Linking NDCPs with 401(k) requires a “contingency” plan for compliance

Pizzano-DominickThis blog is part of a 12-part series entitled “The nonqualified deferred compensation plan (NDCP) dirty dozen: An administrative guide to avoiding 12 traps.” To read the introduction to the series, click here.

Last month’s blog discussed similarities and differences between the rules governing participant deferrals made under a nonqualified deferred compensation plan (NDCP) versus those contributed to a qualified 401(k) plan. This month’s entry will again turn to the NDCP-401(k) connection; however, this time it will show that when NDCP sponsors choose to link their NDCP’s benefits with their 401(k) plans’, they must be aware of and comply with not only Internal Revenue Code Section 409A’s restrictions but also Section 401(k)’s “contingent benefit rule” (CBR). While such compliance does not directly affect the NDCP, it is a qualification requirement for the 401(k) plan.

In general, an employer may not directly or indirectly condition another employer benefit (other than matching contributions) upon an employee’s election to make or not make elective contributions. If the employer conditions any such other employer benefit upon elective contributions, it is a qualification defect. The purpose of this rule is to prevent employers from encouraging employees to make or not make elective contributions by linking valuable benefits to their contributions or lack of contributions. These other benefits include but are not limited to the following:

• Benefits under a defined benefit plan
• Nonelective employer contributions to a defined contribution plan
• The right to make after-tax employee contributions
• The right to health and life insurance
• The right to employment
• Benefits under a NDCP

Because NDCP benefits are included among the items for which 401(k) contingency is prohibited, NDCP sponsors must guard against including provisions in their NDCPs under which participants may receive additional deferred compensation under the NDCP, depending on whether they make or do not make 401(k) elective contributions. Each of the following three examples illustrates provisions that would create such a contingent benefit and thus a violation of the CBR:

Example 1: Employer T maintains a 401(k) plan for all of its employees and a NDCP for two highly paid executives, Employees R and C. Under the terms of the NDCP, R and C are eligible to participate only if they do not make elective contributions under the 401(k) plan. Participation in the NDCP is a contingent benefit because R’s and C’s participation is conditioned on their electing not to make elective contributions under the 401(k) plan.

Example 2: Assume the same fact pattern as Example 1 except that this time, under the terms of the NDCP, Employees R and C may defer a maximum of 15% of their compensation and may allocate their deferrals between the 401(k) plan and the NDCP in any way they choose (subject to the overall 15% maximum). Because the maximum deferral available under the NDCP depends on the elective deferrals made under the 401(k) plan, the right to participate in the NDCP is a contingent benefit.

Example 3: Employer S maintains three plans: a 401(k) plan, a qualified defined benefit (DB) plan, and a defined benefit NDCP. Under the terms of the NDCP, each participant’s NDCP benefit is offset not only by the qualified DB plan benefit but also by the total account balance under the 401(k) plan. Because the amount a participant elects to defer or not defer under the 401(k) will directly affect the amount of the offset and thus the resulting NDCP benefit, the offset is a contingent benefit.

Fortunately, for NDCP sponsors who wish to link the benefits of their NDCPs to their 401(k) benefits, there are ways this can be done without violating the CBR rule. While this rule generally prohibits any such linkage, it also contains two limited exceptions, both of which involve the effect of certain statutory limits:

(1) Any benefit under an excess benefit plan described in Section 3(36) of ERISA that is dependent on the employee’s electing to make or not make elective contributions is not treated as contingent.

(2) Deferred compensation under a nonqualified plan of deferred compensation that is dependent on an employee’s having made the maximum elective deferrals under section 402(g) or the maximum elective contributions permitted under the terms of the plan also is not treated as contingent.

The exception described in (1) has limited practical appeal because Section 3(36) defines an excess benefit plan as “a plan maintained by an employer solely for the purpose of providing benefits for certain employees in excess of the limitations on contributions and benefits imposed by section 415 of the Code on plans to which that section applies without regard to whether the plan is funded.” Accordingly, this exception cannot be relied upon by NDCPs that also provide benefits in excess of other qualified plan limitations, e.g., the 401(a)(17) limit on compensation, or those that provide benefits in excess of just “restoration benefits” (i.e., the NDCP’s benefit formula is not limited to only restoring benefits the participant would have received under the applicable qualified plan if not restricted by IRS limits).

Consequently, it is the exception described in (2) that is useful for most NDCP sponsors that wish to create a linkage with or offset of the 401(k) plan benefits. This exception clarifies that, while the NDCP amount may not be contingent upon the NDCP participants making or not making elective deferrals under the 401(k) plan, the NDCP amount can be contingent upon the NDCP having to make the maximum amount of elective deferrals permitted, either under law (e.g., the annual limit for 2016 is $18,000) or under the terms of the plan, e.g., if the plan only permits a maximum 401(k) elective deferral equal to 10% of compensation. To illustrate how this rule applies, let’s take another look at the previous Examples 2 and 3 to see how they can be modified so that they no longer violate the CBR:

Example 2. In addition to being subject to the annual dollar limit required by law, the 401(k) only permits employees to defer 10% of pay. The NDCP provides that participants may only defer under the NDCP if they are already deferring at the maximum rate under the 401(k). Employee R is only deferring 4% of pay under the 401(k) plan and will not hit the $18,000 limit in 2016. However, Employee C is deferring at a rate of 10% of pay and may reach the limit. Consequently, R is not permitted to defer under the NDCP for 2016 while C is allowed. Because the maximum deferral available under the NDCP depends on the participants making the maximum elective deferrals permitted (whether by law or plan terms) under the 401(k) plan, the right to participate in the NDCP is not a contingent benefit and, therefore, it now complies with the CBR.

Example 3: Employer S maintains three plans: a 401(k) plan, a qualified DB plan, and a defined benefit NDCP. Under the terms of the NDCP, each participant’s NDCP benefit is offset not only by the qualified DB plan benefit but also by the total account balance that the participants would have accumulated under the 401(k) plan, assuming they made the maximum elective deferrals permitted during each year in the measurement period. In this case, the offset provision in question is no longer a contingent benefit because the offset is no longer subject to fluctuations that could be manufactured by participants increasing or decreasing their 401(k) contributions. Instead, the offset is based on the maximum elective deferral that a participant could make to the 401(k) plan (regardless of the actual election) and thus it now complies with the CBR.

The 409A rules governing NDCPs are complex enough. When NDCP benefits are linked to 401(k) benefits, the CBR rule presents even more compliance challenges. Sponsors contemplating such designs or already maintaining this type of plan should contact their employee benefits consultants and/or ERISA counsel to ensure they have an acceptable “contingency plan” in place.

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