As the national economy
continues its recovery, more and more businesses are beginning to
see their financial situations improve to near pre-recession levels.
Companies that have not thought about making profit sharing
contributions for years are starting to consider their options.
Just as the economy as a whole or the circumstances of a
particular company change over time, companies should review their
retirement plans to make sure the design changes with them.
Companies that find themselves on solid footing may find
themselves thinking of making employer contributions to their
retirement plans. Whether the goal is to maximize benefits to the
owners, reward employees, reduce tax liability or some combination
of all of these, the cross-tested plan design is one worth
Although there are a number of ways a company may choose to
divide a profit sharing contribution among the employees, there are
three methods that are commonly used.
Salary Proportional (a/k/a Pro Rata):
This method divides the contribution based on the proportion that
each individual participant's compensation bears to the total
compensation of all eligible participants. It results in each person
receiving a uniform percentage of his or her pay.
Integrated (a/k/a Permitted Disparity):
This method considers that employees whose pay exceeds the taxable
wage base do not receive social security benefits on their total
compensation and allows those people to receive a larger profit
sharing contribution to help equalize the benefit.
Cross-Tested (a/k/a New Comparability):
This method allows employees to be divided into groups based on
valid business classifications, i.e., owners and employees, and
provides different levels of contribution to each group.
The first two methods are relatively straightforward and are
considered to be "safe harbor" allocation methods, meaning that they
automatically satisfy certain nondiscrimination requirements.
However, with ease and safe harbor status often comes limited
The cross-tested method, on the other hand, provides a great deal
of flexibility but also comes with a few more rules to follow and
must undergo additional testing to ensure it complies with the
nondiscrimination rules. For companies that are willing to accept a
little more complexity, new comparability plans can be used to meet
a number of business goals.
The General Concept
Cross-tested designs generally rely on the time value of money to
allow companies to maximize benefits to the owners who may have
spent the earlier parts of their careers reinvesting everything into
growing the business. Since they are closer to retirement, it takes
a larger contribution to fund an equivalent benefit than it does for
someone who is just entering the workforce.
A simple example may help to illustrate. A company has two
participants in its plan—the owner (age 55) and an employee (age
35)—and it wants to provide a retirement benefit of $100,000 to each
one at age 65. Assuming there are no investment gains, the owner
would need a contribution of $10,000 per year for 10 years to reach
the target benefit, while an annual contribution of $3,333 would get
the employee to the goal.
Once you factor in an assumed interest rate, the spread gets even
greater. The actual calculations and tests are much more involved,
but this is the general concept.
Unlike a defined benefit plan in which the company would have to
commit to making those contributions each and every year, in a
cross-tested profit sharing plan, the company has the discretion to
contribute more or less or nothing at all each year.
The Ground Rules
There are several additional rules that apply to cross-tested
As noted above, the plan must define the employee groups that are
used to allocate contributions. In the early days of this design,
many plans would specify groups based on company ownership, officer
status, division, office location, etc. Some often-seen combinations
were owners and employees; partners, associates and non-lawyers;
doctors, nurses and staff; etc.
More recently it has become common for plans to specify that each
participant makes up his or her own group, providing maximum
flexibility in making contributions. While a law firm could still
decide to contribute the same amount for all non-lawyers, it could
decide to contribute more or less for certain employees as long as
all of the other testing requirements are met.
To ensure that rank-and-file employees receive enough of a
benefit relative to the highly compensated employees or HCEs
(generally the owners and those earning more than $115,000 per
year), the company must provide a minimum gateway contribution to
the non-HCEs. This is kind of like the cover charge to get into the
cross-testing club. In other words, it does not guarantee the plan
will pass the other nondiscrimination tests.
The amount of the gateway contribution is the lower of 5% of
compensation or one-third of the highest percentage allocated to any
HCE. For example, if the highest HCE allocation is 9% of pay, the
gateway contribution to the non-HCEs is 3%. Once the highest HCE
contribution reaches 15%, however, the gateway is capped at 5%.
For 401(k) plans that make a flat 3% of pay contribution to meet
the safe harbor rules, that safe harbor contribution actually counts
toward the gateway requirement if the company also decides to make a
cross-tested profit sharing contribution. In other words, assuming
all other tests are met, it may be possible for the sponsor of a
safe harbor 401(k) plan to contribute an additional 6% of pay on
behalf of the owners (bringing the total to 9%) without having to
contribute anything more for the employees.
Average Benefits Test
This is another nondiscrimination test the plan must pass.
Essentially, all of the contributions made on behalf of each
employee (in some cases, including 401(k) deferrals) are added
together and converted to a benefit at the plan's retirement age
using several factors taken from IRS tables. The average benefit of
the non-HCEs is then compared to the average benefit of the HCEs to
make sure they are within the appropriate range of each other.
Some plans will pass the test giving only the gateway
contribution to the employees and providing the maximum to the
owners. Other plans will need to provide additional contributions to
some or all of their non-HCE participants in order to increase the
average benefit to a passing level.
Since this test is based on the demographics of the workforce,
the results are likely to change each year depending on the degree
to which the demographic composition fluctuates. Using a small
medical practice as an example, the addition of a new physician who
is much younger than the other doctors and maybe some of the
longer-term staff could cause a plan that was once passing with ease
Another common cause for extreme demographic shifts is when the
child of an owner comes to work for the company. Since children are
generally attributed their parent's ownership, they will be
considered HCEs even though their actual pay might be very low.
Companies anticipating such changes should speak to their TPAs ahead
of time to determine the impact to the average benefits test and
consider any design modifications that might avoid a problem.
Practical Uses for Cross-Testing
We have already discussed using this design as a means of
maximizing the benefits for owners or certain key individuals;
however, there are other situations when cross-testing can come in
With the improving economy, some companies are also beginning to
pay employee bonuses again. But, along with the cost of the bonus
itself comes additional payroll taxes. By using a cross-tested plan
design, a company could make individualized profit sharing
contributions to certain employees without incurring the cost of the
Not only does this option eliminate the extra payroll cost, it
also helps to address increasing concerns of employee retirement
readiness that are becoming more prevalent among companies.
Recognizing that a bonus is meant to be a reward, and many employees
appreciate cash in hand more than a contribution, some companies
will split the "bonus" amount, contributing half to the plan and
paying out the other half in cash.
Reimbursing Surrender Charges or Market
From time-to-time when a company removes certain investment
options from the menu, that change can trigger a surrender charge to
all those invested in the option being eliminated. This most often
occurs in conjunction with a change in service providers. Some
companies facing this situation do not want their participants to be
harmed as a result of the change and would like to "reimburse" them
by contributing to the plan.
The challenge is that these types of charges are usually assessed
proportionately based on account balance; however, the money the
company deposits as a reimbursement must be allocated as a
contribution. Plans that provide for pro rata or integrated
allocations would have to allocate the reimbursement accordingly. By
amending the plan to provide for a cross-tested allocation with each
participant in his or her group, the company could target the
contribution to those impacted by the surrender charge.
It might not be possible to make everyone whole, but this option
can sometimes get very close. For example, to the extent any HCEs
share in the allocation, it could trigger the gateway requirement
for all non-HCEs (including those not affected), so it may be
necessary to find another way to compensate HCEs. In addition, some
people who share in the surrender charge will be former employees,
and contributions can only be allocated to those who are
participants during the year of the contribution. While not a
perfect solution, it can be a step in the right direction.
A well-designed cross-tested plan can be a very effective tool
for satisfying a variety of company objectives, but it also comes
with a few more moving parts. As a result, it is even more important
to work with a knowledgeable TPA or consultant who will ask the
right questions to understand your goals and design a plan tailored
to meet them.