Certified Plan Sponsor Professional (CPSP) Practice Exam

Which allocation method ensures that contributions to a retirement plan are distributed based on the percentage of an employee's pay?

1. Fixed allocation formula

2. Pro Rata allocation formula

3. Graduated allocation formula

4. Equal allocation formula

The correct answer is: Pro Rata allocation formula

The pro rata allocation formula is the correct method for distributing contributions to a retirement plan based on the percentage of an employee's pay. This method ensures that contributions are proportionally allocated relative to each employee's earnings. Essentially, each employee's share of the total contribution is determined by their individual pay compared to the total payroll for all eligible employees, thereby ensuring that higher earners receive a larger portion of the contributions in alignment with their salary. In retirement plan contexts, using a pro rata formula helps maintain fairness and reflects employees' contributions according to their compensation levels, which can be crucial for incentivizing higher pay scales and ensuring compliance with nondiscrimination rules that work to prevent any disproportionate benefits to higher-paid employees in comparison to their lower-paid counterparts. The other methods listed do not operate on a percentage of pay. The fixed allocation formula distributes a set contribution amount equally among plan participants, which may benefit lower-paid employees more than those with higher salaries. The graduated allocation formula often provides contributions based on a tiered structure related to earnings levels rather than the total pay itself. An equal allocation formula divides contributions equally among all participants regardless of their pay, lacking proportionality to compensation. Thus, the pro rata allocation formula uniquely aligns contributions with employee compensation.