March 1, 2018—When it comes to defined contribution retirement plans, employers have numerous goals. As I meet with them, there are two objectives that I hear frequently from those that sponsor a 401(k) plan. One is that they want to encourage greater participation and higher rates of saving to help company employees achieve financial security in retirement. Just as important, they want to make sure highly compensated executives and company owners can make the maximum contributions allowed by law.
Regarding the second goal, employers know that their company’s retirement plan must meet ERISA’s non-discrimination rules – that highly compensated executives and company owners, as defined by the IRS, cannot benefit disproportionately from the plan – or the plan will lose its tax-qualified status. So, at this time of the year, Third Party Administrators of 401(k) plans with a year-end date of 12/31 are performing non-discrimination tests to verify that the plans are in compliance or identify corrective measures.
Some plan sponsors guarantee their highly compensated executives and owners will be able to make the maximum allowable contributions by adopting Safe Harbor measures. While Safe Harbor plans are deemed to “pass” non-discrimination testing, sponsors of those plans should still request and review testing annually to determine if their Safe Harbor status must be continued. Operating as a non-Safe Harbor plan provides plan sponsors with greater plan design flexibility. One example – explored further below – is a stretch match, a strategy that may be employed to incentivize increased participant savings.
Before, we go further, let’s review three key ERISA non-discrimination rules and the tests that measure compliance:
- The average contributions of highly compensated executives and company owners as a percentage of salary cannot exceed the average contribution of non-highly compensated employees as a percentage of salary by more than a defined allowable difference. Compliance is measured by testing both pre-tax and ROTH contributions using the Actual Deferral Percentage or ADP Test.
- The average matching employer contributions to the highly compensated executives and owners as a percentage of salary cannot exceed the average employer contributions to the non-highly compensated employees as a percentage of salary by more than a defined allowable difference. Compliance is measured by the Actual Contribution Percentage or ACP Test.
- Only up to 60 percent of a plan’s assets may be held by the company’s highly compensated executives and owners. This is measured by the Top Heavy Test.
Sponsors considering operating without Safe Harbor design protection would want to consult with their service providers (particularly their Third Party Administrator) to make sure the result of the ADP and Top Heavy tests were well within the passing range. They would also consider whether eliminating any aspect of the Safe Harbor design – such as an incentivizing Safe Harbor match – might cause employee participation and savings to decrease and thus result in future test failures. Then, with service provider help, sponsors could consider other design features.
The stretch match presents one interesting opportunity to increase participant deferrals. Here’s how it works: the employer’s match is “stretched” so that employees need to defer a larger percentage of their pay in order to receive the employer’s full contribution. As an example, an employer who has traditionally offered a dollar-for-dollar match up to 4 percent of compensation might offer a 50-cent on the dollar match up to 8 percent of compensation. As a result, a participant receiving the full 4 percent match would enjoy annual retirement savings equal to 12 percent of compensation.
What about the plan that can’t pass testing without Safe Harbor status? One Safe Harbor plan option – the Qualified Automatic Contribution Arrangement or QACA – combines automatic enrollment with a matching contribution of 3.5 percent of compensation and a two-year vesting schedule. Over time, the auto enrollment feature can lead to increased participation and a greater likelihood that tests can be passed without the Safe Harbor status.
Many strategies exist to help 401(k) plan sponsors meet organization priorities. Reviewing annual plan testing is important to identify all available plan design options. Working with knowledgeable service providers, employers can evaluate their options and improve their company retirement plans to benefit all participants.
This blog is written to help make the lives of plan sponsors easier in the process of meeting legal requirements under ERISA and providing employees with a better defined contribution retirement plan. Please understand that reading this blog should not alone take the place of a one-on-one consultation regarding the needs of your specific plan, and cannot be a guarantee against fiduciary breaches.