The new $150,000 limit on qualified plan compensation.

Beginning in 1994, the maximum amount of compensation that can be used to compute contributions and benefits for a participant in a qualified plan is reduced to $150,000. This reduction was part of the Revenue Reconciliation Act of 1993, and represents a significant cutback from the 1993 compensation limit of $235,840.

This change will have an impact on benefits in small and large plans alike, and will not only affect contributions and benefits, but also nondiscrimination testing. Newer plan designs, such as age-weighted and comparability plans, will receive serious consideration, particularly among smaller employers, as owners seek to maximize contributions on their own behalf.

In 1993, a small corporation with a profit-sharing plan could provide its owner with a contribution allocation of $30,000 (the maximum amount allowable in a defined contribution plan), provided the owner had at least $200,000 in compensation. Beginning in 1994, a typical profit-sharing plan will generally yield at most a $22,500 contribution allocation to any participant (approximately $25,000 if the plan is integrated with social security).

One method available for an owner to continue receiving a $30,000 contribution allocation each year is to install a second plan, specifically a money purchase pension plan. Generally, contributions to a profit-sharing plan are limited to 15% of the collective compensation of all participants. However, a money purchase plan will allow contributions of up to 25% of compensation. Therefore, an owner with $150,000 in compensation could still receive a $30,000 contribution allocation by combining a 5% money purchase contribution with a discretionary profit-sharing plan contribution that equals 15% of compensation. However, all other plan participants would also receive a similar contribution allocation, substantially increasing the annual company retirement contribution. In addition, the administrative costs of maintaining two plans must be considered.

Alternatively, if the owner or another member of the targeted group) is, on average, several years older than the typical rank an file participant, an age profit-sharing plan could continue to maximize the contribution allocations with only one plan. Comparability plans, which are also tested for nondiscrimination purposes based on the benefit provided rather than the traditional measure of contributions received, can be effective if the goal is to benefit only certain members of the highly compensated group. These plans are generally not appropriate for larger employers, because the age diversity of the work force may cause excessive benefits to be provided to some participants outside the targeted group. In addition, the required nondiscrimination testing may become onerous. It should be noted that legislation will likely be introduced to limit age-weighted and comparability plans because of perceived discrimination and the fear that the availability of such plans may cause even more defined benefit plan terminations.

Larger plans will see similar reductions in the contributions allocated to highly paid employees. it will generally be prohibitively expensive to increase contributions to all participants as a means of replacing the benefits lost by the targeted group. Nonqualified plans specifically designed to supplement qualified plans and to provide for additional benefits lost may become even more popular. These plans, which are generally "top hat" plans, may become the predominant feature when designing plans for the remainder of the 1990s.

In addition, middle managers in large companies may lose the ability to contribute as much to their Sec. 401(k) plans as they have in the past. The Sec. 401(k) nondiscrimination rules may limit the pretax contributions of highly paid employees, depending on the pretax contribution rate of the nonhighly paid employees. The contribution rates, called deferral percentages, are calculated for each participant by dividing his elective contribution by his compensation. Generally, the average of the deferral percentages for highly paid employees cannot exceed two percentage points more than the average of the deferral percentages of nonhighly paid employees. (For example, an average deferral percentage of 5.2% for highly paid employees would be acceptable if the average deferral percentage for nonhighly paid employees was 3.4%, but not if the nonhighly paid percentage was 3.1%.) If the average deferral percentage test is not met, the highly paid employees with the highest deferral percentages will be forced to reduce their contributions until the test is satisfied.

Example: Under prior law, a highly paid employee who contributed $8,000 and whose compensation was $70,000 would have a deferral percentage of 11.43, while a highly paid employee contributing $8,994 with considered compensation of $235,840 would have a deferral percentage of only 3.81. If these two employees were the only highly paid employees, the highly paid average deferral percentage would be 7.62. If the nonhighly paid average deferral percentage was 5.65, the plan would pass (although not by much) the average deferral percentage (ADP) nondiscrimination test.

Under the new $150,000 compensation limit, the highly paid employee with the highest compensation would have a deferral percentage of 6.0, and the highly paid group would have an average deferral percentage of 8.72. The plan would fail the ADP test, and only the highly paid middle manager would have his contributions cut back to 9.3%, a reduction of $1,491, because his reduced deferral rate would still be higher than that of the highly paid employee with the highest compensation. Therefore, it is possible that in some Sec. 401(k) plans the reduction in compensation could affect only middle managers, but not the very highly paid employees whose compensation limit is actually reduced.

The new $150,000 limit is effective for plan years beginning after 1993. The limit will be indexed only in increments of $10,000. That is, indexing will occur at the same rate as the old $200,000 limit ($235,840 in 1993), except the indexed amount will only be recognized each time a $10,000 increment is reached.