Consolidate 401(k), SIMPLE 401(k), Thrift, 403(b), and Governmental 457 plans, as well as SIMPLE IRAs and SARSEPs, into Employer Retirement Savings Accounts (ERSAs), which would be available to all employers and have simplified qualification requirements.

The concept of consolidation here is good. The alphabet-soup mix of plan types and which types of employers may sponsor which types of plans makes no sense. Why should the retirement plan of an employee be different just because they work for a government, school, or private company.

ERSAs would follow the existing rules for 401(k) plans, subject to the plan qualification simplifications described below. Thus, employees could defer wages of up to $12,000 annually (increasing to $15,000 by 2006), with employees aged 50 and older able to defer an additional $2,000 (increasing to $5,000 by 2006). The maximum total contribution (including employer contributions) to ERSAs would be the lesser of 100 percent of compensation or $40,000.

Taxability of contributions and distributions from an ERSA would be the same as contributions and distributions from the plans that the ERSA would be replacing. Thus, contributions could be pre-tax deferrals or after-tax employee contributions or Roth contributions, depending on the design of the plan. Distributions of Roth and non-Roth after-tax employee contributions and qualified distributions of earnings on Roth contributions would not be included in income. All other distributions would be included in the participants’ income.

Existing 401(k) and Thrift plans would be renamed ERSAs and could continue to operate as before, subject to the simplification described below. Existing SIMPLE 401(k) plans, SIMPLE IRAs, SARSEPs, 403(b) plans, and governmental 457 plans could be renamed ERSAs and be subject to ERSA rules, or could continue to be held separately, but if held separately could not accept any new contributions after December 31, 2004.

Here the proposal contradicts is stated objective of reducing complexity to encourage plan formation. SIMPLE IRAs, which have been around only 6 years, are a good choice for very small companies with limited ability to make contributions. The plans are typically set up with a fund company, the money goes into individual IRAs, and the company makes a matching contribution. There are no plan documents to prepare, no 5500 forms to file, and no discrimination testing. Most small employers who currently have SIMPLE IRAs will not adopt new ERSAs, they will simply eliminate their SIMPLEs.

ERSA Nondiscrimination Testing. The following single test would apply for satisfying the nondiscrimination requirements with respect to contributions for ERSAs: the average contribution percentage of HCEs could not exceed 200% of NHCEs’ percentage if the NHCEs’ average contribution percentage were 6% or less. In cases in which the NHCEs’ average contribution percentage exceeded 6%, the goal of increasing contributions among NHCEs would be deemed satisfied, and no nondiscrimination testing would apply. For this purpose, “contribution percentage” would be calculated for each employee as the sum of all employee and employer contributions divided by the employee’s compensation. The ACP and ADP tests would be repealed. Plans sponsored by state and local governments would not be subject to this test. A plan sponsored by a section 501(c)(3) organization would not be subject to this nondiscrimination test (unless the plan permits after-tax or matching contributions) but would be required to permit all employees of the organization to participate.

This test is an improvement over the current ADP/ACP tests, but it still must be performed and corrections made if the plan fails.

ERSA Safe Harbor. The design-based safe harbor described below would be sufficient to satisfy the nondiscrimination test for ERSAs described above. The design of the plan must be such that all eligible NHCEs are eligible to receive fully vested employer contributions (including matching or non-elective contributions, but not including employee elective deferrals or after-tax contributions) of at least 3 percent of compensation. To the extent that the employer contributions of 3 percent of compensation for NHCEs are matching contributions rather than non-elective contributions, the match formula must be one of two qualifying formulas. The first formula would be a 50 percent employer match for the elective contributions of the employee up to 6 percent of the employee’s compensation. The second would be any alternative formula such that the rate of an employer’s matching contribution does not increase as the rate of an employee’s elective contributions increase, and the aggregate amount of matching contributions at such rate of elective contribution is at least equal to the aggregate amount of matching contributions which would be made if matching contributions were made on the basis of the percentages described in the first formula. In addition, the rate of matching contribution with respect to any elective contribution of a HCE at any rate of elective contribution cannot be greater than that with respect to an NHCE.

The safe harbor concept is a good one, however many employers balk at providing a fully vested contribution. Current law already provides for such a safe harbor plan. They have not caught on in great numbers however. Employers want to get some return on their contribution investment. Vesting schedules encourage employee longevity. The longest possible vesting schedule under current law is only 6 years.

Roth ERSAs. The effective date for Roth contributions to ERSAs would be after December 31, 2003 (changed from after December 31, 2005, under current law).

Having ROTH contributions in an employer plan just leads to complexity and mistakes. The employer must distinguish between pre-tax ERSA contributions and after-tax ROTH contributions. For what purpose? Employees can establish their own ROTH accounts outside their employer plans. We do not expect many small employers to see a benefit in offering this in their plans.

Simplify defined-contribution plan qualification requirements.

Defined-contribution plan qualification requirements would be simplified as follows:

Minimum Coverage Requirement. The following single test would apply: plans would be required to cover a percentage of NHCEs that is not less than 70 percent of the share of HCEs that are covered. The existing rules for applying this test would remain, but the general 70 percent test and the average benefit test would be repealed.

The coverage ratio is the same as under current law, and most plans already satisfy this. However, the proposal repeals the average benefits test, which is helpful in some cases, especially smaller employers, where the ratio test fails. Yes, it is somewhat complex, but it saves small employers money that they would otherwise have to contribute for employees who have already terminated employment.

Top-heavy rules. The top-heavy rules would be repealed.

This is good. Top Heavy rules are blatantly discriminatory against small firms and should be completely eliminated.

Permitted disparity and cross-testing. Permitted disparity and cross-testing would no longer be permitted.

This is a major mistake. Permitted disparity and cross-testing permit plans to make different rates of contribution for different groups of employees. Yes, these rules are often used to provide higher contribution rates to key employees and owners, but these higher rates provide incentive for these companies to sponsor plans. New IRS rules require in most cases that the lower paid employees in such plans receive a minimum contribution of 5% of pay. If an employee receives a 5% contribution every year for 30 years and gets an average 7% return, this will convert into a lifetime pension income of over 40% of pay at retirement age 65! This is a better plan than Social Security.

Without permitted disparity and cross-testing, owners and other decision makers in small firms will find they are better off taking advantage of the new Lifetime Savings Accounts and Retirement Savings Accounts, and just eliminate their company-sponsored plan, or sponsor an ERSA.

This will hurt the lowest paid employees the most. Consider, under current law, an employee earning $20,000 per year would receive a 5% contribution, or $1,000 per year, under a company’s cross-tested plan. If the company eliminates that plan and has just an ERSA, then this employee will receive NO contribution from the company unless he contributes out of his own pay. He will have to contribute 6% on his own to receive a 3% contribution from the company. The Pension Group, Inc. administers hundreds of 401(k) plans, we can tell you from experience that very few low paid employees can afford to contribute out of their own pay. They live paycheck-to-paycheck, and taking a 6% hit to their income is not possible. And these lower-paid employees pay very little income tax, so the tax subsidy to their contribution is miniscule.

Definitions of compensation and highly compensated employee. The uniform definition of compensation would be all compensation provided to an employee by the employer for purposes of income tax withholding for which the employer is required to furnish the employee a written statement Form W-2, plus elective deferrals. The definition of “highly compensated employee” would be any employee with compensation for the prior year in excess of the Social Security wage base for that year. For 2003, the Social Security wage base is $87,000. The wage base is indexed and increases every year.

This is not all that different than current law, where the threshold is $90,000.

In Conclusion

Under the guise of simplification, the proposal eliminates key design elements of current profit sharing and 401(k) plans that provide incentive for small firms to provide plans to their employees.

Incredibly, the proposal makes no changes in existing defined benefit plan law. These plans are even more complex than defined contribution plans. Furthermore, these plans are not practical for many small companies. Defined Benefit plans can provide the same sorts of “age-weighted” benefits that current cross-tested plans provide, but at the expense of flexibility. Defined benefit plan contributions are REQUIRED, under threat of IRS penalties of up to 100% if they are not made. And employees earn a benefit each year in a defined benefit plan regardless of whether or not the company makes any money.

For these reasons, the plan of choice for small firms has been the cross-tested 401(k) or profit sharing plan. The contributions are not required and can be varied year-to-year. If the company has a bad year it can skip the contribution entirely without IRS penalty.

The proposal undoes most of the incentives for small firms to provide significant retirement benefits to their employees. With the ERSA plan the proposal will provide retirement benefits only to those small business employees who can afford to save for themselves, while preserving defined benefit pensions for large company employees.

The proposal is opposed by the Small Business Council of America, their press release can be seen at http://www.benefitslink.com/cgi-bin/pr.cgi?database_id=34042.