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"Back-to-Basics" Coverage Testing - Part One
April 29, 2004
     

An employer must perform coverage testing to demonstrate that its plan benefits a fair cross-section of employees. Because of the many facets involved, we're beginning a series on coverage testing. Our first installment describes which employees are included in the testing and which are not. It also explains the fundamentals of the ratio percentage test.

What is Coverage Testing?
The coverage testing requirements provide assurance that a qualified retirement plan is providing benefits to a significant percentage of a company's nonhighly compensated employees (NHCEs). The favorable tax treatment given to qualified retirement plans results in the Federal government foregoing a considerable amount of immediate tax revenue. In return for this favorable treatment, Congress imposes the obligation that retirement plan benefits are provided to a large portion of the company's NHCEs.

The coverage tests were developed to measure the ratio of NHCEs to HCEs benefiting under the plan. An individual is considered to be benefiting under the plan if the individual receives a contribution or accrues a benefit from the retirement plan, or, in the case of a 401(k) plan, is eligible to make elective deferrals. The coverage requirements may be tested on a daily, quarterly or annual basis. (Overall elective deferral and matching contribution percentage testing must be performed on an annual basis.) The principal coverage test is the “ratio-percentage test.” The “magic” number to remember with the ratio-percentage test is 70%. The ratio test is passed if 70% of the nonexcludable NHCEs receive benefits. For plans that do not pass this test, Congress has provided an alternative coverage test known as the average benefits test (ABT). However, because of the level of expertise required to perform it, the ABT is extremely complex to understand, time consuming, and may result in considerable expense for the employer and the plan. This article will focus on the ratio percentage test.

Who Must Be Considered for the Coverage Test?
For purposes of the coverage requirements, all employees of the employer must be considered, including leased employees and those employed by controlled groups and, generally, affiliated service groups.

Which Employees May Be Excluded From the Coverage Test by Treas. Regulation §1.410(b)-6?

     
  1.

Employees who have not met the statutory age (21) or service requirements (1 year of service based on 1,000 hours in a 12-month period).

Note: Plans that permit earlier entry are permitted to test affected employees separately. Specifically, the plan would test the “otherwise excludable group” that is those under age 21 and those with less than 1 year of service as a separate testing group.
  2. Terminated participants who have completed less than 500 hours of service.
  3. Employees who are members of a collective bargaining unit if retirement benefits have been the subject of good faith bargaining.
  4. Nonresident aliens with no U.S. source of income.
  5. Employees of an employer which is part of the controlled group but which is considered a separate line of business.
     

May a Classification of Employees Be Excluded?
Keep in mind that other employees may be excluded in a nonstandardized prototype, volume submitter or custom designed plan, provided that the exclusion is not discriminatory and provided the plan can pass coverage by including the excluded class in the test. The typical method of excluding employees is by job category, geographic location or employee designation as an hourly or salaried employee.

The 70% Ratio Percentage Test Requires Several Steps

  1. Step one: Separate all excluded employees from the eligible employees. This requires identifying those employees who are eligible to participate in the plan and who are benefiting (as defined above) from employees who may be excluded pursuant to the regulation outlined above.
  2. Step two: Divide the eligible employees into two groups: the HCEs and the NHCEs.
  3. Step three: Divide the number of NHCEs benefiting in the plan by the total number of all nonexcludable NHCEs.
  4. Step Four: Divide the number of HCEs benefiting in the plan by the total number of all nonexcludable HCEs.
  5. Step Five: Divide the NHCE percentage in 3. above by the HCE percentage in 4. above. If the answer is 70% or greater, the coverage test is passed. If the percentage is less than 70%, it fails.
     

Examples of the Ratio Percentage Test
Assume that a medical employer has 13 employees [3 doctors (HCEs) and 10 NHCEs]. If all 3 doctors were benefiting, the HCE ratio would be 100%. If all 10 NHCEs were benefiting, the NHCE percentage would be 100%. The ratio of 100% over 100% would be 100%. This is a passing result.

Using the same example, if 3 NHCEs did not benefit because these three did not meet the plan's requirement for an allocation (for example: not employed on the last day of the plan year or were not credited with the 1,000 hours required to receive an allocation), then the NHCEs' percentage would be 70%, which, if divided by the 100% rate of the HCEs, would still pass the coverage test.

However, if only 6 NHCEs received an allocation because the other four NHCEs failed to satisfy the allocation requirements, then the test would fail, because the NHCE/HCE ratio percentage would be 60% (60% NHCE divided by the HCE 100%).

If only 2 doctors benefited, then the HCE ratio would be 66.7% (2/3); 70% of that would be 46.7%, so that the minimum number of NHCEs that would need to benefit under the plan would be 5. In this example, when the NHCEs' 50% benefiting percentage is divided by the HCEs' 66.7% benefiting percentage, the ratio percentage equals 75%, which allows the plan to pass.

Will Certain Plan Designs Automatically Pass Coverage?
Yes. Examples of such plan designs include:
  1. Plans that do not benefit any NHCEs.
  2. Plans that do not benefit any HCEs.
  3. Plans that benefit collectively bargained employees only.
  4. Plans that do not accrue a benefit for any participant for a plan year, (i.e., such as, a discretionary profit sharing plan with no contribution for a specific year.).
  5. Plans that are established under the terms of a standardized prototype plan.
     

What if the plan does not pass?
Generally, the plan document may have provisions to use the alternative coverage test called the average benefits test or the document will provide a method of providing enough additional employees with a benefit so that the plan passes coverage.

There are many other complicated issues involved in performing coverage testing. These include such matters as how HCEs are defined, the definition and role of leased employees, and the aggregation and disaggregation of plans, to name a few. We will address more of these coverage-related topics in our next article.
     
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