The IRS’s proposed closed plan regulations included a proposal unrelated to closed plans that could limit plan sponsors’ ability to offer enhanced executive benefits under their qualified retirement plans. This would occur in arrangements often called qualified supplemental executive retirement plans (QSERPs). The IRS announcement proposes that the new limitation take effect for plan years beginning on or after the rule’s publication in final form. The IRS is soliciting comments on the proposal through April 28, 2016, and has not announced an anticipated date for the final rule, but sponsors of plans with a QSERP feature may wish to consult with their actuaries and legal counsel now to gauge the proposal’s potential effect.
The Internal Revenue Code imposes compensation limits, benefit limits, and nondiscrimination restrictions on qualified retirement plans intended to prevent these plans (and their attendant tax benefits) from being used in a manner that disproportionately favors an employer’s highly compensated employees (HCEs). Consequently, employers often provide highly compensated executives additional retirement benefits outside of qualified plans using nonqualified deferred compensation plans (NQDC). NQDCs that provide a defined benefit to executives are often called supplemental executive retirement plans (SERPs). To offer tax-deferred benefits under SERPs and other NQDCs, amounts set aside to fund the benefits must remain at risk to an employer’s creditors in the event of the employer’s insolvency. Additionally, benefits payable under a SERP (or any NQDC) generally are subject to the stringent limitations of section 409A on when and in what form a benefit may be paid.
Because of these disadvantages to using SERPs and other NQDCs, some employers have instead capitalized on flexibility built into the qualified plan nondiscrimination rules to provide enhanced benefits for executives. Under the nondiscrimination rules, qualified plan benefit accruals need not be uniform among participants. So long as there are a sufficient number of non–highly compensated employees (NHCEs) who accrue benefits at a rate equal to or greater than the accrual rate for each HCE designated for an enhanced benefit, the designated HCEs can accrue benefits under a different or additional formula.
Because the amount of permissible pension enhancement is likely to be unique to each affected HCE, plans that use this QSERP approach typically identify each QSERP participant and his or her benefit or accrual rate by name or employee identification number in the plan document. Under the proposed rule, the nondiscrimination test crucial to a QSERP analysis and its viability will no longer permit individual identification of participants eligible for different or special benefit formulas. Instead, each testing group, or rate group (including each QSERP benefit or rate group), under a plan must be based on a reasonable business classification. The proposal’s preamble and a proposed new example state expressly that the common practice of specifying that a “benefit formula applies solely to [an HCE] who is identified by name” will not be viewed as a reasonable business classification.
If the new rules take effect as proposed, they will sound the death knell for QSERPs—both new QSERPS and future accruals under existing QSERPs. Plan sponsors that currently use QSERPs will likely have to amend their plans to eliminate them prospectively. Instead, the proposal will likely drive benefits currently provided under QSERPs to SERPs and other types of NQDCs , even though these plans pose some insolvency risk to executives and are subject to onerous time and form of payment restrictions. The adoption of additional restrictions that push more executive benefits out of qualified plans, like this proposed rule affecting QSERPs, can be expected to have the unintended consequence of further disengaging senior executives from qualified retirement plans, leading to more pension freezes and stagnant employer contribution rates for rank-and-file employees.