Articles | November 11, 2022

Impact on Plan Sponsors of Higher IRS Retirement Plan Limits

As a result of sustained high rates of inflation over the past several months, the 2023 retirement plan limits recently announced by the IRS reflect unprecedentedly large increases over the 2022 limits. The high inflation has similarly affected the 2023 update of annual amounts published by PBGC and Social Security.

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In this article, we examine the implications of the 2023 limit increases for retirement plan sponsors from a variety of different perspectives to help them better prepare and manage the potential impacts points for next year. The content presented is most relevant to single-employer corporate plan sponsors, but there may be some applicability to multiemployer and public sector sponsors as well.

Overview of retirement plan limits

The 2023 retirement plan limits, thresholds and other amounts are presented in Segal’s October 25 insight, “Numbers Retirement Plan Sponsors Need to Know for 2023.” The following table is an excerpt of one of the tables in that insight.

Selected IRS Retirement Plan Limits

  2022 2023
Maximum 401(a)(17) annual compensation amount considered for qualified plans and 403(b) plans $305,000 $330,000
Maximum 415(b) annual payout at age 62 from a DB plan 245,000 265,000
Annual elective 401(k), 403(b) and 457(b) deferral limit 20,500 22,500

As noted, the increases in the limits for 2023 are significantly higher than in prior years. For example, the IRC 401(a)(17) compensation limit, which is increased in $5,000 increments, has only been increased by more than one $5,000 increment three times in the past 20 years. Moreover, the maximum annual increase in that limit (until now) was $15,000. For 2023, this limit was increased by $25,000, which is five times the $5,000 incremental increase.

Implications for plan sponsors

The annual limit increases in previous years may not have warranted much attention from most plan sponsors because the increases have typically been small. However, the considerably more significant increases in plan limits for 2023 may result in a more visible impact for plan sponsors in several areas of plan management, including:

  • Financial impact
  • Participant communication and education
  • Plan compliance and nondiscrimination testing

Financial impact

In 2023, retirement plan finances could incur a more significant impact from the limit increases than in prior years. Specifically, the ability to recognize higher compensation, benefits and contribution amounts in qualified DB and DC plans could increase the cash cost and/or accounting expense for these plans.

At the same time, the increases in these limits could result in reduced costs for non-qualified plans that are designed to recognize compensation, benefits and contributions that exceed the respective limits. In this sense, there may be more of a shift in plan cost from the non-qualified to qualified plan, rather than an increase in overall plan cost.

The potential impact may vary from plan to plan based on the following:

  • The extent to which the plan’s covered plan population is earning compensation or benefits in excess of the respective limits. Plans with a larger portion of the population in this category will have a greater impact.
  • Although, as noted, there may be some shifting of cost between qualified and non-qualified plans, the mechanics of the calculation of certain components of accounting expense can result in asymmetric impacts between the two plans.
  • Non-qualified benefit plans are often not pre-funded. As such, from a cash-cost perspective, the limit increases may result in increased cash requirements in the near term to fund the qualified plan. In contrast, the offsetting reduction in cash cost for the non-qualified plan may not be realized until the resulting increases in plan benefits are actually paid to participants.
  • For DC plans in particular there is an additional potential impact on the employer contribution cost, aside from the impact of the increase in the compensation contribution limits. Specifically, the increase in the 401(k)/403(b) limit on participant deferrals can also result in an increase in a plan sponsor’s matching contributions. This will depend on the specific matching provision of the plan.

An important consideration relating to the cost impact of increases in retirement plan limits is timing of recognition. Financial accounting for DB plans generally looks at projected benefits and, therefore, recognizes the full impact of limit increases immediately. In contrast, contribution requirements under the IRS funding rules reflect participant accrued benefits as of the valuation date, which results in a more gradual recognition of cost increases due to the higher limits.

Other potential financial impacts for plan sponsors include:

  • For DB plans, the increase in limits may have an impact on the plan’s funded status. Changes in plan funded status are reported on a plan sponsor’s balance sheet and, under IRS funding rules, can even trigger certain restrictions on plan operations if the funded status falls below applicable thresholds.
  • Increases in PBGC premium rates and the resulting increase in PBGC premium expenses can result in increased DB pension plan funding costs and accounting expense. Typically, this is reflected as an increase in the provision for assumed plan administrative expenses.
  • Plans with Social Security offset formulas may potentially see a decrease in plan costs as a result of the increase in the Social Security offset component to the plan benefit.
  • Plans with integrated Social Security benefit formulas will likely see increases in cost, where the increase may vary based on participant compensation levels in relation to the compensation level reflected in the integration formula (e.g., Social Security taxable wage base or covered compensation).

Participant communication and education

Plan sponsors should consider the potential impact of the 2023 limit increases on participant communication and the need to provide education. For example:

  • Participants may see significant changes in benefit statement values compared to prior years and may need additional information or guidance to better understand the changes. While accrued benefits will initially only reflect one year of the higher limits, projected benefits could incur a compounded impact of projecting from the higher 2023 limits over multiple future years.
  • For DC plans, the limit changes may result in needed participant education and action regarding plan elections and/or deferral rates. Plan sponsors should consider providing information and/or training to participants regarding how the large increases in the limits could impact participants’ target deferral percentages that were previously set to achieve certain goals (e.g., to maximize the employer match or to maximize the deferral), which may now need to be adjusted for the increased limits.

Plan compliance/nondiscrimination testing

Plan sponsors should also consider the potential impact of the 2023 limit increases on their plan’s ability to pass nondiscrimination testing (NDT) requirements. For example:

  • The increase in compensation limits for 2023, including the threshold for determining whether a participant is considered “highly compensated” for testing purposes, will likely not have a uniformly consistent directional impact on NDT results across all plans. The direction of impact could go either way depending on plan specifics/population.
  • Although the direction of impact can vary, the magnitude of the impact may be more significant than a typical year due to larger shifts in plan amounts and participant testing status resulting from the new limits. For a plan that has been passing in prior years by only a small margin, this may especially be something to examine further.
  • The timing impact for different components of the test results varies. Specifically, the compensation for determining a participant’s testing status is based on prior year compensation, whereas the benefit accrual rate reflects current year compensation.
  • DC plan 401(k) plan testing is based on participant deferral elections. If those participants who change testing status due to the change in the compensation threshold have significantly different deferral levels than the result of the population, this could have a material impact on the test results.

Plan sponsor next steps

Plan sponsors may wish to gain further insight and/or conduct further analysis to better understand the potential impact of the issues identified above. Based on the various considerations identified above, each plan may be affected differently. Plan sponsors are advised to review the specific circumstances of their plans to better understand the potential impact. This would include looking at the extent to which its plan participants are affected by the limits (in terms of compensation and benefit levels), funded status risk (e.g., could a potential deterioration in funded status be an issue?), looking at plan design factors which may apply (e.g., DB versus DC, Social Security offset or integration and DC match formula) and how DB plan accounting may be affected.

In addition, sponsors may also wish to consider the broader implications of high inflation on retirement plans beyond the specific issues raised in this article. For example, the potential impact of high inflation on other economic variables affecting retirement plans, such as rates of salary increase, interest rates and capital markets may also be worth exploring.

Sponsors should reach out to their plan actuary to assist with these efforts.

Interested in examining the impact of higher IRS limits on your retirement plans and/or exploring related issues?

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This page is for informational purposes only and does not constitute legal, tax or investment advice. You are encouraged to discuss the issues raised here with your legal, tax and other advisors before determining how the issues apply to your specific situations.