Private Pensions: "Top-Heavy" Rules for Owner-Dominated Plans (Letter
Report, 08/31/2000, GAO/HEHS-00-141).

The federal government has for many years granted tax incentives as a
way of encouraging the formation of private pension plans. These pension
laws and regulations intended to ensure that workers benefit equitably
from their pension plans. The key differences between top-heavy rules
and the general rules for nondiscrimination and vesting in contributions
and benefits. The most recent data available for GAO analysis on the
characteristics of new plans that report being top-heavy, and what is
known about the overall effects of top-heavy rules on numbers of plans
and participants and on employer costs. New plans reporting top-heavy
status tend to be small, defined contribution plans in the service
sector of the economy. Little is known about the overall effects of
top-heavy rules on plan formation. GAO found no research that has
quantified the overall effects of top-heavy rules on the number of
pension plans and participants.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  HEHS-00-141
     TITLE:  Private Pensions: "Top-Heavy" Rules for Owner-Dominated
	     Plans
      DATE:  08/31/2000
   SUBJECT:  Pension plan cost control
	     Tax expenditures
	     Investments
	     Tax law
	     Private sector
	     Retirement pensions
	     Employee retirement plans
IDENTIFIER:  Keogh Plan

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GAO/HEHS-00-141

Report to the Chairman, Special Committee on Aging, U. S. Senate

August 2000 PRIVATE PENSIONS “Top- Heavy” Rules for Owner-
Dominated Plans

GAO/ HEHS- 00- 141

Letter 3 Appendixes Appendix I: Scope and Methodology 34

Appendix II: Detailed Differences in Testing Apportionment of Benefits Under
Nondiscrimination and Top- Heavy Rules 37

Appendix III: Comments From the Department of the Treasury 43 Bibliography
44 Related GAO Products 47 Tables Table 1: Effect of Top- Heavy Rules on
Contributions in a Defined

Contribution Plan Using an Age- Weighted Allocation Formula and Cross-
Testing to Satisfy the Nondiscrimination Rules 14 Table 2: Minimum
Contributions Under a Top- Heavy 401( k) Plan 16 Table 3: Small Employers'
Primary Reasons for Not Offering a Pension

Plan, 1991 27 Table 4: Small Employers' Reasons for Not Offering a Pension
Plan,

1999 28 Table 5: Rules Governing What and Who Are Being Tested Differ 38
Table 6: Different Techniques Are Used in Compliance Tests to

Measure Contributions and Benefits 40 Figures Figure 1: Sequence of Rules
for Ensuring That a Plan's Apportionment

of Contributions and Benefits Is Tax- Qualified 8 Figure 2: Vesting
Schedules Under General and Top- Heavy

Qualification Rules 17 Figure 3: Difference in Vested Benefits Under Cliff
Vesting Schedules

for Worker With 3 to 5 Years' Service in a Defined Contribution Plan With
End- of- Year $1,000 Profit- Sharing Contribution 18 Figure 4: Difference in
Vested Benefits Under Gradual Vesting

Schedules for Worker With 2 to 7 Years' Service in a Defined Contribution
Plan With End- of- Year $1,000 Profit- Sharing Contribution 19 Figure 5:
Very Small Plans Are Most Likely to Be Top- Heavy 22

Figure 6: Top- Heavy Status Varies Widely With Plan Type 23 Figure 7: Top-
Heavy Status, by Industry Sector 25

Abbreviations

IRS Internal Revenue Service PWBA Pension and Welfare Benefits
Administration

Health, Education, and Human Services Division

Lett er

B- 282169 August 31, 2000 The Honorable Charles E. Grassley Chairman,
Special Committee on Aging United States Senate

Dear Mr. Chairman: At about $76 billion, tax preferences for pension plans 1
are the largest “tax expenditure,” exceeding those for either
home mortgages or health benefits. 2 The purpose of these pension tax
preferences is to raise private savings for workers' retirement. They are
structured to strike a balance between providing incentives for employers to
start and maintain voluntary, tax- preference- qualified plans and ensuring
that employees receive an equitable share of the tax- subsidized benefits.
In 1998, about 61. 5 million workers, or 47 percent of the employed labor
force, excluding the self- employed, participated in employer- sponsored
pension plans.

To achieve “tax- qualified” status, plans must comply with
several sets of rules that promote equity and inclusiveness. Two sets of
these rules address required apportionment of contributions and benefits,
and both generally apply to all private employers' plans- rules on
nondiscrimination in contributions and benefits, and the “top-
heavy” rules. A plan is deemed top- heavy if more than 60 percent of
its contributions or benefits accrue to the top employees- the owners and
officers of the business. Top- heavy rules require such plans to provide
“workers”- as contrasted with owners

1 The two basic types of pension plans are defined benefit plans and defined
contribution plans. In a defined benefit plan, the employee's benefit at
retirement can be specifically determined by using such factors as salary
and number of years of service. In defined contribution plans, individual
accounts are established for each participant, and the plan defines the
amount or share of profits or pay to be contributed to an individual's
account each year.

2 Fiscal year 2000 estimate from the Joint Committee on Taxation, Estimates
of Federal Tax Expenditures for Fiscal Years 2000- 2004, prepared for the
House Committee on Ways and Means and the Senate Committee on Finance, JCS-
13- 99 (Dec. 22, 1999), p. 23. “Tax expenditures” are revenue
losses attributable to provisions of federal tax laws and include any
reductions in income tax liabilities that result from special tax provisions
or regulations that benefit particular taxpayers.

and officers- higher minimum benefits and earlier rights to those benefits
than would otherwise be required under the general qualification rules.

Over time, the role and effectiveness of top- heavy rules in ensuring plan
equity have been questioned. Some contend that the nondiscrimination rules
alone are adequate to address equity in distribution of benefits; they
maintain that top- heavy rules are costly and burdensome, discouraging small
employers in particular from providing pensions. Others argue that these
rules provide necessary protections to workers who- even when participating
in a pension plan- might otherwise receive little or no benefit. You asked
us to review the top- heavy rules in relation to other pension laws and
regulations intended to ensure that workers benefit equitably from their
pension plans. In response, this report (1) identifies key differences
between top- heavy rules and the general rules for nondiscrimination and
vesting in contributions and benefits, (2) summarizes the most recent data
available for our analysis on the characteristics of new plans that report
being top- heavy, and (3) discusses what is known about the overall effects
of top- heavy rules on numbers of plans and participants and on employer
costs.

To do this work, we reviewed pension literature and legislative history and
interviewed personnel from cognizant federal agencies; personnel from
actuarial and employee benefit associations; pension consultants suggested
to us by leading actuarial and benefit associations, the Small Business
Administration, and the Department of the Treasury; and others knowledgeable
about pension law and practices. We also analyzed topheavy plans established
in 1996 using a Department of Labor data set based on reports that plans
submit annually to the Internal Revenue Service. 3 We conducted our work
between March 1999 and June 2000 in accordance with generally accepted
government auditing standards. (Our scope and methodology are presented in
more detail in app. I.)

3 We used the Department of Labor's electronic data set derived from 1996
Form 5500 “Return/ Report of Employee Benefit Plan” submissions
from plan sponsors across the country; these were the most recent data
available during our analysis. Sponsors of taxqualified pension plans are
generally required to submit the Form 5500 to the Internal Revenue Service
to satisfy annual reporting requirements under the Employee Retirement and
Income Security Act and the Internal Revenue Code.

Results in Brief The top- heavy rules for measuring how benefits are
apportioned, together with required minimum benefits and vesting, ensure
that workers get

certain minimum benefits that they would otherwise not receive under the
general nondiscrimination and vesting rules. Top- heavy rules are designed
to address situations prevalent in owner- dominated firms. The rules
identify pension plans in which the majority of benefits accrue to owners
and officers, and they require higher minimum benefits and faster vesting
for workers in such plans. Top- heavy rules utilize a single measure of the
current value of participants' accumulated contributions or benefits. In
contrast, nondiscrimination rules permit employers to choose among many
optional measures for valuing the amount of benefits, a number of which may
rely on projections that overstate the value of pension benefits workers
actually receive. Use of certain nondiscrimination rules can leave workers
who are outside the top employee group with annual employer contributions or
benefit accruals that are well below those that are required if the top-
heavy rules are applied.

New plans reporting top- heavy status tend to be small, defined contribution
plans in the service sector of the economy. Approximately 84 percent of all
top- heavy plans established in 1996, the most recent year for which data
were available, had fewer than 10 participants. The vast majority of all new
plans, and of new top- heavy plans, were defined contribution plans. Whereas
52 percent of new plans were in the service sector of the economy, plans of
service firms constituted 70 percent of new top- heavy plans in 1996. Within
the service sector, two- thirds of plans started by physicians, dentists,
and legal service firms were top- heavy, a rate far higher than for other
parts of the service sector.

Little is known about the overall effects of top- heavy rules on plan
formation. Formidable data and methodological challenges make it difficult
to isolate the incremental effect of top- heavy rules from the many other
economic and regulatory factors that influence employers' behavior regarding
pension plan formation. We found no research that has quantified the overall
effects of the top- heavy rules on the number of pension plans and
participants. However, survey research on small business suggests that while
employer contribution costs are a major obstacle to forming pension plans,
uncertain revenues, average employee tenure, and employees' preferences for
wages and health benefits are the primary disincentives to providing
coverage. Available research and our interviews with pension consultants
suggest that incremental administrative costs associated with top- heavy
rules are not likely to be significant enough to discourage plan

formation or maintenance. The most significant pension costs added by the
top- heavy rules are instead those associated with increased employer
contributions and faster vesting of participants; any negative effect
topheavy rules might exert upon plan formation would likely stem primarily
from these costs. In evaluating top- heavy rules' impact, the federal
government must weigh the extent to which top- heavy rules discourage
coverage against the higher participant benefits they provide.

Background A fundamental requirement for all tax- qualified pension plans is
that contributions or benefits be apportioned in a nondiscriminatory manner

between a top group of highly paid employees and owner- employees, and
workers who are outside the top group. The Congress first legislated
requirements for nondiscrimination in pension plan coverage of a firm's
employees in 1942. 4 To ensure that employers would meet the coverage
requirement with meaningful benefits for workers, the Congress also required
that the amount of contributions or benefits provided to those covered under
the plan not discriminate in favor of a top group of officers, shareholders,
supervisors, or highly compensated employees. A highly complex and flexible
set of rules has evolved for assessing whether a plan's coverage and its
apportionment of contributions and benefits are nondiscriminatory. Under the
rules, employers can develop a customtailored plan design and apply complex
general testing techniques to a plan's apportionment of contributions or
benefit accruals each year, or they can elect one of several standardized
“safe harbor” designs that obviate or reduce the need for annual
testing to determine compliance with nondiscrimination rules.

In addition to the general rules on nondiscrimination and vesting,
ownerdominated firms have always faced additional, more stringent rules for
pension plan tax qualification. In establishing more stringent rules, the
Congress cited a greater potential for tax shelter abuses in such plans. The
current top- heavy rules are the latest generation of such restrictions.
Before 1962, sole proprietors, partners, and the self- employed were
prohibited altogether from participating in tax- qualified pension plans,
though as employers they could establish a plan for the benefit of their
employees. In contrast, shareholder- employees in corporations could
participate in qualified plans, and the general nondiscrimination rules set

4 Revenue Act of 1942, P. L. 77- 753, 162 (1942).

requirements for the apportionment of contributions and benefits between a
top employee group and other workers. After 1962, plans created by
unincorporated “owner- employees” became eligible for tax
qualification with owner- employee participation in the plan, but the plans
were subjected to both the nondiscrimination rules and a second, more
restrictive set of requirements for equitable apportionment of contributions
and benefits. The latter rules originated as the “H. R. 10” or
“Keogh” rules under the law that first allowed sole proprietors,
partners, and the selfemployed to participate as owner- employees in tax-
qualified plans. 5 The current top- heavy rules came about as part of the
Tax Equity and Fiscal Responsibility Act of 1982, 6 when the Congress
decided that additional restrictions on owner- dominated plans should not be
based on corporate versus noncorporate business structures but on whether
any plan's delivery of contributions and benefits was “top-
heavy” in favor of owners and officers. 7

The general nondiscrimination and vesting rules and the top- heavy rules
share the goal of ensuring an appropriate distribution of pension benefits
to a broad group of workers- not just to a top employee group. In addition,
the two sets of rules have parallel, though different, steps for testing the
way contributions and benefits are apportioned, different requirements for
minimum contributions or benefits, and different requirements for vesting
participants with nonforfeitable rights to benefits. Figure 1 illustrates
the steps a plan must take in testing its compliance with the rules on
nondiscrimination in contributions and benefits and then testing its
compliance with top- heavy rules.

5 P. L. 87- 792, the Self- Employed Individuals Tax Retirement Act of 1962,
emerged from bill H. R. 10, sponsored by Congressman Keogh. 6 P. L. 97- 248,
title II, subtitle C (1982).

7 In response to proposals in House bill H. R. 6410 that would have extended
certain H. R. 10 rules to personal service corporations, or professional
corporations, the Department of the Treasury proposed the alternative top-
heavy concept (“ key employee concept”) in the Hearing on the
Pension Equity Tax Act of 1982, before the Committee on Ways and Means,
House of Representatives, 97th Congress, June 10, 1982, Serial 97- 65, pp.
24- 25.

Qualified Plan Design

Figure 1: Sequence of Rules for Ensuring That a Plan's Apportionment of
Contributions and Benefits Is Tax- Qualified

Select Among Yes

Apply Test No General

Pass for

Top- Heavy Nondiscrimination

? Top- Heavy

? and Vesting Rules

Status Yes

Select Raise

Apply Top- Heavy Different

and/ Benefits

No Minimum Benefit

Test and or

and and Retest

Retest Vesting Rules

Note: The use of a design- based “safe harbor” obviates the need
for the general nondiscrimination test. In addition, inclusion of required
top- heavy minimum contributions or benefits, and vesting, obviates the need
for top- heavy testing.

To attain tax- qualified status, the Internal Revenue Code and regulations
provide distinct compliance testing rules for three categories of pension
plans: defined benefit plans; defined contribution plans; and defined
contribution plans with cash or deferred arrangements, known as 401( k)
plans. 8 In a defined benefit plan, the employee's benefit at retirement can
be specifically determined using such factors as salary and number of years
of service. In defined contribution plans, individual accounts are
established for each participant, and the plan defines the amount or share
of profits or pay to be contributed to an individual's account each year;
but an employer contribution is not required every year in profit- sharing
defined contribution plans. In addition to employer contributions for all
participants, 401( k) defined contribution plans can provide for two
additional types of contributions: (1) employee “elective
deferrals,” or “elective contributions,” in which an
employee elects to have the employer contribute to a tax- deferred 401( k)
account in lieu of providing the same amount as salary and (2) employer
“matching contributions” made on the basis of employee elective
contributions. 9 In all defined contribution plans, the account balance
accumulates any investment earnings tax- free until an individual withdraws
it for retirement. Generally, all plans, regardless of type, must comply
with both the nondiscrimination rules and the top- heavy rules to be tax-
qualified. The rules for defined benefit plans generally are more extensive
and complex than for defined contribution plans, and this complexity is
reflected in higher administrative expenses for such plans.

Top- Heavy Rules Important differences exist between top- heavy rules and
the general

Ensure Benefits That nondiscrimination and vesting rules. The top- heavy
rules were developed

to address opportunities for pension- plan- related tax abuses in
ownerdominated Workers Would Not

firms. Top- heavy rules differ from nondiscrimination rules in Receive Under
the

how they measure or test whether top employees receive a General

disproportionate share of contributions or benefits, compared with
Nondiscrimination and

workers; Vesting Rules

8 The term “hybrid” plan is used to refer to plans that have
characteristics of both traditional defined contribution and defined benefit
plans. In this category are “cross- tested” defined contribution
plans and “cash balance” defined benefit plans, among others.

9 401( k) refers to the section of the Internal Revenue Code that sets out
rules for these cashor- deferred defined contribution arrangements.

requiring top- heavy plans to meet more generous minimum standards for
benefits 10 to workers, including (1) higher minimum benefits than
nondiscrimination rules may require and (2) a shorter length of time the
employee must work before acquiring vested, or nonforfeitable, rights to
benefits.

Rules for Testing Top- Heavy The test for top- heavy status differs from
general nondiscrimination

Status of Plans Differ From standards in two basic ways:

General Nondiscrimination the definition of the “plan” and of
the top employee group whose

Standards benefits are to be measured against those of workers and

the use of fundamentally different techniques and assumptions to measure
equity in apportionment of contributions and benefits.

Without the unique test for top- heavy status, a disproportionate
accumulation of pension plan assets by owners and officers may not be
detected, and such plans would not be required to provide the top- heavy
rules' larger minimum benefits and faster vesting schedules. The following
sections provide a summary of how the tests differ; additional explanation
is provided in appendix II.

Top Employee Groups and Both nondiscrimination and top- heavy testing rules
divide plan participants

Grouping of Plans Differ into a top employee group and a remaining group of
“workers” before

measuring whether the top group received a disproportionate share of pension
plan benefits. Top- heavy rules define a top group, called “key
employees,” primarily on the basis of whether an employee is an owner
or officer of the firm, with compensation factored in. Nondiscrimination
rules define a different top group, called “highly compensated
employees,” on the basis of compensation or a 5- percent ownership
status. While one can be in the top, highly compensated group solely on the
basis of salary, one cannot be in the key employee group on that basis
alone. The top- heavy rules' key employee definition emphasizes ownership
because in small, owner- dominated firms, compensation may not be a reliable
indicator of who controls the firm and the pension plan design. Without
identifying key employees, owners of smaller firms could manipulate
assignments and

10 In this report, we use “benefits” to refer generically to
benefit accruals under defined benefit plans and contributions under defined
contribution plans, unless the context indicates a specific technical
meaning of a defined benefit plan benefit accrual.

salaries to avoid top- heavy status and exclude nonfamily workers from
topheavy benefits.

The retirement plan in which a worker participates can differ from what
nondiscrimination or top- heavy rules define as the “plan” or
the part of a plan to be tested, and the two sets of rules can aggregate or
subdivide plans very differently. Nondiscrimination rules generally permit
employers to choose whether to combine or to subdivide their plans when this
may aid in meeting testing requirements. As a result, employers are able to
reward different groups of employees differently. In contrast, top- heavy
rules set a fixed boundary as to what the “plan” is for top-
heavy testing and for requiring top- heavy minimum benefits and vesting
schedules; this is to ensure that all workers are equally eligible for top-
heavy minimum benefits. Without the mandated top- heavy definition of the
aggregated plan to be tested, an employer could divide employees into two
plans so that only one would be top- heavy, leaving workers in the remaining
plan without the intended protection of top- heavy minimum benefits and
vesting.

Measures and Thresholds Differ Nondiscrimination and top- heavy testing
rules use fundamentally different measurements. Nondiscrimination testing
rules allow employers to choose among several optional methods to measure
contributions and benefits as a percentage of compensation. In contrast,
top- heavy rules allow an employee's benefit to be measured in only one way.
The different measures of benefits allowed under nondiscrimination rules can
result in an apportionment of benefits that is most favorable to older
employees, those employees with long periods of service, those who remain
with the company their entire career and retire under the plan, or those who
earn wages well above the Social Security taxable wage base. In a small
firm, the owner is most likely to fit this profile and is most likely to
retire under the plan, because a plan often terminates upon the owner's
retirement. To address typical conditions for smaller, owner- dominated
plans, top- heavy rules assess how well employees have fared under the plan
to date- measuring the amount to which the employee would be entitled if the
plan were terminated at that point. 11 For example, the top- heavy test of
accumulated values apportioned to owners and officers versus workers is more
effective in detecting whether forfeitures of nonvested benefits by workers
in high- turnover, small firms is leading to a plan becoming largely a tax
shelter for owners. Appendix II includes a comparison of the single

11 For defined benefit plans that terminate, adequacy of funds can also
affect participants' entitlements.

benefit measure of the top- heavy rules with those benefit measures
allowable under nondiscrimination rules.

The nondiscrimination rules provide employers many optional ways to measure
benefits or contributions, and differing choices can result in a wide range
of required minimum allocations to workers that satisfy the rules. An owner
can choose to compare a defined contribution plan's contributions in current
value, so that the owner and younger workers get the same percentage of pay.
Alternatively, an employer can choose to compare estimated future benefits
as a percentage of current compensation. In doing so, the benefits accruing
to a younger worker can be found to be “equivalent” to those of
an older owner, even though the current allocation for the older owner is up
to 36 times the percentage of compensation going to the younger employee in
a defined contribution plan. Larger disparities are possible under defined
benefit plan rules.

If an employer's pension plan fails a nondiscrimination test under one
choice of measurement rules, the employer may be able to choose different
measurement rules and pass the test using the same allocations. The employer
may also elect to increase plan benefit allocations to workers to pass the
test or can elect to both increase allocations and choose different
measurement rules. After passing the nondiscrimination test, a plan
undergoes the top- heavy test. An employer is permitted to increase plan
allocations to workers to avoid top- heavy status but cannot vary the
topheavy method of measuring contributions and benefits. Plan consultants
and Treasury officials said that many employers elect to bypass the
administrative burdens associated with nondiscrimination testing and
topheavy testing. The use of master or prototype plans with design- based
safe harbors obviates the need for the general nondiscrimination test. In
addition, inclusion of required top- heavy minimum contributions or
benefits, and vesting, obviates the need for top- heavy testing.

Top- Heavy Plans Have If a plan has a top- heavy apportionment of benefits,
it must provide

Higher Minimum Standards workers- that is, those not in the top employee
group- two things: (1) a

for Benefits Going to specified minimum- level contribution or benefit that
can be higher than

Workers required in certain design and testing options allowed under

nondiscrimination rules and (2) faster minimum vesting schedules. The
minimum vesting schedule is the amount of time workers must have with their
employer before they must receive nonforfeitable rights to benefits
contributed on their behalf.

Top- Heavy Minimum Benefits The minimum required employer contribution for
workers in top- heavy

Can Exceed Minimums Under defined contribution plans is 3 percent of
compensation; 12 the only

Nondiscrimination Rules and exception to this minimum rate occurs if the
highest contribution rate for

Tests an owner or officer is below the 3- percent standard. If so, top-
heavy plans

must contribute for workers at the highest rate received by any owner or
officer in the top employee group. Many top- heavy plans adopt designs that
already comply with top- heavy minimum benefits rules, so that incremental
allocations to workers are not required. However, plan design and testing
choices that are likely to require additional contributions to workers in
order to comply with top- heavy minimums include custom plan designs that
apportion larger annual increments- as a percentage of compensation- to
owners in comparison to workers. Examples include defined benefit plans
using methods that favor older, longer- service owners; and hybrid,
“cross- tested” defined contribution plans that test compliance
with nondiscrimination rules on the basis of benefits projected to each
individual's retirement age, rather than on the basis of current
contributions. In addition, 401( k) defined contribution plans that rely on
elective employee salary deferrals will have to add a full 3- percent
topheavy contribution if an equivalent “nonelective” employer
contribution to all participants has not been included in the plan's design.

To illustrate a situation that requires added contributions for workers to
meet top- heavy minimums, table 1 shows an actual top- heavy defined
contribution plan that is cross- tested and age- weighted. 13 This is one of
the designs that can leave workers with an annual contribution well below
the required top- heavy minimum of 3 percent of compensation, while giving
owners a percentage of pay that is much higher. The plan passed the
nondiscrimination test with contributions to workers of about 1 percent of
pay. However, under the top- heavy rules, the employer had to reallocate
about a quarter of the $20,000 budgeted for pension contributions from top

12 We address defined contribution plan contributions in this discussion and
in the examples to avoid the additional complexity of discussing the more
involved actuarial rules and options that accompany defined benefit plans.
The standard minimum top- heavy benefit for defined benefit plans is a total
accrued benefit of 2 percent of average annual pay for each year a plan is
top- heavy, up to a maximum benefit of 20 percent (2 percent times 10
topheavy years). The top- heavy minimum no longer applies if an individual's
accrued benefit has reached 20 percent or more.

13 Under a pledge of confidentiality, a practitioner provided us this client
example to illustrate the incremental effects of top- heavy rules on an age-
weighted, cross- tested plan. We present an age- weighted, cross- tested
example to avoid the added complexity of “new comparability”
cross- testing.

employees in order to meet the 3- percent minimum contribution that topheavy
rules require for workers.

Table 1: Effect of Top- Heavy Rules on Contributions in a Defined
Contribution Plan Using an Age- Weighted Allocation Formula and Cross-
Testing to Satisfy the Nondiscrimination Rules

Employer contributions Incremental allocation to Allocation satisfying

meet top- heavy Total allocation to meet topheavy nondiscrimination rules

minimum minimum Employee

Amount Percentage

Amount Amount

Percentage status Age Salary

(dollars) of pay (dollars) (dollars) of pay

Key employee 60 $160, 000 a $15, 360 9.6 - $4, 630 $10,730 6. 7 32 31, 400
310 1. 0 -100 210 0. 7 54 10, 700 630 5. 9 -190 440 4. 1 Nonkey employee

35 34, 200 430 1. 3 600 1, 030 3.0 35 26, 900 340 1. 3 470 810 3.0 36 24,
900 340 1. 4 410 750 3.0 38 61, 300 980 1. 6 860 1, 840 3.0 36 49, 400 670
1. 4 810 1, 480 3.0 33 66, 600 710 1. 1 1,290 2, 000 3. 0 33 23, 700 250 1.
1 460 710 3.0

Plan total $20, 000 $0 $20,000

Note: Dollar amounts are rounded to the nearest 10, so they may not add to
total. a The limit on annual compensation that can be used to compute
allowed contributions under Internal

Revenue Code 401( a)( 17) was $160,000; owner- employee's salary exceeded
this limit.

In this example, the nondiscrimination rules, absent the top- heavy rules,
would have allocated to the owner a contribution equal to 9.6 percent of the
$160,000 salary amount, versus 1. 1 percent of salary ($ 250) to the
youngest and lowest- paid worker. The top- heavy standard for a minimum
contribution resulted in nearly all the workers getting an incremental
allocation that was larger than the initial allocation needed to satisfy
nondiscrimination rules.

Another design that plan consultants told us can require additional employer
contributions due to top- heavy minimums is a 401( k) plan that

ordinarily has elective deferrals and possibly employer matching
contributions, but not employer nonelective contributions. Nondiscrimination
rules for 401( k) plans apply different tests for employees' elective
deferrals of salary and for employer matching contributions. Both tests have
thresholds that permit average salary deferrals and matching contributions
for the higher- paid group to exceed the average for the lower- paid group
by specific margins. In addition, because the tests averagecontributions for
each group, lower- paid employees who are eligible to participate but elect
not to contribute are averaged into the group as “zeros.” The
nondiscrimination rules consider zeros as “covered” or
benefiting under the plan because they had the opportunity to participate.

In contrast, all workers in a top- heavy 401( k) plan, including zero
contributors, must receive a contribution equal to 3 percent of pay that is
in addition to elective contributions and employer matching contributions
made on their behalf. 14 Treasury officials explained that allowing the
counting of matching contributions toward top- heavy minimum contributions
would have the effect of eliminating the employee participation incentive of
matching contributions, and therefore they would lose their character as a
match if used to satisfy the top- heavy rules. The actual plan illustration
presented in table 2 shows the effect of topheavy rules on workers' added
benefits and on employer contributions for a top- heavy 401( k) plan. 15

14 26 C. F. R. 1.419- 1, sections M- 19 and M- 20, address prohibiting the
counting of matching and elective contributions, respectively, toward
satisfying top- heavy minimum contributions.

15 Under a pledge of confidentiality, a practitioner provided us several
examples of 401( k) plans in which added top- heavy 3- percent contributions
had been required. This example was selected to illustrate top- heavy
minimums going to “participants” with zero contributions, as
well as to those who made an elective deferral and received matching
contributions.

Table 2: Minimum Contributions Under a Top- Heavy 401( k) Plan Contributions

3% required Employee

Employer top- heavy

Employee status Salary elective match

minimum

Key employee $93,530 $5, 980 $920 0

75,490 4, 550 700 0 34,170 1, 710 340 0 Nonkey employee

3,900 390 40 $120 25,170 1, 180 240 750

2, 110 320 20 60 31,160 3, 120 310 930

8, 950 360 90 0 a 23, 940 0 0 720 21,940 970 200 660

Plan total $320,360 $18, 570 $2, 850 $3, 250

Note: Dollar amounts are rounded to the nearest 10, so they may not add to
total. a Nonkey employee terminated employment, so did not receive a top-
heavy contribution.

In addition to providing protection to employees whose pensions are
structured as 401( k) plans, top- heavy minimum benefit rules provide
protection under other scenarios in which plan terms permitted under the
nondiscrimination rules can leave participants ineligible to receive a
contribution or benefit. These include, for example,

defined contribution plan participants who would be considered parttime and
ineligible for contributions because they worked fewer than 1,000 hours in a
year and defined benefit plan participants who worked at least 1, 000 hours
but

are ineligible for an annual accrual because they left the employer before
the last day of the plan year.

Top- heavy rules require that these participants receive the top- heavy
minimums. Because part- time workers and high turnover are often found in
small businesses, these top- heavy rules on eligibility for contributions
can deliver more benefits to workers.

Vesting Requirements Differ The pension plan qualification rules set
standards for the maximum time an employer can delay granting plan
participants full, 100- percent vesting- that is, nonforfeitable rights to
pension contributions or benefit accruals made on an employee's behalf. For
plans that are not top- heavy, two standard options exist: (1) immediate
full vesting- called “cliff” vesting in the pension community-
after a 5- year delay and (2) a gradual buildup to 100- percent vesting-
called “graded” vesting in the pension community- at the rate of
20 percent each year, beginning after a 3- year delay and culminating in
100- percent vesting after 7 years. However, if a plan is topheavy, the top-
heavy rules require that plans fall within either a 3- year cliff vesting
option or a 2- to 6- year gradual schedule. 16 These requirements are
contrasted in figure 2.

Figure 2: Vesting Schedules Under General and Top- Heavy Qualification Rules

16 A 2- year cliff vesting schedule is mandated if an employer elects to
exclude employees from eligibility for plan participation for a period
longer than the 1- year standard qualification rule. Ineligibility can be
extended up to 2 years but will require immediate cliff vesting after 2
years. This extended ineligibility is not allowed for 401( k) plans.

The top- heavy rules' faster vesting schedules can result in higher benefits
for workers. This faster vesting affects employees who leave their employer
after the top- heavy schedule begins but before the year when topheavy and
nondiscrimination vesting schedules have both reached 100 percent vesting.
Under cliff vesting, this would occur for those working for an employer at
least 3 years but fewer than 5 years (see fig. 3). Under gradual vesting,
the differences in the amounts vested between the topheavy and general
vesting schedules are smaller (see fig. 4).

Figure 3: Difference in Vested Benefits Under Cliff Vesting Schedules for
Worker With 3 to 5 Years' Service in a Defined Contribution Plan With End-
of- Year $1, 000 Profit- Sharing Contribution

Note: The dollar amounts in this figure exclude investment earnings.

Figure 4: Difference in Vested Benefits Under Gradual Vesting Schedules for
Worker With 2 to 7 Years' Service in a Defined Contribution Plan With End-
of- Year $1, 000 Profit- Sharing Contribution

Note: The dollar amounts in this figure exclude investment earnings.

Some Differences Between After the 1984 implementation of top- heavy rules,
the Tax Reform Act of

the Rules Have Narrowed 1986 shortened the maximum permitted delays in
vesting for all non- topheavy

plans from 10 to 5 years for cliff vesting and from the former 5- to 15year
gradual schedule to a 3- to 7- year schedule. Although this brought

vesting schedules under the general rules much closer to top- heavy vesting
schedules, the remaining difference between the schedules can still increase
benefits to workers who leave after 3 years' employment, but before 5 years.
Bureau of Labor Statistics' 1998 data on length of service with employers
showed a median job tenure for workers age 25 and older of 4.7 years across
all industries. On the basis of this statistic, many workers would have had
no vested pension benefits with the company employing them in 1998 under a
5- year cliff vesting schedule but would have been vested under 3- year top-
heavy cliff vesting.

In addition to the vesting schedule changes, other changes have narrowed
differences between general nondiscrimination and parallel top- heavy rules.
Different limits on annual benefits and contributions have disappeared; as a
result, limits are now the same for all plans. 17 All plans now are subject
to the same upper limit on individual compensation that can be the basis for
tax- qualified contributions or benefits. Top- heavy plans originally had a
lower limit than allowed by nondiscrimination rules. In addition, top- heavy
rules no longer have a more stringent upper limit on contributions or
benefits when an employer sponsors both a defined benefit and a defined
contribution plan, because recent legislation repealed the dual- plan limit
for all plans.

17 26 U. S. C. 416( d), the top- heavy compensation limit, was repealed when
section 401( a)( 17), the annual compensation limit, was extended to all
plans as part of the Tax Reform Act of 1986. 26 U. S. C. 416( h), dual- plan
limit rules for super top- heavy plans, were repealed with the repeal of
section 415( e) in the Small Business Job Protection Act of 1996 (P. L. 104-
188).

Most New Top- Heavy Most new top- heavy plans had few participants-
approximately 84 percent

had fewer than 10 participants in 1996. 18 Furthermore, the incidence of a
Plans Have Few

top- heavy apportionment of benefits drops rapidly as plan size increases
Participants and Are

(see fig. 5), which may be due largely to a higher proportion of owners to
Defined Contribution

total employees in small firms. While 52 percent of plans with 2 to 9 Plans
in the Service

participants reported being top- heavy, the proportion dropped to 14 percent
of plans with 10 to 24 participants, 5 percent of plans with 25 to 49

Sector participants, and 3 percent in the 50- to 99- participant range. Only
2 percent

of plans with 100 or more participants reported top- heavy status. 18
“New” plans in 1996 are defined as plans indicating an effective
date of 1996. These data are not projectable to the universe of qualified
plans. We used these data because they were the best available data to
identify top- heavy status and plan characteristics. Our analysis used data
from 1996 Form 5500 annual reports that tax- qualified plans submitted to
the Internal Revenue Service and that are made available through the
Department of Labor. Our use of these data is discussed further in app. I.

Figure 5: Very Small Plans Are Most Likely to Be Top- Heavy

Number of Plans

22,000 21,710

20,000 Total Plans in Category

18,000 Top- Heavy Plans

16,000 14,000

12,870 12,000

10,000 8,000

6,640 6,000

11,350 4,000

3,270 2,670

2,000 1,750 0

320 100 50 2- 9

10- 24 25- 49 50- 99 100+ Participant Size of Plan

Note: Analysis is based on 1996 plan reports that indicated an effective
date of 1996.

Different plan types reported top- heavy status with widely varying
frequency, as shown in figure 6. While 401( k) defined contribution plans
were the most numerous type of new plan in 1996, they reported top- heavy
status less than 10 percent of the time. Defined contribution plans without
401( k) features were the next most numerous type of new plan and reported
being top- heavy 58 percent of the time; they constituted 71 percent of the
13,461 new plans that reported top- heavy status. While defined benefit
plans were the least frequent type among new plans, they reported being top-
heavy at the highest rate- 67 percent of the time.

Figure 6: Top- Heavy Status Varies Widely With Plan Type

Number of Plans

30,000 28,070

Total Plans in Category 25,000

Top- Heavy Plans 20,000

16,590 15,000

10,000 5,000

9,620 1,720 2,690

1,160 0

401( k) Defined Non- 401( k)

Defined Benefit Contribution Defined Contribution

Type of Plan

Note: Analysis is based on 1996 plan reports that indicated an effective
date of 1996.

Employers in the service sector of the economy represented 52 percent of new
plans and 70 percent of new top- heavy plans in 1996. Within the service
sector, plans for physician, dentist, and legal services firms were top-
heavy most frequently- at 67 percent, a rate far higher than that for other
components of the service sector. The higher proportion of top- heavy plans
among physician, dentist, and legal services firms likely reflects the
relatively high salaries of key employees versus other workers and may
indicate that the key employees can afford to defer salaries to the

maximums available under qualification rules. 19 The “other
services” sector had the most new plans- 13,180- and 26 percent
reported top- heavy status. 20 (See fig. 7.)

19 A legislative proposal rejected in favor of the top- heavy rules was to
apply these more stringent rules only to professional firms. Tax court cases
as well as journal and news articles had raised concerns about tax shelter
abuses among medical and other professionals.

20 Other services include educational or engineering services and other
services not classified elsewhere.

Figure 7: Top- Heavy Status, by Industry Sector

Number of Plans

14,000 13,180 Total Plans in Category

12,000 Top- Heavy Plans

10,000 8,000

7,530 6,150 6,000

4,000 3,570

3,850 3,300 2,640

5,020 2,000

3,450 620

1,000 560 750 740 0

Wholesale Finance,

Retail Trade Construction Manufacturing Physician, Other Services Trade
Insurance,

Dentist, Legal Real Estate

Services

Sector

Note: Analysis is based on 1996 plan reports that indicated an effective
date of 1996.

Top- Heavy Rules' The overall effects of the top- heavy rules have not been
quantified.

Aggregate Effects Have Identifying the effects of the top- heavy rules in
isolation from effects of

other pension rules has become more difficult over time. Some have voiced
Not Been Quantified

concern over additional benefit commitments and the administrative burden,
saying that such requirements have discouraged small businesses from
offering pensions. Available research suggests that, although contribution
costs are indeed a major obstacle to establishing a pension plan, the
primary obstacles are the overall economic situation of the company, which
can make contribution costs prohibitive, and

characteristics and preferences of employees. In addition, pension
consultants indicated that the incremental administrative costs added by
top- heavy rules are a minor part of total administrative costs, and
available studies of administrative costs did not find top- heavy costs
significant enough to isolate and quantify.

Top- Heavy Rules' Overall We found no studies that quantified overall
effects- positive or negative-

Effects Have Not Been of the top- heavy rules on numbers of plans or
participants, or on

Isolated employers' contributions or administrative costs. The lack of such
analysis

reflects methodological obstacles generally; it also likely reflects the
fact that baseline empirical research was not mandated at the time the rules
went into effect. It is extremely difficult to develop a sound or credible
estimate of the overall effect of top- heavy rules. The dramatic pace and
scope of regulatory and economic changes since the enactment of the topheavy
rules significantly complicate efforts to isolate the top- heavy rules'
overall effects.

Available studies provide limited quantitative indicators of top- heavy
rules' effect or rely on expert opinion. We surveyed a sample of plans when
the top- heavy rules became effective in 1984, and we reported in 1989 that
many more participants would have had smaller or no vested benefits if the
top- heavy vesting rules had been replaced with the general vesting rules
implemented under the Tax Reform Act of 1986. 21 However, we could not
quantify the added employer contributions due to the top- heavy rules or any
administrative costs the employers bore. Other assessments of the topheavy
rules relied on expert opinion and anecdotal illustrations and produced a
range of positive and negative views of the top- heavy rules. Similarly, our
more recent discussions with practitioners and experts yielded mixed
reactions. Consultants' reactions ranged from a judgment that the rules did
not result in enough benefits to be worth the costs they add, to the
conclusion that they add little burden. Others noted that the rules could be
simplified by applying the top- heavy minimums to all businesses. Advocates
for workers generally saw the top- heavy rules as necessary and important.

21 Private Pensions: Impact of Vesting and Minimum Benefit and Contribution
Rules in Top- Heavy Plans( GAO/ HRD- 90- 4BR, Oct. 23, 1989), p. 3.

Employer Contribution Surveys of small employers without pension plans
indicate that the primary

Costs Are Important but Are obstacles to offering a plan are the economic
situation of the employer and

Not a Primary Barrier to the characteristics and preferences of the
workforce typical of small firms.

Small Business Pension In a recent survey, most employers also cited the
expense associated with

employer contributions as a major barrier, but not the primary barrier, Plan
Formation

while a minority of respondents cited administrative costs as a major
barrier.

An extensive 1991 survey done for the Small Business Administration found
that employer economic reasons were the overwhelmingly dominant deterrent to
small firm pension plan formation, as shown in table 3. 22 The study also
noted that small employers reported placing a higher priority on offering
health insurance to their employees than on offering a pension plan; yet
nearly half did not offer health insurance.

Table 3: Small Employers' Primary Reasons for Not Offering a Pension Plan,
1991

Numbers in percent (percentages are rounded)

Employers with Employers with Primary reason for not offering retirement
plan 1- 24 employees 25- 99 employees

Employer economic reasons (uncertain income, mergers and plant shutdowns,
owner has other job with a plan) 61 43

Employee economic reasons (high turnover rate, employees are part- time,
employees are too young or too old to want retirement plan) 12 27

Employee/ employer preference reasons (employees prefer cash or other fringe
benefits, or employer prefers other types of savings plans) 8 13

Setup or annual administrative costs too high 9 11

Federal laws or regulations (too costly to comply with, change too
frequently, limit benefits to owners) 9 6

In a 1999 Employee Benefit Research Institute survey of small business,
employers with 5 to 100 employees cited uncertain revenue and workforce
characteristics as primary reasons for not offering a plan (see table 4). 23

22 David L. Kennell, Arnold T. Brooks, and Terry Savela, Retirement Plan
Coverage in Small and Large Firms, final report submitted to the Office of
Advocacy, U. S. Small Business Administration (Vienna, Va.: Lewin- ICF, June
1992), p. III. 27. 23 Paul Yakoboski, Pamela Ostuw, and Bill Pierron, The
1999 Small Employer Retirement Survey: Building a Better Mousetrap Is Not
Enough, Issue Brief No. 212 (Washington, D. C.:

Employee Benefit Research Institute, Aug. 1999), p. 5.

Fifty- five percent of firms cited revenue- related or employee- related
reasons as the most important reason for not offering a plan. Although only
10 percent cited the expense of company contributions as the most important
reason for not offering a plan, 51 percent said it was a major reason. The
1999 study concluded that “while cost and administrative issues do
matter, they are not the sole reason for low plan sponsorship rates among
small employers.”

Table 4: Small Employers' Reasons for Not Offering a Pension Plan, 1999
Percentage who cited reason as the Reasons cited for not offering a plan

Most important reason Major reason Revenue- related

Revenue is too uncertain 19 50

Employee- related

Large portion of employees are seasonal or part- time, or turnover rate is
high 19 42

Employees prefer wages or other benefits 17 53

Cost and administration

Costs too much to set up and administer 12 30 Required company contributions
are too expensive 10 51

Too many government regulations 3 32

Other

Vesting requirements provide too much to short- term workers 2 38

Don't know where to obtain information to start a plan 2 5

Benefits for the owner are too small 1 17 Other 12 17

Top- Heavy Rules Can The top- heavy rules' required minimum 3 percent of pay
contribution for

Increase an Employer's defined contribution plans can increase employers'
costs above what

Pension Costs nondiscrimination rules require. Actual plan illustrations
presented in

tables 1 and 2 showed that top- heavy minimums can require employers to
raise contributions for nonkey employees. In such cases, nondiscrimination
rules- absent the top- heavy rules- could leave some younger workers with
about 1 percent of pay.

Top- heavy vesting schedules can also increase benefits for workers who
leave an employer after 3- year top- heavy vesting begins but before a
standard 5- year vesting schedule would have granted them nonforfeitable
rights to contributions or benefits (see figs. 2 and 3). Given that the
median tenure across industries for workers age 25 and older was 4. 7 years,
it is reasonable to expect that significant numbers of employees leave plans
after working between 3 and 5 years.

Administrative Costs of TopHeavy Annual administrative costs to ensure
compliance with the top- heavy rules

Rules Appear Small generally appear to be a minor part of an employer's
total administrative

costs to operate a tax- qualified plan. Studies on the administrative costs
of pension plans did not find these costs significant enough to count
separately. Indeed, pension consultants we interviewed estimated the costs
to be low in most situations. However, the rules can introduce significant
costs in certain nonroutine situations. While per capita administrative
costs for very small plans are generally much higher than for larger plans,
this is a general issue for pension administration that extends well beyond
topheavy rules. The high per capita costs are caused by high fixed costs and
the absence of economies of scale in very small firms.

Pension plan consultants told us they do not separately account for or
charge separate fees for routine tasks for compliance with top- heavy rules.
Consultants we interviewed estimated that the cost increment top- heavy
rules added to their administrative fees ranged from
“insignificant” to “5- to 10- percent.” Staff at one
large firm consulting for small businesses estimated that the costs of
dealing with issues related to top- heavy rules were about 0.6 percent of
their compliance- related costs. Practitioners explained that computer
software makes running top- heavy tests as routine as hitting a key on a
computer.

Studies on pension plan administrative costs did not isolate the costs that
top- heavy rule compliance adds to employers' routine costs to maintain a
tax- qualified plan. Rather, most identified the rapid pace of legislative
change and the resulting costs and regulatory complexity as the primary
drivers of pension plan administrative costs. Plan administrators and small
employers cited the frequency and complexity of regulatory changes as the
main problem with pension regulation- a problem significantly affecting plan
formation, administration, and termination, according to a 1990 Small
Business Administration- sponsored study. 24

Pension consultants did cite specific situations in which the top- heavy
rules can generate significant one- time administrative costs or pose
unusual burdens. These situations can occur when a moderate- sized plan- for
example, a plan with 100 to 200 participants- is audited by the Internal
Revenue Service and must develop the necessary records to demonstrate that
it is not top- heavy. In other cases, practitioners that gain an existing
pension plan as a new client may need to create records or correct poorly
maintained records. Typically, however, several consultants noted that the
common practice is to make an initial judgment as to whether top- heavy
status is likely and to bypass added top- heavy determination costs by
simply designing top- heavy minimum contributions and vesting schedules into
the plan.

Concluding The federal government has for many years granted tax incentives
as a way

Observations of encouraging the formation of private pension plans. The
granting of

these incentives stems from federal pension policy that seeks to balance a
desired benefit- reasonable levels of retirement income for a broad
complement of workers- against the cost to the government of the related
income tax preferences and, to the extent possible, the regulatory costs
imposed on firms that choose to form plans. Top- heavy rules were designed
to achieve an equitable balance between small business owners' tax benefits
and future pension benefits to workers, but their mandated benefit levels
and the administrative costs of compliance may discourage some small
employers from offering pension plans at all.

From the small employer's perspective, the decision of whether to form a
pension plan appears driven primarily by the financial stability of the firm
and the characteristics and preferences of its employees. Firms considering
initiating pension plans must also weigh the trade- off between the tax
savings the plan can provide for the owners and employees and the costs to
the firm of contributing to and administering the plan. Reducing the top-
heavy rules' costs or administrative requirements could induce some
employers to form new pension plans, but it might also result in lowering
the benefit levels offered to currently covered workers under those plans.

24 John Trutko and John Gibson, Cost and Impact of Federal Regulation on
Small Versus Large Business Retirement Plans, final report submitted to the
Office of the Chief Counsel for Advocacy, Small Business Administration
(Arlington, Va.: James Bell Associates, Inc., June 1990), pp. v, 54.

In evaluating top- heavy rules' impact, the federal government must weigh
the extent to which the rules may in fact discourage pension coverage
against the higher benefit levels and faster vesting schedules the top-
heavy rules have brought about for certain workers, a task made difficult by
the lack of quantifiable information. Fundamentally, however, the government
must balance the larger issues of the cost of favorable tax treatment and
regulation on one hand and the benefits workers receive on the other.

Agency Comments In commenting on a draft of this report, the Department of
the Treasury agreed with our findings. Its response emphasized the view that
the aim of

national policy in this area should be to ensure an equitable distribution
of pension benefits to all Americans, not solely to generate more plans.
Treasury's comments appear in their entirety in appendix III.

The Department of Labor also reviewed the draft report and provided
technical comments. We incorporated these comments where appropriate.

As agreed with your staff, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 30 days after
its issue date. We will then send copies to the Honorable Lawrence H.
Summers, Secretary of the Treasury; the Honorable Alexis M. Herman,
Secretary of Labor; the Honorable Charles O. Rossotti, Commissioner of
Internal Revenue; and others who are interested.

If you or your staff have any questions concerning this report please call
me on (202) 512- 7215. The major contributors to this report are Charles A.
Walter III, Paula J. Bonin, Andrew M. Davenport, Roger J. Thomas, and
Anthony J. Wysocki.

Sincerely yours, Barbara D. Bovbjerg Associate Director Education,
Workforce, and

Income Security Issues

Appendi Appendi xes xI

Scope and Methodology Analysis of Top- Heavy To identify and summarize key
differences between the top- heavy rules and and General

the general nondiscrimination and vesting rules, we Nondiscrimination and

reviewed the Internal Revenue Code and regulations; Vesting Rules

reviewed the legislative history of laws for both sets of rules, as well as
relevant congressional hearings; obtained input from practitioner
associations and from pension

consultants selected on the basis of recommendations from leading actuarial
and employee benefit associations, the Small Business Administration, and
the Department of the Treasury; discussed the rules with Treasury and
Internal Revenue Service (IRS)

officials; reviewed texts and training materials from actuaries and
actuarial

associations, tax attorneys, accountants, and other pension professionals;
discussed the differences with advocates for workers and retirees; and
reviewed literature on pension benefits published from 1983 to 1999 that

documented differences between the rules. We assessed and illustrated the
potential effects of these differences in discussions with pension
professionals and officials of the Treasury and IRS and by reviewing case
examples provided by small- plan consultants and training materials. We
provided a pledge of confidentiality to plan consultants who gave us client
plan examples and proprietary information.

Characteristics and To describe the characteristics of new top- heavy plans
formed in 1996, we

Data on Top- Heavy analyzed the Department of Labor's electronic database of
1996 Form 5500

“Return/ Report of Employee Benefit Plan” submissions from plan
sponsors Plans

across the country (1996 data were the most recent available during our
analysis). Sponsors of tax- qualified pension plans are generally required
to submit Form 5500 and applicable schedules to IRS to satisfy annual
reporting requirements under the Employee Retirement and Income Security Act
and the Internal Revenue Code. Form 5500 data are the only data available on
pension plan sponsor characteristics and top- heavy status. IRS constructs a
database of all Form 5500 submissions it receives and conducts quality
control procedures to correct data errors or omissions before providing the
data to the Department of Labor. Labor's Pension and Welfare Benefits
Administration (PWBA) performs additional completeness and consistency edits
on the Form 5500 filings it receives from IRS. We did not independently
verify the accuracy of IRS' and PWBA's

quality control procedures on Form 5500 data because it would be costly and
impractical.

We focused our analysis of Form 5500 data on top- heavy status and major
plan and sponsor characteristics. The specific characteristics we chose to
analyze included (1) number of plan participants, (2) plan type, and (3)
industrial classification of the sponsor. The Labor database is used to
publish similar data annually. Statistics on these major characteristics
should provide reasonable comparative indicators because they should be less
subject to self- reporting errors than the more detailed characteristics
requested on Form 5500.

We limited our data analysis to newly formed 1 pension plans because the
Form 5500 reports do not clearly identify the current top- heavy status of
established plans. Employers are simply asked to code the form to indicate
whether the plan was top- heavy “in 1984 or subsequent plan
year.” For the year 2000 and beyond, this top- heavy question is no
longer asked. Because we only analyzed data on newly formed plans in 1996,
our results cannot be projected to the universe of all tax- qualified
pension plans or all top- heavy pension plans. We excluded single-
participant plans from our analysis, as top- heavy rules have no effect on
such plans.

Analysis of Top- Heavy To analyze what is known about the overall effects of
the top- heavy rules,

Rules' Aggregate we reviewed relevant professional and academic literature
we obtained in

our review of the key differences between the top- heavy and Effects

nondiscrimination rules. We also conducted detailed interviews with
smallplan practitioners representing a variety of industries and plan types
to identify barriers to plan formation, key cost components of pension plan
administration, and representative illustrations of the effects of the
topheavy rules on an employer's pension contribution costs. In addition, we
discussed the effects of the top- heavy rules with Treasury, IRS, PWBA, and

1 “Newly formed” plans in 1996 are defined as plans indicating
an effective date of 1996. Of these, about 9 percent are plans that
indicated they had been amended in 1996. A plan can be amended in its first
year of existence. However, there is no means, using these 1996 Form 5500
data, to distinguish plans that are both new and amended in 1996 from
amended older plans that may have indicated an effective date of 1996
because of the amendment. About one- fourth of 1 percent of plans indicated
they were merged plans; these may have been started before 1996.

Small Business Administration officials as well as other pension and
employee benefit researchers and industry representatives.

Detailed Differences in Testing Apportionment of Benefits Under

Appendi xII

Nondiscrimination and Top- Heavy Rules Although nondiscrimination and top-
heavy rules follow parallel steps in assessing the apportionment of
contributions or benefits, the rules generally differ at each step.
Nondiscrimination testing alone cannot ensure the detection of
disproportionate accumulation of benefits by owners and officers that the
top- heavy test is designed to identify.

Rules for Testing TopHeavy Nondiscrimination rules for measuring the
apportionment of contributions

Status of Plans and benefits between the top, “highly- paid
employee” group versus other

workers permit employers many choices that do not exist in top- heavy Differ
From General

rules. Top- heavy rules for defining the plan and the top, “key
employee” Nondiscrimination

group to be tested are designed to address the special situation of
ownerdominated Standards

firms. In addition, top- heavy rules provide a fixed, present- value measure
of what the employer has contributed into the plan and what those amounts
have earned, or what an employer may be obligated to provide to fund accrued
benefits. In contrast, nondiscrimination rules allow employers to choose
among various options that yield significantly different values of
contributions and benefits, and required allocations to workers.

Employee Groups and To prevent employers from artificially partitioning
their operations in ways

Grouping of Plans Differ that would exclude workers from pension benefits, a
preliminary step in

testing a plan's apportionment of benefits for either top- heavy status or
nondiscrimination is to define the two employee groups whose benefits are to
be assessed. Table 5 compares the rules for dividing employees into a top
employee group and other workers and for deciding which plans must be
treated as a single entity for testing if an employer has more than one
plan.

Table 5: Rules Governing What and Who Are Being Tested Differ
Nondiscrimination rules Top- heavy rules Top employee group Highly
compensated employees a

Key employees a

Criteria for inclusion: Criteria for inclusion: $85,000 compensation or

5% ownership in firm, b or 5% ownership in firm. b

10 largest owner- employees with compensation over $30,000, b or 1% owners
with compensation over

$150, 000, b or officers with compensation over $67, 500.

“Plan” or entity to be tested

Employers are generally permitted to Employers must aggregate any plans in
choose whether to aggregate or subdivide

which a key employee participates or that plans.

were aggregated to pass the nondiscrimination test. a The Internal Revenue
Code provides different “look- back” time periods for
classifying highly compensated employees versus key employees- a 1- or 2-
year period for highly compensated employees and a 5- year period for key
employees. b Under family ownership attribution rules, 26 U. S. C. 318,
spouses, children, and parents are deemed

to own each other's shares. Both the top- heavy rules and the
nondiscrimination rules incorporate these family attribution rules by
reference; see 26 U. S. C. 416 (i)( 1) and 414( q)( 2), respectively.

Nondiscrimination rules define a top group, called “highly compensated
employees,” on the basis of high salaries or 5 percent ownership. Top-
heavy rules' top group of “key employees” is based on ownership
and officer criteria. The key employee criteria are designed to address the
small business environment, where owners would otherwise have greater
flexibility to structure their pension plans and their compensation as a tax
shelter for themselves and their family. Treasury officials explained that
without the key employee definition, including its supporting family
ownership attribution rules, small business owners would have more latitude
to manipulate ownership, assignments, and salaries in ways that exclude
nonfamily employees from plan benefits or provide them little benefit.

After defining the top group, the “plan” to be tested is
defined. Nondiscrimination rules generally give employers flexibility to
choose to combine or subdivide their plans when it may aid in meeting the
requirements. Top- heavy rules, however, mandate that certain plans be
combined for testing in certain situations. Without the mandated aggregation
requirements, an employer could divide employees into two plans so that one
would have all the key employees and be top- heavy. This

would leave workers in the remaining plan without the protection of the top-
heavy minimum benefits and vesting.

Rules That Measure Table 6 contrasts top- heavy and nondiscrimination rules
for assessing the

Apportionment of Benefits apportionment of contributions and benefits
between the top employee

Differ group and other workers. The methods of measurement listed here for
the

nondiscrimination rules represent the more basic optional design and testing
rules employers can choose to give annual contributions or accruals that
strongly favor highly compensated employees by providing annual allocations
that are a significantly higher percentage of pay than workers receive.
Other optional techniques exist but are not discussed here. Under these
nondiscrimination design and testing options, smaller employers could direct
the vast majority of cumulative plan contributions or benefits to
themselves, their families, or other key employees. In contrast to the
flexible choices under nondiscrimination rules, top- heavy rules measure
contributions or benefits in just one way. Other special nondiscrimination
testing rules applicable to 401( k) plans' testing of salary deferrals and
employer matching contributions are not discussed here.

Table 6: Different Techniques Are Used in Compliance Tests to Measure
Contributions and Benefits

Nondiscrimination- major options Top- heavy- required Compliance testing
technique a 1. Test benefits orcontributions

Counts cumulative, present value of Benefits testing compares benefit
annuities

participants' pension contribution account at each employee's future
retirement age,

or accrued benefit. expressed as a percentage of current pay. This applies
to defined benefit plans and defined contribution plans opting to test

contributions as though they were providing defined benefits.

2. Choose measurement period

Defined benefit plans may test current plan year only; current plan year and
all prior plan years,

divided by years of service; current plan year and all prior and future

years to retirement age, divided by years of service.

Defined contribution plans that test contributions test current year only.

Defined contribution plans that choose to “cross- test” as if
they provided defined benefits can choose either current plan year only or
current plan year and all prior plan years,

divided by years of service.

3. Choose to count Social Security contributions by employer in addition to
pension contributions or benefit accruals. b

Threshold for tests

Is the proportion of highly compensated and Has more than 60 percent of the
present

non- highly compensated employees with a value of cumulative plan benefits
or

specific contribution or benefit rate, as a individual accounts accrued to
key

percentage of compensation, reasonably employees?

representative of the proportion for the employer as a whole? a The use of a
design- based “safe harbor” obviates the need for the general
nondiscrimination test. In addition, inclusion of required top- heavy
minimum contributions or benefits, and vesting, obviates the need for top-
heavy testing. b P. L. 99- 514, the Tax Reform Act of 1986, among other
requirements, modified methods of

coordinating pension benefits with Social Security that resulted in some
rank- and- file participants receiving little or no benefits. The new so-
called “permitted disparity rules,” which apply to plans that
coordinate with Social Security, modified the types of benefit formulas that
effectively denied lowerpaid workers private pension benefits and required
that they provide minimum benefits.

The general test for nondiscrimination in benefits calculates each
participant's benefit as an annuity at the individual's retirement age.
These annuities are expressed as a percentage of current pay, but current
pay is not adjusted to reflect a differing value of money at individuals'
differing future retirement ages. This sequence of computations makes a
younger employee's benefit accrual or cross- tested contribution appear
larger as a share of pay than if the pension allocation and pay were
compared in present- value terms. The top- heavy test measures benefit
accruals in present value. The result of testing a defined contribution plan
as if it were providing a defined benefit is that the plan can favor an
older owner over a young worker such that the allocation on behalf of the
owner, as a share of pay, can be up to 36 times larger if one compares the
age extremes of a 64- year- old owner and a 21- year- old employee. A
defined benefit plan can favor an older owner by even greater margins.

The current- year contribution or accruals test for nondiscrimination can
credit employers with significant allocations to workers that are
subsequently forfeited when employees terminate prior to vesting. In
contrast, the top- heavy cumulative measure better reflects the pattern of
forfeitures and vesting of benefits. 1 General vesting rules permit
employers to require up to 5 years of service before providing employees
nonforfeitable rights to contributions or benefits accrued on the employee's
behalf. This, in effect, excludes all but longer- term employees from
receiving benefits. 2 In a small plan, the owner is generally fully vested.
If employees typically leave without vesting, over time the owner can
accumulate an ever- increasing share of the cumulative plan contributions or
benefits. This “forfeiture effect” escapes detection in a 1-
year measure of contributions and accruals, but the top- heavy cumulative
measure is more effective in detecting an owner's increasing share.

Under nondiscrimination rules for defined benefit plans, an employer can,
alternatively, choose to count all benefit accruals up to the current year,
then divide each employee's accruals by the employee's years of service. In
a small plan in which an owner is significantly older and has longer service

1 When the Department of the Treasury proposed the top- heavy concept, it
recommended measuring only vested accrued benefits. This stricter test was
not adopted. 2 Given that the median term of employment for workers aged 25
and older was 4. 7 years in 1998, most would have had no vested pension
benefits at the company employing them in 1998 under a 5- year cliff vesting
schedule but would have had vested benefits under a 3- year top- heavy cliff
vesting schedule.

than many employees, the effect of dividing by years of service is to make
the owner's accrued benefit appear smaller relative to workers' than if one
compared the present value of current allocations. In contrast, the topheavy
rules' measure of cumulative benefits captures the total present value of
cumulative benefits.

Nondiscrimination rules further give a defined benefit plan the option of
calculating benefits for employees projected out to retirement age, based on
existing salary. In a small, owner- dominated business, plan consultants
explain that the plan typically terminates at the retirement of the owner.
Thus, the future benefits credited in testing are realized by the owner but
are not fully realized by younger workers.

In testing compliance with nondiscrimination rules, retirement plans are
permitted to count employers' Social Security contributions or benefits as
though they were employer pension contributions on behalf of an employee. 3
Top- heavy testing counts only pension plan contributions. Counting Social
Security contributions or benefits under nondiscrimination rules reduces the
employer's required pension contributions for that portion of salaries under
the Social Security taxable wage base, so that higher- paid employees
receive higher pension benefits relative to salary.

3 The Internal Revenue Code sec. 401( l) allows this “permitted
disparity” in apportioning contributions or benefits to highly
compensated and non- highly compensated employees. This was formerly
referred to as “integration” with Social Security.

Comments From the Department of the

Appendi xI II Treasury

Bibliography Altman, Nancy J. “Rethinking Retirement Income Policies:
Nondiscrimination, Integration, and the Quest for Worker Security.”
Tax Law Review, Vol. 42, No. 3 (Spring 1987), pp. 433- 508.

American Academy of Actuaries. The Impact of Government Regulation on
Defined Benefit Plan Terminations: A Special Report by the American Academy
of Actuaries. Washington, D. C.: Mar. 1993.

Andrews, Emily S. Pension Policy and Small Employers: At What Price
Coverage? Washington, D. C.: Employee Benefit Research Institute, 1989.

Bankman, Joseph. “Tax Policy and Retirement Income: Are Pension Plan
Anti- Discrimination Provisions Desirable?” University of Chicago Law
Review, No. 55 (Summer 1988), pp. 790- 835.

Bluestein, Joseph S., and Jack B. Levy. “Owner Dominated Plans-
TopHeavy and H. R. 10 Plans,” 1996 update. Tax Management. Washington
D. C.: Bureau of National Affairs, Inc., 1986.

Calimafde, Paula. The Impact of the Top- Heavy Rules on Small Business
Retirement Plans: Do the Costs Outweigh the Benefits Following the Tax
Reform Act of 1986, report submitted to the Office of Advocacy, U. S. Small
Business Administration (SBA). Bethesda, Md.: Jan. 1987.

Cvach, Gary, Gregory E. Matthews, and Lisa C. Germano. Employee Benefits and
Compensation, Tax Planning and Advising for Closely Held Businesses- Sixth
Course. Jersey City, N. J.: American Institute of Certified Public
Accountants, 1998.

Economic Systems, Inc. Study of 401( k) Plan Fees and Expenses, final report
submitted to the U. S. Department of Labor, Pension and Welfare Benefits
Administration. Springfield, Va.: Economic Systems, Inc., Apr. 13, 1998.

Enrolled Actuaries Meeting Transcript, Mar. 20- 22, 1995. Washington, D. C.:
American Academy of Actuaries, 1995.

Grubbs, Jr., Donald S. “Age- Weighted Plans and New Comparability
Plans .” Journal of Pension Planning and Compliance, Vol. 20. No. 2
(Summer 1994), pp. 1- 28.

Hay/ Huggins Company, Inc. Pension Plan Expense Study for the Pension
Benefit Guaranty Corporation. Philadelphia, Pa.: Hay/ Huggins Company, Inc.,
Sept. 1990.

Hustead, Edwin C . Retirement Income Plan Administrative Expenses, 1981
Through 1996. Philadelphia, Pa.: Hay Group, May 1996.

Kennell, David L., Arnold T. Brooks, and Terry Savela. Retirement Plan
Coverage in Small and Large Firms, final report submitted to the Office of
Advocacy, SBA. Vienna, Va.: Lewin- ICF, June 1992.

Knox, William T., IV. (two- part series) “Coping With the Top- Heavy
Qualified Plan Rules: Points, Problem Areas and Planning.” The Journal
of Taxation, Vol. 62, No. 5. (May 1985), pp. 258- 264; and “How the
Final Regs Interpret the Special Requirements Imposed on Top- Heavy
Plans.” The Journal of Taxation, Vol. 62, No. 6 (June 1985), pp. 350-
355.

LaBombarde, Adrien R. A Guide to Nondiscrimination Requirements for
Qualified Pension and Profit- Sharing Plans. Chicago, Ill.: Commerce
Clearing House, Inc., 1991.

Lubick, Donald C., Assistant Secretary for Tax Policy, Department of the
Treasury. Statement before the Subcommittee on Oversight, House Committee on
Ways and Means, Oversight Hearing on Pension Issues. Washington, D. C.: Mar.
23, 1999.

McGill, Dan M., and others. Fundamentals of Private Pensions, 7th ed.
Philadelphia, Pa.: University of Pennsylvania Press, 1996.

Salisbury, Dallas L. Pension Tax Expenditures: Are They Worth the Cost?
Issue Brief No. 134. Washington, D. C.: Employee Benefit Research Institute,
Feb. 1993.

Tripodi, Sal L. The ERISA Outline Book, Volumes I and II. Highlands Ranch,
Colo.: TRI Pension Services, 1999.

Trutko, John, and John Gibson. Cost and Impact of Federal Regulation on
Small Versus Large Business Retirement Plans, final report submitted to the
Office of the Chief Counsel for Advocacy, SBA, Arlington, Va.: James Bell
Associates, Inc., June 1990.

U. S. Small Business Administration, Office of the Chief Counsel for
Advocacy. The Regulation of Small Retirement Plans: A Reexamination of the
Top- Heavy Rules and Incentives for Small Employer Pensions. Washington, D.
C.: SBA, Apr. 1987.

U. S. Congress. House. H. R. 6410- Pension Equity Tax Act of 1982, Committee
on Ways and Means, Washington, D. C.: U. S. Government Printing Office, 97th
Congress, Second Session, 1982. Serial 97- 65.

_____ . Senate. Hearing 98- 172, Effect of TEFRA on Private Pension Plans,
before the Subcommittee on Savings, Pensions, and Investment Policy of the
Committee on Finance, U. S. Senate. 98th Congress, first ses., Apr. 11,
1983.

U. S. Department of Labor, Bureau of Labor Statistics. Employee Tenure
Summary: Employee Tenure in 1998. Washington, D. C.: Bureau of Labor
Statistics, Sept. 23, 1998.

_____. Employee Retirement Income Security Act (ERISA) Advisory Council on
Employee Welfare and Benefit Plans. Report of the Working Group on Small
Business: How to Enhance and Encourage the Establishment of Pension Plans.
Washington, D. C.: ERISA Advisory Council, Nov. 13, 1998.

U. S. General Accounting Office. Private Pensions: 1986 Law Will Improve
Benefit Equity in Many Small Employers' Plans. GAO/ HRD- 91- 58, Mar. 29,
1991.

_____. Private Pensions: Impact of Vesting and Minimum Benefit and
Contribution Rules in Top- Heavy Plans. GAO/ HRD- 90- 4BR, Oct. 23, 1989.

_____. Effects of the Employee Retirement Income Security Act on Pension
Plans With Fewer Than 100 Participants. GAO/ HRD- 79- 56, Apr. 16, 1979.

Yakoboski, Paul, Pamela Ostuw, and Bill Pierron. The 1999 Small Employer
Retirement Survey: Building a Better Mousetrap Is Not Enough, Issue Brief
No. 212. Washington, D. C.: Employee Benefit Research Institute, Aug. 1999.

Related GAO Products Integrating Pensions and Social Security: Trends Since
1986 Tax Law Changes( GAO/ HEHS- 98- 191R, July 6, 1998).

401( k) Pension Plans: Many Take Advantage of Opportunity to Ensure Adequate
Retirement Income( GAO/ HEHS- 96- 176, Aug. 2, 1996).

Women's Pensions: Recent Legislation Generally Improved Pension Entitlement
and Increased Benefits( GAO/ T- HRD- 92- 20, Mar. 26, 1992).

Private Pensions: Changes Can Produce a Modest Increase in Use of Simplified
Employee Pensions( GAO/ HRD- 92- 119, July 1, 1992).

Private Pensions: 1986 Law Will Improve Benefit Equity in Many Small
Employers' Plans( GAO/ HRD- 91- 58, Mar. 29, 1991).

Private Pensions: Impact of New Vesting Rules Similar for Women and Men
(GAO/ HRD- 90- 101, Aug. 21, 1990).

Private Pensions: Impact of Vesting and Minimum Benefit and Contribution
Rules in Top- Heavy Plans( GAO/ HRD- 90- 4BR, Oct. 23, 1989).

Private Pensions: Plan Provisions Differ Between Large and Small Employers(
GAO/ HRD- 89- 105BR, Sept. 26, 1989).

Private Pensions: Portability and Preservation of Vested Pension Benefits
(GAO/ HRD- 89- 15BR, Feb. 3, 1989).

Pension Portability and Preservation: Issues and Proposals( GAO/ T- HRD88-
24; July 12, 1988).

Pension Plans: Vesting Status of Participants in Selected Small Plans (GAO/
HRD- 88- 31, Oct. 30, 1987).

Vesting Status of Selected Participants in Top- Heavy Plans( GAO/ T- HRD-
883, Oct. 23, 1987).

(207054) Lett er

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Page 1 GAO/ HEHS- 00- 141 "Top- Heavy" Pension Plan Rules

Contents

Contents Page 2 GAO/ HEHS- 00- 141 "Top- Heavy" Pension Plan Rules

Page 3 GAO/ HEHS- 00- 141 "Top- Heavy" Pension Plan Rules United States
General Accounting Office

Washington, D. C. 20548 Page 3 GAO/ HEHS- 00- 141 "Top- Heavy" Pension Plan
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Page 34 GAO/ HEHS- 00- 141 "Top- Heavy" Pension Plan Rules

Appendix I

Appendix I Scope and Methodology

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Appendix I Scope and Methodology

Page 36 GAO/ HEHS- 00- 141 "Top- Heavy" Pension Plan Rules

Page 37 GAO/ HEHS- 00- 141 "Top- Heavy" Pension Plan Rules

Appendix II

Appendix II Detailed Differences in Testing Apportionment of Benefits Under
Nondiscrimination and Top- Heavy Rules

Page 38 GAO/ HEHS- 00- 141 "Top- Heavy" Pension Plan Rules

Appendix II Detailed Differences in Testing Apportionment of Benefits Under
Nondiscrimination and Top- Heavy Rules

Page 39 GAO/ HEHS- 00- 141 "Top- Heavy" Pension Plan Rules

Appendix II Detailed Differences in Testing Apportionment of Benefits Under
Nondiscrimination and Top- Heavy Rules

Page 40 GAO/ HEHS- 00- 141 "Top- Heavy" Pension Plan Rules

Appendix II Detailed Differences in Testing Apportionment of Benefits Under
Nondiscrimination and Top- Heavy Rules

Page 41 GAO/ HEHS- 00- 141 "Top- Heavy" Pension Plan Rules

Appendix II Detailed Differences in Testing Apportionment of Benefits Under
Nondiscrimination and Top- Heavy Rules

Page 42 GAO/ HEHS- 00- 141 "Top- Heavy" Pension Plan Rules

Page 43 GAO/ HEHS- 00- 141 "Top- Heavy" Pension Plan Rules

Appendix III

Page 44 GAO/ HEHS- 00- 141 "Top- Heavy" Pension Plan Rules

Bibliography Page 45 GAO/ HEHS- 00- 141 "Top- Heavy" Pension Plan Rules

Bibliography Page 46 GAO/ HEHS- 00- 141 "Top- Heavy" Pension Plan Rules

Page 47 GAO/ HEHS- 00- 141 "Top- Heavy" Pension Plan Rules

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