There is more than one way to do it.
When asked to, most people describe a 401(k) plan as one that allows employees to contribute money pre-tax for retirement; usually provides employer matches on a portion of the employee’s deferrals, most often at 50 percent; is difficult to withdraw money from, although loans are often available; and gives participants the responsibility of investing their contributions in a range of mutual funds.
A 401(k) plan should be designed to meet employers’ goals, yet many employers do not explore some useful plan design options. Let’s consider some design options available to address the following frequent concerns.
- When poor ADP/ACP test results prevent highly paid employees (HCEs) from contributing as much as they would like to the plan. Most plan sponsors and providers offer well-designed and targeted communication programs to improve contribution rates, and many companies are implementing automatic enrollment. But some industries such as retail and staffing have large populations of lower-paid, high-turnover employees. This fact severely impedes the plan’s ability to maximize the tax-saving potential for all employees, especially HCEs. In these circumstances, even the best communication program will produce limited results. If a safe-harbor design is not an option due to cost, the company should investigate the possibility of setting up separate plans: one to cover a large portion of the non-HCEs, and the other for HCEs and the remaining non-HCEs. If both plans satisfy the coverage requirements of Section 410(b), they will be evaluated separately for ADP/ACP tests, often significantly improving the average deferral rates in the plan covering HCEs.
- When cost control is a priority. Companies can reduce cost without decreasing the stated matching contribution percentage by implementing a last-day rule. This provides that the company match will be allocated only to those plan participants who are employed on the last day of the plan year. This reduces the matching expense (and improves cash flow during the year) by eliminating matching contributions for employees who terminate during the year. A company may also impose other restrictions such as requiring that an employee work at least 1,000 hours during the plan year to be match eligible.
- When moving from a defined-benefit to a defined contribution-only environment negatively affects long-service, older employees. When a defined benefit plan is frozen or terminated, many employers replace those benefits with increased 401(k) matching contributions. Employees with a long period of service at the time of plan conversion often will not accumulate the retirement assets they had anticipated even if the match is increased. In industries that value long service and low turnover, it is possible to reward these longer-service employees by implementing a service-graded matching schedule. This type of schedule will be subject to additional analysis because each level of match must satisfy the benefits, rights, and features test under the nondiscrimination requirements.
Profit-sharing contributions—employer contributions that are not dependent on an employee’s contributions to the plan—also offer a great deal of design flexibility. Profit sharing allocation formulas can reflect service and/or age and more closely replicate the benefit that a traditional pension plan would have provided.
The next time you look at changes to your defined contribution plan, remove the blinders and think creatively. You have many options to consider.
The Way They Were—And Are
|Today’s typical design is actually a vestige of thrift and savings plans commonly found before the IRS sanctioned salary deferral savings plans in 1978. IRS guidelines on historical thrift plans resulted in most plans being designed to limit employee contributions and employer matches to six percent of pay. Many employers simply converted the old thrift plans into “new” 401(k) plans while maintaining the same basic plan design. In addition, the early and almost universal outsourcing of 401(k) administration perpetuated conformity in this basic 401(k) plan design. In fact, many outsourced administrators provide “check-the-box” prototype plans and urge companies into plan designs that are easily managed within existing recordkeeping systems. Ease of administration is a commendable goal, but it should be only one of many.|