Certain rules in the Internal Revenue Code are designed to prevent employers from discriminating against non-highly paid employees in their pension plans. Unfortunately for the retirement security of their employees, some employers look for ways to get around the nondiscrimination rules.
Instead of sponsoring pension plans that treat all participants equally, some employers circumvent the rules by creating “carve-out” pension plans. These plans often provide rich benefits for senior, well paid employees-often the company’s owners and officers-while covering only a relatively small percentage (or in some cases none) of the non-highly paid employees. While these plans may comply technically with the tax rules as they are now interpreted they are fundamentally unfair.
Case in point: An article in Physicians News Digest promotes the use of carve-out plans, noting that they allow doctors to “focus the majority of an employer’s contribution to a select group of employees, usually key or highly compensated employees.” In other words, a medical practice can save big bucks by providing one plan for its doctors, while offering many of its lower-paid employees a different, less valuable plan:
By including the key or highly-compensated employees in a defined benefit plan and the remaining employees in a more affordable 401(k) plan, you can keep your retirement plan in compliance with non-discrimination regulations, while keeping expenses at a minimum.
We have discussed the merits of a traditional pension over a 401(k) plan several times in the past. The truly insidious aspect of carve-outs is the fact that the higher-paid employees – the ones who are more likely to be able to save for retirement on their own – are given the better plan, while the lower-paid workers – the ones who can least afford to save for retirement – are stuck with an inferior one.
Have these employers forgotten that the success of their business is not just a one-(wo)man show? Or do they just not care?
Moreover, the IRS could probably limit somewhat the discriminatory impact of these plans by issuing new regulations on the technical rules that employers exploit to make carve-outs possible.
For information on another type of carve-out plan, see our fact sheet on Q-SERPs.