivering disproportionate benefits to owners and partners. The top-heavy rules are thus a critical line of protection for lower-income workers in firms with cross-tested plans. Yet proposed pension legislation such as the Portman-Cardin and Graham-Grassley bills introduced last year, the vetoed tax bill, and the Senate bankruptcy bill would relax the top-heavy safeguards.
As explained in other analyses the Center on Budget and Policy Priorities has published,(12) these proposed changes not only would disproportionately benefit high-income executives but also could endanger pension security for some lower-income workers. These changes are particularly dangerous in the context of new comparability plans, which already allow substantial tilting toward higher-income workers. As noted, the degree to which the benefits can be skewed toward high-income executives often is limited only by the top-heavy rules and the limits on contributions and maximum considered compensation. If those limits were increased and the top-heavy rules eased, employers could use cross-tested and new comparability plans to devote an even larger share of pension contributions to higher-income executives while still enjoying the tax benefits the pension laws provide.
To see how the proposed changes could further skew contributions toward high-income owners, and even endanger pensions for lower-income workers, consider again the hypothetical firm explored above. We consider two of the proposed changes in the bills mentioned above: Increasing the combined employer-employee contribution limit from $30,000 to $40,000, and relaxing the top heavy rules by excluding family members who are not officers or owners of the firm from the definition of a "key employee" for the purposes of determining whether a plan is top heavy.
- New comparability plan under current law: The third column in the table below shows the new comparability plan under current law.
- Maximum contribution = $40,000: The next column shows the impact on the new comparability plan of raising the maximum combined employer-employee contribution from $30,000 to $40,000. The first effect of the higher limit is to allow high-income owners to raise their pension contributions. In the example below, the contributions for both owners increases from $30,000 to $34,590. Advocates of high contribution limits argue that in many cases, the non-discrimination rules would require any such increase in contributions for high-income owners to be matched by higher contributions for lower-income workers.(13) The example highlights why the non-discrimination rules often do not require such higher contributions for lower-income workers, especially in the context of new comparability plans. In this example, the contributions made on behalf of lower-income workers do not increase at all. Yet the firm still meets the non-discrimination test despite the higher contributions for the owners. In other words, the entire increase in total contributions accrues to the high-income owners, who already were receiving 92 percent of the pension contributions. The change in the maximum contribution limit allows the owners to accumulate almost $5,000 more in tax-favored pension saving, and raises their share of total contributions to 93 percent.
- Top-heavy protections relaxed. The final column shows the impact of relaxing the top-heavy protections as proposed in several legislative packages, including the bankruptcy bill the Senate has approved. Assume the two owners are spouses. The proposed changes would allow the firm to avoid the top-heavy protections simply by having one spouse shift ownership to the other spouse (while both still receive $150,000 in compensation). The hypothetical plan would then no longer be top-heavy, as it is in all the other examples in the tables. The firm could reduce the contributions made for all other employees by 13 percent (from $4,950 to $4,300), while maintaining the $30,000 contributions for both spouses. In other words, the proposed change would not only further skew the contributions toward the high-income couple, but also reduce pension contributions for the other workers.
Treasury/IRS Review of New Comparability Plans
On February 24, the Treasury Department and the Internal Revenue Service issued a notice that they were initiating a review of new comparability plans. The notice suggests that new comparability plans may be incompatible with the intent of the non-discrimination rules, noting that "new comparability plans...are defined contribution plans that generally reflect higher rates of employer contributions to highly compensated employees...the Service and Treasury are concerned whether cross-tested plan designs that provide for built-in disparities between highly compensated and nonhighly compensated employees can be reconciled with the basic purpose of the nondiscrimination rules as applied to defined contribution plans." The notice also states that "when a sponsor replaces its existing defined contribution plan with a new comparability plan, rank-and-file workers may suffer significant reductions in their allocation rates, while owners and executives may benefit from a significant increase in their allocation rates."
Age |
Compensation |
New comparability plan under current law |
New comparability plan if maximum contribution=$40,000 |
New comparability plan if top-heavy protections relaxed |
|
Owners |
|||||
55 |
$150,000 |
$30,000 |
$34,590 |
$30,000 |
|
50 |
$150,000 |
$30,000 |
$34,590 |
$30,000 |
|
Workers |
|||||
60 |
$40,000 |
$1,200 |
$1,200 |
$1,041 |
|
50 |
$35,000 |
$1,050 |
$1,050 |
$911 |
|
45 |
$30,000 |
$900 |
$900 |
$781 |
|
25 |
$25,000 |
$750* |
$750 |
$650 |
|
21 |
$20,000 |
$600* |
$600 |
$520 |
|
21 |
$15,000 |
$450* |
$450 |
$390 |
|
TOTAL |
$465,000 |
$64,950 |
$74,131 |
$64,293 |
|
Owners |
$300,000 |
$60,000 |
$69,181 |
$60,000 |
|
Workers |
$165,000 |
$4,950 |
$4,950 |
$4,293 |
|
Owners’ % of total |
65% |
92% |
93% |
93% |
|
| * Reflects 3 percent mandatory contribution for top-heavy plans. | |||||
The Treasury and IRS notice invites public comments on a policy proposal that would curtail new comparability plans, while still allowing simple cross-tested plans. In particular, the proposal would require that if cross-testing were used to demonstrate compliance with the non-discrimination tests, only a single contribution rate, as adjusted for age, could be used. New comparability plans require more than one such rate and typically use two different contribution rates.
Conclusion
Cross-tested plans carry significant negative ramifications for rank-and-file workers. The "new comparability plan" version of such cross-tested plans is a particularly worrisome development for those concerned about the distribution of pension tax benefits. The rapid growth of new comparability plans will be even more dangerous if proposed pension reforms are adopted that weaken the top-heavy rules and raise the contribution and maximum considered compensation limits.
The Treasury Department's recent willingness to explore methods of curtailing the use of new comparability plans is a welcome development. But an even more aggressive policy stance, which would include the curtailment of cross-tested plans in addition to new comparability plans, may be warranted.
End notes:
1. In general, firms can meet the non-discrimination tests for either a defined benefit or defined contribution plan in two potential ways: the ratio percentage test or the average benefits test. Under the ratio percentage test, the percentage of non-highly compensated employees (NHCEs) benefitting from the plan at or above a particular rate of benefit accrual (in the case of a defined benefit plan) or rate of contribution (in the case of a defined contribution plan) is compared to the percentage of highly compensated employees (HCEs) benefitting at or above the same rate. The percentage of NHCEs benefitting at or above the particular rate may be no less than 70 percent of the percentage of HCEs benefitting at or above that rate. If a plan does not meet this ratio percentage test, it would have to meet the average benefits test. Under the average benefits test, the firm must meet a nondiscriminatory classification test and provide an average benefit percentage for the NHCEs that is at least 70 percent of the average benefit percentage for the HCEs. Under a defined benefit plan, the average benefit percentage is based on the benefit provided at retirement. Under a defined contribution plan, the average benefit percentage is based on contributions relative to current compensation. The non-discriminatory classification test (one of the two prongs of the average benefits test) generally consists of a specialized ratio percentage test that is geared to the share of NHCEs and HCEs in the firm, and is substantially easier to meet than the 70 percent ratio percentage test itself.
2. We assume that the firm in this case meets the nondiscriminatory classification test under the average benefits test because a sufficient number of the younger workers benefit from a contribution rate equal to the owner's contribution rate (even though the average contribution rate for all the younger workers is only 70 percent of the contribution rate for the older worker).
3. The maximum permitted disparity between the contribution rate above the Social Security maximum taxable earnings and below it is 5.7 percentage points. In other words, a firm can contribute 10 percent of pay to the defined contribution plan for earnings below $76,200, plus 15.7 percent of pay for any earnings above $76,200, and not violate the non-discrimination rules.
4. For example, assume the contribution rate on behalf of all the younger 21-year-old workers is 1 percent (i.e., the contribution is equal to 1 percent of compensation for each worker). Given 8.5 percent annual growth over the 44 years between age 21 and age 65, each worker's account balance from that contribution would grow to 36.2 percent of current compensation. Since the projected retirement benefits are directly proportional to this accumulated balance, the older owner can therefore receive a contribution that would grow to 36.2 percent of current compensation. A current contribution of 24.1 percent of compensation would accumulate to 36.2 percent after five years. Therefore, the contribution rate for the owner could be as high as 24.1 percent of current compensation while the younger worker received pension contributions equal to only one percent of compensation. Note that the owner could contribute an even higher percentage of compensation if the non-discriminatory classification test were met at the owner's higher contribution rate. In that case, the owner could contribute as much as 34.4 percent of compensation to the plan even though the average contribution rate for the younger workers was only one percent of compensation.
5. The terminology used to describe these plans is sometimes confusing: Some pension experts refer to the first generation of cross-tested plans as "age-weighted" and refer to "new comparability" plans as "cross-tested." A related innovation to the "new comparability" plan is the super-integrated plan, which substantially skews benefits to high-income owners by providing a substantially higher contribution rate above a very high compensation threshold than below it.
6. Web site of Louis Kravitz and Associates, Inc.
7. Joseph Nicola, "Reconfiguring your practice's pension plan," Physician's News Digest, February 1999.
8. Technically, the new comparability plans typically create two contribution rates for different types of workers. The contribution rates are arranged to produce higher allocations for the owners and lower allocations for any older workers. Each contribution rate is then subjected to non-discrimination testing. The "trick" of the new comparability plan is to design the system such that each contribution rate satisfies the non-discrimination tests (thereby ensuring that the plan as a whole meets the non-discrimination tests) while maximizing the allocation for the owners and minimizing the allocation for the workers.
9. Employers are currently required to vest benefits under one of two schedules: cliff vesting or graded vesting. Under cliff vesting, the employer is allowed to vest nothing until the worker achieves 5 years of service. Under graded vesting, the employer must vest 20 percent for each year of service beginning in the third year and ending with the seventh. In other words, under graded vesting, the vested percentage of a worker's benefit is zero for years 1-2, 20 percent for year 3, 40 percent for year 4, 60 percent for year 5, 80 percent for year 6, and 100 percent for year 7 onward.
10. An informal survey of Internet sites turned up scores of pension specialists actively marketing new comparability plans to doctors and other professionals with small businesses.
11. For a discussion of the problems associated with these proposed changes, see Peter R. Orszag, Iris Lav, and Robert Greenstein, "Exacerbating Inequities in Pension Benefits: An Analysis of the Pension Provisions in the Tax Bill," October 8, 1999, and Peter R. Orszag, Iris Lav, and Robert Greenstein, "Criticism of CBPP Pension Analysis Rests on Selective Use of Data And Leaves Misleading Impressions," October 28, 1999.
12. Orszag, Lav, and Greenstein, op. cit.
13. For example, the Association of Private Pensions and Welfare Plans argues that "In order for highly paid employees to take advantage of the higher limits and still pass the non-discrimination tests, many companies will have to provide greater benefits to all other workers." See Association of Private Pensions and Welfare Plans, Legislative Action bulletin, October 19, 1999.