Pension nondiscrimination rules and the incentive to cross subsidize employees

Peter J. Brady

Journal of Pension Economics and Finance, 2007, vol. 6, issue 2, 127-145

Abstract: Among the requirements a pension plan must meet to qualify for tax benefits are the nondiscrimination rules. Nondiscrimination rules are designed to ensure that pension benefits do not disproportionately accrue to highly compensated employees. But the rules are also complex and increase administrative and compliance costs associated with offering a pension plan. Recent pension reform proposals would simplify nondiscrimination rules, reducing administrative and compliance costs and potentially leading to more employers offering pension benefits. However, there are concerns that any loosening of the rules could lead to a drop in participation by low-wage workers. This paper examines the economic incentive that nondiscrimination rules provide to employers to cross subsidize employees; that is, the incentive to increase pension benefits (and total compensation) paid to low-paid workers for the express purpose of enabling high-paid workers to receive a higher proportion of compensation in the form of pension benefits. The study calculates the incentives faced by a hypothetical firm, and then illustrates how those incentives change when assumptions about employee contribution behavior, employee compensation, and employer-matching formulas are allowed to vary. Results show that only firms with a relatively low ratio of low-paid workers to high-paid workers would have an economic incentive under a standard 401(k) plan to cross subsidize employees. Although this incentive may exist in a large number of firms, these firms likely employ only a small portion of the workforce. This is ultimately an empirical question, however, and examining data on the distribution of earnings within pension plans, as well as determining if firms find nondiscrimination rules binding, would be a useful extension of this research.

Date: 2007
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