Creating a “Just Right” Plan Design
The best plan designs help employees save, coordinate matching and automatic contribution levels, use vesting appropriately, and anticipate personnel changes.
Help your employees save more
You can use the incentive of employer contributions to help your employees save more for retirement. Incenting employees to save more dollars can sometimes mean offering a smaller match on a larger percentage of pay which may seem less generous, but in reality, this can lead to greater retirement savings long term.
Example: Matching 100% of employee contributions up to 1% of compensation is generous, but might lead some employees to contribute less to their 401(k) accounts than a match of 25% up to 4%. The cost is the same to the employer, but for an employee basing deferrals on the matching they receive, the total contributions would be only 2% in the former instance but 5% in the latter. With investment and compounding interest over an entire career, this difference will be substantial.
Coordinate automatic contribution and matching levels
Automatic contribution is a powerful tool whereby employees contribute to the 401(k) by default without needing to manually set up deferrals. The default automatic contribution rates can significantly impact how much participants save, which can potentially affect compliance results. If your plan offers matching, it makes sense to coordinate your match with the default contribution rate.
Example: If your company offers matching to 4% of compensation, set the default deferral to 4%. Otherwise, only participants who affirmatively take action to set their contribution rate would receive to the total match amount.
Combine vesting and reduced service requirements
Allowing more employees to participate in the plan can help reduce your compliance testing risks related to having a small number of participants. At the same time, you may wish to use employer contributions as a reward for employee retention. To accomplish both, consider a reduced service requirement and subject employer contributions to a vesting schedule. Employees who stay with the company for the specified amount of time become eligible for the company’s 401(k) benefit or employer contributions.
Anticipate personnel changes
If your company includes only owners, or relatives of owners, keep in mind that as soon as you hire other employees, your plan is likely to have compliance issues related to the large percentage of assets in the plan belonging to owners and other key employees. If you have such a company and think you are likely to hire outside employees in the near future, consider instituting a Safe Harbor Plan design to help address those issues. Another option would be to require a full year service prior to employees entering the plan. With this design, you will have a year after hiring to ensure your plan is designed in the best manner for you and your employees.
Another instance where it might make sense to have a longer service requirement is if you have a workforce with a high turnover, and have people being hired and leaving in very short intervals. This can prevent you from having a lot of employees with low balances that may make administrative requirements more onerous over time. Regardless, by anticipating changes in your workforce you can have a better plan design.
Avoid high-risk plan designs
Matching a low percentage of employee deferrals up to a high level of compensation creates a significant risk of ACP testing failure and compliance issues generally. Instead, consider a modest match designed to encourage broad participation.
Safe Harbor provisions merit consideration
While many 401(k) plans do not include Safe Harbor provisions and may still pass compliance testing without requiring additional contributions, there are certain situations that will likely always benefit from a Safe Harbor plan. If owners and key employees want to be able to max out employee contributions to their 401(k) accounts without worrying about compliance limits, or your plan includes one or more of compliance risk factors, such as low participation rates by rank and file employees, small number of employees, high proportion of owners or highly-paid individuals, large wage discrepancies, or unpredictable earnings. In these cases, a Safe Harbor plan can offer ease and predictability at a cost comparable (or even perhaps less than) having to make after the fact, corrective, employer contributions because of failed nondiscrimination testing.
If you have questions about plan design or want to make changes to your existing plan, please contact us!