No Good Deed Goes Unpunished: Don’t Forget the Compensation Ratio Test

Posted by Maria T. Hurd, CPA

ERISA Limited Scope AuditMost plan sponsors know that their retirement plans are subject to discrimination tests, generally designed to prevent highly compensated employees (HCEs) from obtaining a benefit that is disproportionately favorable when compared to the benefits of the non-highly compensated employees (NHCEs). However, plan sponsors tend to associate discrimination tests with limitations on contribution amounts, forgetting the Compensation Ratio Test found in the Internal Revenue Code Section 414(s).

The Compensation Ratio Test divides included compensation by total compensation of each participant and then computes an average for the HCEs and the NHCEs. The average for the HCEs cannot exceed the average for the NHCEs by more than a de minimis amount. The code does not provide a black and white test to determine what would be considered a trivial difference, but as a practical matter, the industry considers a disparity of three percent or less to be a passing test.

A plan sponsor experiencing financial challenges could choose to pay bonuses only to the NHCEs.  Such generosity is commendable, but could end up costing the plan sponsor an additional plan contribution in certain situations. For instance, if the plan document excludes bonuses from the definition of plan compensation, the generous plan sponsor would fail the Compensation Ratio Test, and the previously excluded bonuses would then have to be included when computing the employer contribution in order to eliminate the unexpectedly discriminatory definition of compensation. Planning is important to prevent such acts of kindness from backfiring on the generous plan sponsor, requiring an additional mandatory act of kindness in the form of an employer contribution that wasn’t budgeted. Good communication with your service providers when effectuating any compensation changes is key in ensuring that the pessimistic phrase, “No Good Deed Goes Unpunished,” doesn’t become a reality.

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