Commentary MCHO Home Page

Coverage Testing — Average Benefits Test
May 28, 2004,
Cross-testing ABPT Added on July 23, 2004
     
INTRODUCTION

Part two of our series on coverage testing deals with the average benefits test (ABT). If a plan fails the ratio percentage test, then the ABT may be performed. If the plan passes the ABT test, then it satisfies coverage testing.

If a plan fails to pass coverage testing using the ratio percentage test, there is an alternative test, the average benefits test, which may be used to satisfy coverage testing. A plan only has to pass one of the coverage tests each year. The coverage test being used can change from year-to-year. This is not a document issue but rather an administrative testing issue.

A plan may call for the correction of the ratio percentage test and preclude the use of the average benefits test. Those using our plan document may use the average benefits test.

Typically, the ratio percentage test is done first as it is administratively much easier to perform. If the plan fails the ratio percentage test, the employer can either take steps to pass the ratio percentage test by providing a benefit to enough individuals in order to pass the ratio test or the employer may perform the average benefits test to see if the coverage requirement can be passed using that test.

The average benefits test is actually two tests, the nondiscriminatory classification test and the average benefits percentage test. Both parts of the average benefit test must be passed in order to satisfy coverage testing.

This article is an overview of the average benefits testing process and is not intended to be an all-inclusive treatise on the subject.

A word of caution for those who have never seen the average benefits test before. It is more than the usual test in complexity.

 
 
PART ONE — THE NONDISCRIMINATORY CLASSIFICATION TEST  Regs §1.410(b)-4(b)

To pass the nondiscriminatory classification test, two requirements must be met.

1. The reasonable classification requirement
To be deemed reasonable, the classification first must be established under objective business criteria that identify a category of employees who benefit under the plan.

Bona fide business criteria include classifications based on:

  • geographic location
  • job description or job categories
  • nature of compensation, such as hourly or salaried

 
Unacceptable criteria include a classification of employees based on:
  • part-time employment
  • Though other professionals may disagree, we, at MHCO, take the position that enumeration by name is generally not considered reasonable.
     

2. The nondiscriminatory classification requirement
This mathematical portion of the test utilizes a coverage ratio which will be described below. Whether the test result passes or not is determined by looking at the IRS Table of safe harbor and unsafe harbor percentages. To pass the percentage of NHCEs who are benefiting under the plan result must be either:

  • At least equal to the safe-harbor percentage; OR
  • The percentage exceeds the unsafe-harbor percentage (in table below). If in the range between safe and unsafe harbor percentages, the plan must pass a facts-and-circumstances test (described below).
     

Definitions
The following two definitions are needed in order to understand the explanation of how the test is performed.

  Nonexcludable employees. Generally, all employees who are not excluded from the coverage test by law. All nonexcludable employees are used in this test. The statutory exceptions are:
  • Employees who have not met the plan's minimum age requirement.
  • Employees who have not met the plan's service requirement.
  • Employees covered by a collective bargaining agreement who negotiated for retirement benefits as part of the collective bargaining process.
  • Nonresident aliens with no US source income.
     
  NHCE concentration percentage. The ratio of nonexcludable NHCEs (numerator) over the total nonexcludable employees of the employer. For example, if an employer had a total of 500 nonexcludable employees of which 400 were NHCEs, the NHCE concentration percentage would be 80% (400/500).
 

NHCE Concentration Percentage = Nonexcludable NHCEs / All Nonexcludable Employees
Overview of Applying the Results of the NHCE Concentration Percentage to the IRS Table
For plans with an NHCE concentration of 0 to 60%:
  a. A plan is in the safe harbor range if the percentage of NHCEs who benefit is at least 50 percent of the percentage of HCEs who benefit.
  b. A plan fails the unsafe harbor if the percentage of NHCEs who benefit is 40 percent or less of the percentage of HCEs who benefit.
  c. A plan whose percentage falls between 50%/40% standards will be subject to a facts-and-circumstances test.
     
For plans with an NHCE over 60%:
  a. Both the safe-and unsafe-harbor percentages are reduced as the NHCEs concentration percentage increases above 60 percent.
  b. Unsafe-harbor percentage is always 10% less than the safe harbor, but never less than 20%.
  c. For every 1% increase in the concentration percentage, the 50% and 40% safe-harbor percentage levels decrease by .75%.
  For example, if the employer's NHCE concentration percentage is 75%, then a plan benefiting 40% of the NHCEs is nonetheless in the safe harbor range (which is above 38.75%).
     
To recap: The safe and unsafe harbor percentages are shown in the table below. To select the safe and unsafe harbor percentages, first compute the NHCE concentration percentage by dividing the number of NHCEs by the total number of employees. These numbers are calculated after disregarding nonexcludable employees such as those who have not met the plan's eligibility requirements.
     
Safe Harbor and Unsafe Harbor Percentages Table

NHCE Concentration Percentage

Safe Harbor Percentage

Unsafe Harbor Percentage

NHCE Concentration Percentage

Safe Harbor Percentage

Unsafe Harbor Percentage

0-60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79

50.00
49.25
48.50
47.75
47.00
46.25
45.50
44.75
44.00
43.25
42.50
41.75
41.00
40.25
39.50
38.75
38.00
37.25
36.50
35.75

40.00
39.25
38.50
37.75
37.00
36.25
35.50
34.75
34.00
33.25
32.50
31.75
31.00
30.25
29.50
28.75
28.00
27.25
26.50
25.75

80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
96
97
98
99

35.00
34.25
33.50
32.75
32.00
31.25
30.50
29.75
29.00
28.25
27.50
26.75
26.00
25.25
24.50
23.75
23.00
22.25
21.50
20.75

25.00
24.25
23.50
22.75
22.00
21.25
20.50
20.00
20.00
20.00
20.00
20.00
20.00
20.00
20.00
20.00
20.00
20.00
20.00
20.00

     

Following are two examples to demonstrate the test:
 

Example 1
Joe's Pizza Company has 4 nonexcludable HCEs and 9 nonexcludable NHCEs of which 3 are not benefiting.

The NHCE Concentration Percentage is 9/13 = 69.2%
(Nonexcludable NHCEs/total nonexcludable employees)

The ratio percentage is calculated
6/9 NHCEs benefiting = 66.67% NHCEs
4/4 HCEs benefiting = 100% HCEs

66.67%/100% = 66.67% benefiting

The safe harbor percentage from the table is 43.25; thus, with 66.67% benefiting this portion of the test passes.

Example 2
JW Counseling and Mose Editing, Inc. are a controlled group and maintain one plan. JW participates in the plan while Mose does not. This is acceptable if the controlled group can pass coverage including all companies. The plan does not satisfy the 70% ratio percentage test. Thus, the average benefits test is being utilized. This assumes the plan does not call for the correction of the ratio percentage test.

First Calculate the NHCE Concentration Percentage
   
Nonexcludable
       Employees
JW Consulting
Mose Editing
Total
HCE
40
50
90
NHCE
150
360
510
Total
190
410
600
The NHCE concentration percentage is 510/600 = 85%
(all nonexcludable NHCEs/all nonexcludable employees)
 

According to the IRS Safe Harbor-Unsafe Harbor Table above, the NHCE benefiting safe harbor percentage is 31.25%. Therefore, the percentage of NHCEs benefiting under the plan must be at least 31.25% of the percentage of the HCEs who are benefiting under the plan.

     
  Second Calculate the ratio of benefiting employees
   
Benefiting
       Employees
JW Consulting
Mose Editing
Total
Ratio
HCE
40
0
90
 44.44% (40/90)
NHCE
150
0
510
 29.41% (150/510)
Ratio benefiting = 29.41%/44.44% = 66.18%
     
  Third compare the ratio of benefiting employees to the safe harbor percentage
    The table safe harbor percentage is 31.25% and since this plan has 66.18%, it passes.

FACTS-AND-CIRCUMSTANCES TEST - Regs §1.410(b)-4(c)(3)
A plan that exceeds the safe harbor percentage is deemed to pass. A plan that is below the unsafe harbor percentage is deemed to fail. However, if a plan percentage is between the unsafe harbor and safe harbor percentage, the fact and circumstances test may be run.

A plan that fails to satisfy the safe harbor percentage but meets or exceeds the unsafe harbor percent-age can still satisfy the reasonable classification requirement based on all the relevant facts and circumstances of the case. The factual determination is based on:

  a. the business reason for the classification.
  b. the percentage of all employees eligible by statute who are benefiting under the plan.
  c. the percentage of employees eligible by statute in each salary range who benefit under the plan.
  d. the difference between the plan's ratio percentage and the safe harbor percentage.
  e. the extent to which the plan's average benefit percentage exceeds 70%.
 
 
PART TWO — THE AVERAGE BENEFIT PERCENTAGE TEST  Regs §1.410(b)-5

Once a plan satisfies the nondiscriminatory classification test, it then must satisfy the average benefit percentage (ABPT) test. The ABPT is satisfied if the average benefit percentage (ABP) of the NHCEs is at least 70 percent of the ABP of the HCEs. To perform this test, the employer must determine a benefit percentage for each nonexcludable employee. All qualified plans, including 401(k) plans and ESOPs, must be tested together. The only amounts excluded are after-tax contributions; thus, even elective deferrals are considered part of this test. In summary, the ABPT test is done as follows:

     
  1. The employer determines an annual contribution or accrual rate for each employee covered under the plan. Alternatively, an accrued-to-date method may be used.
  2. The contribution or accrual rate determined in step 1 is divided by the employee's compensation to determine a percentage.
  3. If the plan may use and utilizes permitted disparity, the percentage determined in step 2 may be increased by an amount representing the employer-provided portion of Social Security. This provides a higher rate for those earning lower amounts. The resulting percentage is added to the percentage for plans that cannot use permitted disparity (for example, CODAs and ESOPs), and the result is the benefit percentage for each employee.
  4. The individual benefit percentages are then averaged for both HCEs and NHCEs to determine whether the average benefit percentage for NHCEs is at least 70 percent of the ABP for HCEs.
     
Note: The ABPT may be calculated on a contributions or benefits basis, regardless of the type of plan involved.
     

ABPT Example
Joe's Pizza Company from example 1 above has:
      4 nonexcludable HCEs, all benefiting, and
      9 nonexcludable NHCEs of which 6 were benefiting.*

Calculate the HCE Benefit Percentage

Each HCE Benefit Percentage
(Based on benefit/compensation)

Calculate the NHCE Benefit Percentage

Each NHCE Benefit Percentage
(Based on benefit/compensation)
HCE 1
7.05%
                 NHCE 1
9.32%
HCE 2
6.01%
NHCE 2
8.75%
HCE 3
5.31%
NHCE 3
6.32%
 HCE 4 
4.54%
NHCE 4
5.32%
Total
22.91%
NHCE 5
5.18%
Divided by Number of Nonexcludable HCEs
 22.91% / 4 = 5.72%
NHCE 6
4.87%
HCE benefiting percentage
5.72%
NHCE 7
0%
   
NHCE 8
0%
   
NHCE 9
0%
   
Total
             39.76%
    Divided by Number of nonexcludable NHCEs 39.76%/9 = 4.41%
   
NHCE Benefiting Percentage
4.41%
       
    *NOTE: NHCEs 1-6 are covered by the plan, NHCEs 7 - 9 are not covered but must be included in the test as zeros. 

Calculate the ratio of benefiting NHCEs to benefiting HCEs. This must pass 70%.

          4.41%/5.72% = 77.1%   Thus, Joe's Pizza Company passes both parts of the ABT test.

Future coverage articles will be presented on topics such as aggregation and disaggregation, Qualified Separate Lines of Business, Testing Options and other facets of coverage testing.

     

 

Cross-testing the Allocation to See if the Allocation Passes
Under the Average Benefits Percentage Test
Added July 23, 2004

 

If the allocation fails the average benefits percentage test on a contribution allocation basis, the allocation may be cross-tested to see if the allocation passes on a benefit accrual basis.

The following example plan tested 4 HCEs and 6 NHCEs who are benefiting.

How is the test done?
   
Column 1
Age of Participant
Column 2 Participants compensation.
Column 3 Participant's allocation .
Column 4 The 8.50% rate for this plan is a given in this example.
Column 5 Obtain the “value at normal retirement age” (NRA) by multiplying the current year allocation by the interest factor (columns 3 times column 4).
Column 6 The 8.50% annuity factor in this example under the UP 1984 GAM Table is $7.949.
Column 7 Divide the value at NRA (column 5) by the 8.50% Annuity factor which is 7.949(column 6) to arrive at the normalized benefit.
Column 8 Calculate the equivalent accrual rate by dividing the normalized benefit (column 7) by the compensation (column 2). For example, employee D 3,109.54/37855.14 = 8.21%.
     

Finally, run rate group testing by creating a rate group for each HCE that includes all NHCEs and HCES with an equivalent accrual rate at least equal to or higher than the HCE being tested. (If each rate group has no NHCE with an equivalent accrual rate lower than any HCE, the plan passes.) For example:

  • For the rate group based on HCE F, all the other HCEs have a lesser equivalent accrual rate, and all the equivalent accrual rates of the NHCEs are equal to or above the rate of HCE F. Note that even though NHCE D has the same equivalent accrual rate as HCE F, that does not affect the test negatively. Rate Group for HCE F ¼ HCEs for 25% and 6/6 NHCEs for 100% for a 100%/25% = 400%.
  • For the rate group based on HCE C, only HCE A and B are at a lesser rate then HCE C and all the NHCEs are at a higher rate. Rate Group for HCE C 2/4 HCEs for 50% while there are 6/6 NHCEs for a 100%/50% = 200%.
  • The rate group for both HCE A and B would contain all the employees and none would be below the equivalent accrual rate for HCE A and B of 1.26%. Rate Group for A and B HCEs is 4/4 HCEs = 100% and 6/6 NHCEs = 100% 100%/100% = 100%.
  This test can basically be eye-balled as passing as all the HCEs are at an equivalent accrual rate, that is equal to or less than every NHCE.
     
EQUIVALENT ACCRUAL RATE WORKSHEET
(Measuring Period is the Plan Year)
 
1
2
3
4
5
6
7
8
Emp.
Age
Testing Compensation
10% ctbn Allocation
8.50% Interest Factor

Value @ NRA

8.50% Annuity Factor
Normalized Benefit
Equivalent Accrual Rate
A*
67
200,000.00
20,000.00
1
20,000.00
7.949
2,516.04
1.26%
B*
65
200,000.00
20,000.00
1
20,000.00
7.949
2,516.04
1.26%
C*
62
200,000.00
20,000.00
1.277289
25,545.78
7.949
3,213.71
1.61%
D
42
37,855.14
3,785.51
6.52956
24,717.74
7.949
3,109.54
8.21%
E
40
34,435.32
3,443.53
7.686762
26,469.61
7.949
3,329.93
9.67%
F*
42
91,913.27
9,191.33
6.52956
60,015.32
7.949
7,550.05
8.21%
G
40
86,105.74
8,610.57
7.686762
66,187.43
7.949
8,326.51
9.67%
H
33
44,978.50
4,497.85
13.606663
61,200.73
7.949
7,699.17
17.12%
I
40
44,986.97
4,498.70
7.686762
34,580.41
7.949
4,350.28
9.67%
J
31
49,806.99
4,980.70
16.018103
79,781.35
7.949
10,036.65
20.15%
* HCEs
     
     
Bill Grossman, QPA
May 28, 2004; July 23, 2004
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