GAO

United States General Accounting Office

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

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

Contents

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
Contents

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

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
Page 3 GAO/HEHS-00-141 "Top-Heavy" Pension Plan Rules

United States General Accounting Office

Washington, D.C. 20548

Health, Education, and

Human Services Division

B-282169 Letr

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 plans1 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.
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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.
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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
B-282169

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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).
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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.
B-282169

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

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.

Top-Heavy

?

No

Raise

Benefits

and

Retest

Select

Different

Test and

Retest

Apply Top-Heavy

Minimum Benefit

and

Vesting Rules

Select Among

General

Nondiscrimination

and Vesting Rules

Apply Test

for

Top-Heavy

Status

Pass

Qualified Plan Design

?

and/

or

No

Yes

Yes
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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

Ensure Benefits That

Workers Would Not

Receive Under the

General

Nondiscrimination and

Vesting Rules

Important differences exist between top-heavy rules and the general

nondiscrimination and vesting rules. The top-heavy rules were developed

to address opportunities for pension-plan-related tax abuses in ownerdominated firms. Top-heavy rules differ from nondiscrimination rules in

• how they measure or test whether top employees receive a

disproportionate share of contributions or benefits, compared with

workers;

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.
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• requiring top-heavy plans to meet more generous minimum standards

for benefits10 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

Status of Plans Differ From

General Nondiscrimination

Standards

The test for top-heavy status differs from general nondiscrimination

standards in two basic ways:

• the definition of the “plan” and of the top employee group whose

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

Grouping of Plans Differ

Both nondiscrimination and top-heavy testing rules divide plan participants

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

10In 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.
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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

11For defined benefit plans that terminate, adequacy of funds can also affect participants’

entitlements.
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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

Higher Minimum Standards

for Benefits Going to

Workers

If a plan has a top-heavy apportionment of benefits, it must provide

workers—that is, those not in the top employee group—two things: (1) a

specified minimum-level contribution or benefit that can be higher than

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.
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Top-Heavy Minimum Benefits

Can Exceed Minimums Under

Nondiscrimination Rules and

Tests

The minimum required employer contribution for workers in top-heavy

defined contribution plans is 3 percent of compensation;12 the only

exception to this minimum rate occurs if the highest contribution rate for

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

12We 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.

13Under 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.
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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

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

Employee

status Age Salary

Employer contributions

Allocation satisfying

nondiscrimination rules

Incremental

allocation to

meet top-heavy

minimum

Total allocation to meet topheavy minimum

Amount

(dollars)

Percentage

of pay

Amount

(dollars)

Amount

(dollars)

Percentage

of pay

Key employee

60 $160,000a $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
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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 average contributions 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

1426 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.

15Under 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.
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Table 2: Minimum Contributions Under a Top-Heavy 401(k) Plan

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.

Employee status Salary

Contributions

Employee

elective

Employer

match

3% required

top-heavy

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 0a

23,940 0 0 720

21,940 970 200 660

Plan total $320,360 $18,570 $2,850 $3,250
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Page 17 GAO/HEHS-00-141 "Top-Heavy" Pension Plan Rules

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

16A 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.
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Page 18 GAO/HEHS-00-141 "Top-Heavy" Pension Plan Rules

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.
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Page 19 GAO/HEHS-00-141 "Top-Heavy" Pension Plan Rules

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

the Rules Have Narrowed

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

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 15-

year gradual schedule to a 3- to 7-year schedule. Although this brought
B-282169

Page 20 GAO/HEHS-00-141 "Top-Heavy" Pension Plan Rules

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.

1726 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).
B-282169

Page 21 GAO/HEHS-00-141 "Top-Heavy" Pension Plan Rules

Most New Top-Heavy

Plans Have Few

Participants and Are

Defined Contribution

Plans in the Service

Sector

Most new top-heavy plans had few participants—approximately 84 percent

had fewer than 10 participants in 1996.18 Furthermore, the incidence of a

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

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

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

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

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.
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Page 22 GAO/HEHS-00-141 "Top-Heavy" Pension Plan Rules

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

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.

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

20,000

22,000

2-9 10-24 25-49 50-99 100+

Number of Plans 

Participant Size of Plan

Total Plans in Category

Top-Heavy Plans

21,710

12,870

6,640

3,270

2,670

320 100 50

11,350

1,750
B-282169

Page 23 GAO/HEHS-00-141 "Top-Heavy" Pension Plan Rules

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

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

0

5,000

10,000

15,000

20,000

25,000

30,000

Non-401(k) Defined Benefit

Defined Contribution

401(k) Defined

Contribution

Number of Plans 

Type of Plan

Total Plans in Category

Top-Heavy Plans

28,070

16,590

1,720

2,690

9,620

1,160
B-282169

Page 24 GAO/HEHS-00-141 "Top-Heavy" Pension Plan Rules

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.)

19A 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.

20Other services include educational or engineering services and other services not

classified elsewhere.
B-282169

Page 25 GAO/HEHS-00-141 "Top-Heavy" Pension Plan Rules

Figure 7: Top-Heavy Status, by Industry Sector

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

Top-Heavy Rules’

Aggregate Effects Have

Not Been Quantified

The overall effects of the top-heavy rules have not been quantified.

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

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

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

Physician, Other Services

Dentist, Legal

Services

Finance, Retail Trade Construction Manufacturing

Insurance,

Real Estate

Wholesale

Trade

Number of Plans 

Sector

Total Plans in Category

Top-Heavy Plans

2,640

3,300

3,850

13,180

7,530

6,150

620

3,570

1,000 560 750 740

5,020

3,450
B-282169

Page 26 GAO/HEHS-00-141 "Top-Heavy" Pension Plan Rules

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

Effects Have Not Been

Isolated

We found no studies that quantified overall effects—positive or negative—

of the top-heavy rules on numbers of plans or participants, or on

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.

21Private Pensions: Impact of Vesting and Minimum Benefit and Contribution Rules in TopHeavy Plans (GAO/HRD-90-4BR, Oct. 23, 1989), p. 3.
B-282169

Page 27 GAO/HEHS-00-141 "Top-Heavy" Pension Plan Rules

Employer Contribution

Costs Are Important but Are

Not a Primary Barrier to

Small Business Pension

Plan Formation

Surveys of small employers without pension plans indicate that the primary

obstacles to offering a plan are the economic situation of the employer and

the characteristics and preferences of the workforce typical of small firms.

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

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

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)

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

22David 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.

Primary reason for not offering retirement plan

Employers with

1-24 employees

Employers with

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

23Paul 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.
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Page 28 GAO/HEHS-00-141 "Top-Heavy" Pension Plan Rules

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

Top-Heavy Rules Can

Increase an Employer’s

Pension Costs

The top-heavy rules’ required minimum 3 percent of pay contribution for

defined contribution plans can increase employers’ costs above what

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.

Reasons cited for not offering a plan

Percentage who cited reason as the

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
B-282169

Page 29 GAO/HEHS-00-141 "Top-Heavy" Pension Plan Rules

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 Rules Appear Small

Annual administrative costs to ensure compliance with the top-heavy rules

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
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Page 30 GAO/HEHS-00-141 "Top-Heavy" Pension Plan Rules

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

Observations

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

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.

24John 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.
B-282169

Page 31 GAO/HEHS-00-141 "Top-Heavy" Pension Plan Rules

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.
B-282169

Page 32 GAO/HEHS-00-141 "Top-Heavy" Pension Plan Rules

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
Page 33 GAO/HEHS-00-141 "Top-Heavy" Pension Plan Rules
Page 34 GAO/HEHS-00-141 "Top-Heavy" Pension Plan Rules

Appendix I

Scope and Methodology ApApenednxidexiIs

Analysis of Top-Heavy

and General

Nondiscrimination and

Vesting Rules

To identify and summarize key differences between the top-heavy rules and

the general nondiscrimination and vesting rules, we

• reviewed the Internal Revenue Code and regulations;

• 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

Data on Top-Heavy

Plans

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

analyzed the Department of Labor’s electronic database of 1996 Form 5500

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

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
Appendix I

Scope and Methodology

Page 35 GAO/HEHS-00-141 "Top-Heavy" Pension Plan Rules

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 formed1 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

Rules’ Aggregate

Effects

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

we reviewed relevant professional and academic literature we obtained in

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

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.
Appendix I

Scope and Methodology

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

Small Business Administration officials as well as other pension and

employee benefit researchers and industry representatives.
Page 37 GAO/HEHS-00-141 "Top-Heavy" Pension Plan Rules

Appendix II

Detailed Differences in Testing

Apportionment of Benefits Under

Nondiscrimination and Top-Heavy Rules ApendxiI

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 Status of Plans

Differ From General

Nondiscrimination

Standards

Nondiscrimination rules for measuring the apportionment of contributions

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

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

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

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

Grouping of Plans Differ

To prevent employers from artificially partitioning their operations in ways

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.
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

Table 5: Rules Governing What and Who Are Being Tested Differ

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

Nondiscrimination rules Top-heavy rules

Top employee group

Highly compensated employeesa

Criteria for inclusion:

• $85,000 compensation or

• 5% ownership in firm.b

Key employeesa

Criteria for inclusion:

• 5% ownership in firm,b or

• 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

choose whether to aggregate or subdivide

plans.

Employers must aggregate any plans in

which a key employee participates or that

were aggregated to pass the

nondiscrimination test.
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

would leave workers in the remaining plan without the protection of the

top-heavy minimum benefits and vesting.

Rules That Measure

Apportionment of Benefits

Differ

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

apportionment of contributions and benefits between the top employee

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.
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

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

Contributions and Benefits

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.

Nondiscrimination—major options Top-heavy—required

Compliance testing techniquea

1. Test benefits or contributions

Benefits testing compares benefit annuities

at each employee’s future retirement age,

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.

Counts cumulative, present value of

participants’ pension contribution account

or accrued benefit.

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

non-highly compensated employees with a

specific contribution or benefit rate, as a

percentage of compensation, reasonably

representative of the proportion for the

employer as a whole?

Has more than 60 percent of the present

value of cumulative plan benefits or

individual accounts accrued to key

employees?
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

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.
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

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

Appendix III

Comments From the Department of the

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

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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-88-

3, Oct. 23, 1987).

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