chapter 2 erisa plan management (part 1) unit 1: plan

Module 2 – ERISA Plan Management (Part 1)

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Chapter 2

ERISA Plan Management (Part 1) • Unit 1 Plan Goals and Objectives • Unit 2 Plan Provisions • Unit 3 Plan Types and Plan Design • Unit 4 Participant Outcomes • Unit 5 Service Provider Selection

Unit 1: Plan Goals and Objectives Case Studies Case Study One: A sole proprietor start-up IT company with one owner and two employees wants to start a new plan. The company doesn’t have a lot of cash flow yet, but they are growing fast and will have more money in the future.

Case Study Two: A professional firm (Partnership) has three partners/owners and 25 employees. They have a stable cash flow and have a 401(k) plan. Two of the partners have children working for the company. The firm shares office space with another firm with whom they do business.

Case Study Three: A manufacturer previously sponsored, but now has terminated, a defined benefit pension plan. They currently sponsor a 1,500-participant 401(k) plan, and the key executives have a top-hat non-qualified plan. The 401(k) plan was designed for middle management and rank and file employees.

Guiding Questions • What do you do when your clients from Case Studies One, Two and Three come to you about

the plan? • What documents and information should you request from them?

Retirement Plan Eligibility and Benefits All employers are eligible to sponsor tax-qualified retirement plans for their employees. As we can see from the three case studies, employers range from sole proprietors to partnerships to corporations. Although none of these employers is required to offer a plan, the government offers attractive tax incentives for employers to start and maintain a qualified plan, largely because our society believes in


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saving for retirement to provide a decent standard of living for retirees. Qualified retirement plans offer three primary benefits: help employers attract and retain key employees, help employees save for retirement and provide significant tax benefits to both employers and employees. All of these are reasons employers decide to sponsor qualified plans.

The manufacturing company with 1,500 employees from Case Study Three is a good example of a plan designed to retain middle management employees and help with retirement readiness for rank and file employees.

The other two employers from the case studies illustrate companies whose firm revenues will increase taxes for the owners and partners. These companies are examples of why smaller employers often adopt qualified plans: the plans’ significant tax benefits outweigh the burden of the rules imposed by the Internal Revenue Service (IRS) and Department of Labor (DOL) under ERISA and the Internal Revenue Code (IRC).

Goals and Objectives and Business Structure Plan goals and objectives have an important impact on the design of the plan, and different employers will have different goals and objectives for their qualified plan. Therefore, one of the first questions you should ask of a new plan sponsor client is what his or her goals are with regard to the plan. Some of those goals will vary based on the size of the company, but other objectives will vary based on the plan sponsor’s specific business.

Generally, the more skilled labor needed the more likely it is that sponsors will identify attracting and retaining employees as one of the goals for the plan. For example, a small professional practice like the firm in Case Study Two will be concerned with tax benefits and maximizing the partners’ retirement contributions, but a similarly-sized engineering firm may want to focus on attracting and retaining employees and not just on maximizing benefits to the owners.

Smaller employers generally start by establishing a qualified plan to take advantage of the tax-deductible contributions and the tax deferral of contributions for employees. These plans have a main goal of maximizing benefits for the owners and highly compensated employees (HCEs). Closely held companies will consider their cash availability at the end of the tax year to determine the tax consequences of contributing to a qualified plan for both the owners and the employees, versus simply paying bonuses out of the excess cash as salary to the owners, partners, and staff. Both Case Studies One and Two are closely held businesses and are likely to have plan designs to maximize the benefits to owners and partners, however the business in Case Study One has cash flow constraints, since they are a start-up business and may not have enough cash flow initially to make substantial employer contributions to the plan. Because the IT business needs skilled staff members, such as software engineers, the Plan Sponsor in Case Study One will also likely be more concerned about benefits to non-owners than the professional partners in Case Study Two.

Mid-size and larger employers like the manufacturer in Case Study Three, sponsor qualified plans primarily to attract and retain employees, and allow management and rank and file employees to save for retirement on a tax-deferred basis. Benefits to owners and partners in a qualified plan are frequently a secondary consideration. These sponsors will also be interested in participant outcomes, providing


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plan designs that will encourage long-term employees to retire rather than staying on as their employer-provided healthcare costs increase.

In Case Study Three, the sponsor will likely want different contributions and benefits for the three groups of employees: upper management, middle management, and rank and file. This will impact the plan contributions, how employees are covered under the plan and designs for maximizing participant outcomes.

Questions to Ask You should ask the following initial questions to help determine the plan sponsor’s goals and objectives for the plan:

• Why do you want to sponsor a retirement plan? • What type of business entity is the plan sponsor and what are the tax concerns of the business? • Are tax benefits to the business and the owners a primary concern? • How important is attracting and retaining employees? • How many are employed by the employer? • What are your employee demographics (number of employees, ages, salary levels, average

turnover)? • Which group(s) of employees should be benefiting from the plan? • Are there multiple employee locations? • Do the decision-makers of the company have a philosophy on making employer contributions,

i.e. is there a goal that employees should be required to contribute themselves in order to receive an employer contribution?

• Is the objective to maximize contributions to the principal employees? If yes, what is the objective and budget for non-principal employees?

• Are there one or more groups of employees who may not need the plan or who are unlikely to participate in the plan?

• How important is it that your employees are on track for an adequate retirement income? • What is the company’s cash flow? • What is the approximate budget for plan contributions? • How much time and personnel do you have to devote to plan administrative functions? • Should the contribution be fixed or flexible? • How stable is the company’s cash flow from year to year? • Is simplicity and low cost more important than maximized contributions or deductions? • Is your company growing?

Business Types All “for-profit” businesses generally have the same plan types available to them regardless of their business type. However, qualified plan contributions are tax deductible to the employer, and the employer’s business type impacts how those contributions are deducted and how the owners or partners are ultimately taxed.


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Non-profit firms have no need for tax-deductible contributions and therefore have different plan types available to them. However, law changes over the last 15 years have blurred the lines between for-profit and not-for-profit companies’ plans. For example, most companies can now offer 401(k) plans, but only non-profit entities can offer 403(b) plans. Not-for-profit companies will not be discussed in this course.

It is important for advisors to be familiar with the different types of business, to be able to explain to plan sponsors how compensation is determined, how compensations will be calculated and what documents advisors should ask for from the plans sponsor.

Effective with the 2020 tax year, due to changes to the law under the SECURE Act, employers may adopt a plan as late as the due date of the filing of the tax return (including extensions). Therefore, much of the financial information needed when deciding to adopt a plan will be available soon after the tax year end to aid with the decision to adopt a plan. Note that the elective deferrals under a 401(k) plan may only be made prospectively.

The SECURE Act also increased the amount of the tax credit available to plans with less than 100 employees who receive at least $5,000 in compensation. The tax credit is available for the year of implementation and the following two years. The credit is for implementation and administration of the plan and is the greater of 1) $500 or 2) the lesser of $250 per participant or $5,000. Note that the plan must cover at least one non-highly compensated employee in order to utilize the tax credit.

Sole Proprietorship A sole proprietor is an unincorporated business owned by one person. The two main business characteristics are: 1) the income and expenses of the business are shown as part of the proprietor’s personal tax return; and 2) the proprietor is personally liable and can be sued by anyone who has a claim against the business.

A sole proprietor’s earned income for the year is the net of the business income minus expenses, both of which are reported on Schedule C of the Form 1040.

When the sole proprietor sponsors a qualified plan, the plan contribution is considered a business expense and is deducted from the sole proprietor’s earned income. This deduction includes the contribution for the sole owner, as well as contributions for any employees. Although simple in concept, this deduction method can create a complicated, circular plan contribution calculation, requiring additional data for service providers doing the calculation.

Case Study One is an example of a sole proprietorship. Before working with a TPA or service provider to design a plan for this company, you should ask the plan sponsor for the following information:

• Net Schedule C income for the owner • Self-employment taxes (FICA, which consists of Social Security and Medicare • taxes) for the owner • Census data showing employees’ compensation • 401(k) deferrals (if any)


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• Plan objectives for the owner and the employees

Partnership A partnership is an unincorporated business owned by more than one person. The two main business characteristics are: 1) the income and expenses of the partnership are allocated among the partners according to the partnership agreement; and 2) the partners have “joint and several” liability for claims against the partnership, meaning one or more partners may be sued and all the partners will be liable.

Partnerships do not pay taxes; individual partners pay taxes. Partners’ income and expenses are reported on Schedule K-1. Similarly, deductions for the partner’s share of the employee cost for plan contributions are reported on the Schedule K1. Net income is then reported on the individual’s Form 1040 based upon the K-1 amounts. The partner’s individual contribution, including 401(k) deferrals, if any, is also reported on the Form 1040.

The result of this complicated tax reporting is that the partner’s entire plan contribution and the partner’s share of the employees’ contributions will reduce his or her net taxable income. The partner’s deferrals made under a 401(k) plan will also reduce the partner’s taxable income. As with sole proprietorships, this deduction method can create a complicated circular plan contribution calculation.

Partnerships have an additional complexity factor: partners split the plan contribution expense for the employees according to their partnership agreement. This split is not always done according to the partner’s profit or capital investment portion. The partnership agreement can provide for a separate percentage to split employee expenses, including the plan contribution.

Case Study Two is an example of a partnership. Before working with a TPA or service provider to design a plan for this company, you should ask for the following information:

• Net Schedule K-1 income • Self-employment taxes (FICA, which consists of Social Security and Medicare taxes) • Census data showing employees compensation • Partnership split percentages for employee expenses • Partnership split percentages for partner’s share of profits • 401(k) deferrals (if any) • Plan objectives for the partners and the employees

Corporation The standard C corporation is a separate entity for tax purposes. Its owners only recognize income directly from the corporation through dividends, and generally, they are not personally responsible for the liabilities of the corporation. In general, C-corporation qualified plans use employee compensation reported on a form W-2 as a basis for determining contributions and benefits. Although the plan can include additional compensation to determine contributions, dividends received are not part of W-2 compensation.


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Small C-corporations often function in a similar manner as a partnership at the end of the year when they are trying to determine their plan contribution and their final salary.

Although the owner-employees can take salary during the year, they will zero out the corporation’s accounts at the end of the year to avoid paying corporate tax on the profits. This calculation involves the qualified plan contribution for both the owners and the employees, accruing or making that contribution amount and then paying out the remainder of the profits to the owners as compensation at the end of the tax year.

In a small corporation, the owners are usually also the officers and directors of the company. Large corporations are also more complex, especially if they are publicly traded and/or report to an official Board of Directors.

Regardless, you should ask your client for the following information:

• Census data showing employees compensation (preferably W-2 information) • 401(k) deferrals (if any) • Plan objectives for the different employee groups

LLC/LLP Limited liability company (LLC) and limited liability partnership (LLP) are in general a hybrid of a partnership and a corporation. This type of organization is a contract among the owners, or members, of the business, which provides the limited liability of a corporation.

LLCs and LLPs can elect to be taxed as sole proprietorships, partnerships, S corporations or as C corporations.

How the LLC or LLP elects to be taxed determines its status for the qualified plan. If the organization is taxed as a partnership, the plan contributions will be computed based on the partnership rules. An organization that elects corporate tax treatment will use the contribution rules for a corporate plan sponsor, where compensation is not reduced for contributions.

Case Study Two is a partnership, but, is likely to change to an LLC or an LLP if the partners are worried about their individual liability. Because the company is a professional firm, liability may be a big enough concern to switch from a partnership to a limited liability structure.

Before working with a TPA or service provider to design a plan for a LLC or LLP, you should ask for the following information:

• Net Principals’ income o Schedule K-1 income (for LLP) o W-2 Form (for LLC) • Census data showing employees compensation • Principals’ split percentages for employee expenses • Principals’ split percentages for principals’ share of profits • 401(k) deferrals (if any) • Plan objectives for the principals and the employees


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S Corporation Although S corporations (named for the part of the law that created them) are technically corporations, for tax purposes, they are treated much like partnerships. They enjoy the same limited liability of LLCs or LLPs and C corporations. The net income of the corporation flows through to the shareholder-employees, who are the stockholders of the S corporation. S corporations may not have more than 100 shareholders, only individuals (no entities) may be shareholders.

Shareholders earn both W-2 income and an allocation of net profit, similar to a dividend. However, only the W-2 income may be used to determine qualified plan contributions and deductions. The deduction for both the shareholder’s plan contribution and their share of the employee contribution is shown on the corporate tax return, not on the individual’s return. Unlike partnership plans, the values shown on the Form K-1 cannot be used for retirement plan purposes.

You should ask your client for the following information:

• Net Principals’ income o Schedule K-1 income (cannot be considered for plan contribution) o W-2 Form (used for plan contribution)

• Census data showing employees compensation • Principals’ split percentages for employee expenses • Principals’ split percentages for shareholder’s share of profits • 401(k) deferrals (if any) • Plan objectives for the principals and the employees

Tax-Exempt and Government Entities Tax-exempt employers include any organization that is exempt from paying taxes under Federal tax law. Tax-exempt organizations can include governments, churches, associations, societies, charities, hospitals, schools as well as labor unions, civic organizations and clubs.

Often the term IRC §501(c)(3) organization is used in reference to tax-exempt or nonprofit entities.

Retirement plans for tax-exempt employers generally use W-2 compensation as a basis for determining contributions and benefits.

You should ask your client for the following information:

• Census data showing employees compensation (preferably W-2 information) • 401(k) or 403(b) deferrals (if any) • Plan objectives for the different employee groups


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Related Company Ownership Advisors should be aware of company ownership issues to help determine the employers and their employees that may be eligible for the plan.

In general, related employers are those with the same few owners and/or family members who also own parts of the firm. They can include professional firms who provide significant services to each other.

However, IRS rules that define “controlled group” or “affiliated service group” of employers are complex.

If firms are determined to be part of a related group, the companies can end up being treated as a single employer for qualified plan purposes, and the employees of the related group may be eligible for the plan. This means that one or more of the related firms could be required to make contributions for employees who do not work directly for the company sponsoring the plan. These contributions could have a significant cost impact on a related company who does not expect to have to contribute to a plan. Secondly, related groups and family members of owners can significantly impact plans designed to benefit specific groups of employees. The plan may need to be redesigned, taking into account the ownership and family member information.

Controlled group and affiliated service group determinations are very complex and should involve both experienced service providers and ERISA counsel. The advisor can help gather needed information by asking:

• Who are the owners of the business and what percentage do they own? • Are there any family members who also work in the business, and if so, what is their

relationship to the owner? • Do the owners of the current business own any other businesses, regardless of the form of the

company or the type of business, and what percentage do they own? • Does the current business own any other businesses, if so, what percentage does it own? • Do the family members of the owners of the current business own any other business? • Does the business provide or receive a significant amount of services from another firm?


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The table below summarizes situations that can lead to a possible controlled or affiliated service group. If you encounter any of the situations below, you should advise the plan sponsor to contact experienced service providers and ERISA counsel.

Issue Possible

Controlled

Group

Possible

Affiliated Service

Group

Owner(s) of the business have ownership in

other companies

Yes Yes

Issue Possible

Controlled

Group

Possible

Affiliated Service

Group

Family members of the owner(s) own other companies and are involved in the owner’s business

Yes Yes

Business provides or receives significant services from one service

company

No Yes

Business was involved in a merger or

acquisition that involved multiple plans

Yes Yes

Company recently terminated or is

terminating a defined benefit plan

No No

Company leases employees, has

independent contractors

Yes Yes

Firm has or wants defined benefit plan,

DB/DC combo, cash balance plan

No No


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Example An example of how these rules could impact a plan is in Case Study Two. Remember that the two of three partners/owners have children who are employees of the company. These children would be considered highly compensated employees, regardless of their salary, because their partner parents’ ownership is attributed to them under IRS rules.

Plan designs that take into account the age of the principal employees, such as DB/DC combination plans or 401(k) cross-tested plans, would not work as they were intended if the highly compensated children are not taken into account. By asking questions about family members, the advisor can provide this information to the service provider designing the plan.

Business Cash Flow and Budget Once you have discussed the type of business, the ownership, the structure, plan goals, and objectives, it is time to explore what the firm can contribute to a qualified plan.

Although some plan types allow for flexible contributions based on the plan sponsor’s cash flow, other plan designs have contributions that are required to be made by the employer for eligible employees. Therefore, before designing the plan, it is critical that the employer understand his or her contribution commitment and if the firm’s cash flow and budget will allow for fixed contributions.

In general, required contributions in 401(k) plans will be a percentage of compensation and/or deferrals. You can work with service providers to estimate the employer’s required contribution based on the employee census data provided. It is a good idea to ask about a range of employer contributions that the plan sponsor would feel comfortable with so the service provider can take their budget into consideration when designing the plan.

Smaller employers will have an idea of their contribution budget based on information they receive from their CPA. Remember the end of year “zero out” concept for sole proprietors, partnerships, and small firm corporations. They may base part of their plan design on how much money is left in the business at yearend, which will be subject to tax unless it is contributed to the plan.

However, small firms like the one in Case Study One, may have years where there are no profits left in the business at the end of the year. They should understand that some plan designs will require plan contributions in current and future years regardless of the business’s profitability or availability of cash.

Case Study Two is an example of a professional firm with a stable cash flow that is likely to be concerned about taxes. As a result, their firm may be likely to budget for and afford a large annual fixed contribution.

Mid-size and larger employers are likely to make their plan contributions part of the budget process. They should be aware of increased contribution budgets due to mergers or acquisitions, increased payroll or hiring, or adopting designs that will increase participants’ deferring into a 401(k) plan.


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Advisor Takeaway Plan Sponsors will greatly vary in terms of goals and objectives, business structure, business type, ownership, cash flow and budget for the plan. Before starting to talk about the qualified plan with the plan sponsor, the advisors should be sure to ask these important questions, as it will impact what plan will be sponsored and what the provisions of the plan will be.

PLAN GOALS AND OBJECTIVES

• What are the primary concerns (tax benefits to the business and the owners, attracting and retaining employee rank and file participant requirement outcomes)?

• Which group(s) of employees is the plan sponsor looking to benefit (rank and file employees, mid management, higher management, owners)?

• Is there one or more groups of employees who may not need the plan or unlikely to participate in the plan?

BUSINESS STRUCTURE AND TYPE • What type of business entity is the plan sponsor? • What does the census data look like for the employer?

RELATED COMPANY OWNDERSHIP • Who are the owners of the business and what percent do they own? • Do the owners of the current business own any other businesses? • Do family members of the owners of the current business own any other business?

BUSINESS CASH FLOW AND BUDGET • What is the contribution budget available? • Does the business have stable cash flow?


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Unit 2: Plan Provisions Case Studies Case Study One: Sole Proprietor start-up IT company with one owner and two employees who wants to start a new plan. The company doesn’t have a lot of cash flow yet, but they are growing fast and will have more money in the future.

Case Study Two: Professional firm (partnership) has three partners/owners and 25 employees. They have a stable cash flow and have a 401(k) plan. Two of the partners have children working for the company. The firm shares office space with another firm with whom they do business.

Case Study Three: A manufacturer previously sponsored, but now has terminated, a defined benefit pension plan. They currently sponsor a 1,500-participant 401(k), plan and the key executives have a top-hat non-qualified plan. The 401(k) plan was designed for middle management and rank and file employees who work in multiple locations nationwide. About 50 percent of employees are deferring and sometimes the plan fails testing. The plan currently has a match contribution of 50 percent up to six percent.

Guiding Questions • How do you explain the different plan provisions to the plan sponsor? • What plan provisions can help the different plan sponsors achieve the goals for their plans?

Introduction As we’ve seen, there are many considerations when selecting or evaluating the appropriateness of a plan, such as the plan goals and objectives, the business type, related company ownership and business cash flow and budget. These will impact how different plan provisions will be selected.

Although fiduciaries and advisors should work with other services providers to draft the plan and the necessary documentation for establishing the plan, it is the role of the advisor to talk to the plan sponsor about designing a new plan and evaluating the appropriateness of the current plan to meet plan objectives and participant outcomes. It is also important to always keep in mind regulation requirements for qualified plans.

Eligibility and Participation Eligibility provisions establish who is allowed to participate, who is covered under the plan, and who is excluded from coverage. This begins with the definition of employees and eligible employees, which may include employees of related entities as discussed previously.


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The Internal Revenue Code (IRC) provides the maximum age and length of service an employee must meet to be eligible to participate. An employee must be eligible to enter a qualified plan after attaining age 21 and completing one year of service, or two years of service, if the employee is immediately 100 percent vested in employer contributions upon entry into the plan.

The SECURE Act requires that starting for plan years that begin after December 31, 2020 long-term part-time workers must be allowed to defer under a 401(k) arrangement. A long-term part-time worker is defined as one who is credited with 500 or more hours of service in three consecutive years. While these employees will not have three years of service for this purpose until at least 2023, the employer must start tracking them now. This category of employee will not be required to receive employer contributions (but can if the plan is designed to do so) or be included in coverage and nondiscrimination testing.

These statutory eligibility rules are legal maximums, but plans can provide for more liberal eligibility parameters. Plan sponsors may add additional eligibility provisions to reflect IRS rules as well as the plan goals for their employees. As a result, the eligibility and participation requirements will generally narrow the definition of eligible or participating employees by listing provisions for who will be included in or excluded from the plan.

For example, the professional practice in Case Study Two has turnover among employees who typically work less than a year for the practice. They would likely benefit from a one-year of service requirement to become eligible for the plan.

It is important to note that eligibility for the plan is different from eligibility to receive a contribution allocation. An employee can be eligible for the plan, but not have met the requirements to receive an employer contribution. For example, an employee enters a calendar year plan on January 1st and terminates employment on November 15th. The plan requires that participants be employed on the last day of the plan year and work at least 1,000 hours to receive an employer contribution. Although the participant may have worked 1,000 hours by November 15th, the participant will not be employed on December 31st, and will not receive an employer contribution.

The participant is, however, considered an eligible employee and a participant for purposes of coverage and nondiscrimination testing, and would still be eligible for any safe harbor contributions made to the plan.

Exclusions The law allows plans to exclude union employees who have retirement benefits outside the plan that were subject to good-faith collective bargaining. Plans can also legally exclude non-resident aliens (an employee who is not a citizen of the United States and who receives no U.S. source of income from the employer).

In addition, plan sponsors may choose to add optional exclusions to the plan. To meet plan goals, plans may exclude a group of employees, for example employees who have other benefits outside the plan. However, these optional exclusions are subject to testing. Advisors should carefully work with plan


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service providers when plan sponsors want to exclude groups of employees to assure that their plan will pass the necessary tests to maintain the qualified status of the plan.

Advisor Takeaway Advisors and service providers often spend quite a bit of time with plan fiduciaries on designing contribution arrangements that meet plan goals. Eligibility requirements can sometimes be secondary. In fact, many adoption agreements have the "1 yr./21" box checked without much thought given to why that eligibility parameter was selected. However, advisors can add value by pointing out the advantages and disadvantages of different eligibility requirements. Consider asking the following questions when designing eligibility provisions:

• Do your current plan eligibility provisions work well with your plan goals? • Do you know why they were selected? • Can your HR staff and/or payroll system effectively handle employees who are immediately

eligible for the plan? • Would staff be able to process immediate entry into the plan along with automatic enrollment? • Are you comfortable making matching contributions every payroll period? • Do you have a lot of turnover? • Would a one-year wait help manage the impact of that turnover? • Would a requirement to work on the last day of the plan year help manage the cost of the

turnover? • Are there employee groups that you would like to exclude from the plan if it is possible to do? • Have you started to keep records for the long-term, part-time employees as required by the

SECURE Act

Compensation Compensation is the pay received by employees of the plan sponsor. As we've seen, compensation is typically reported on Form W-2, but can vary depending on the type of business sponsoring the plan.

This is an important component of plan administration because compensation is the starting point for all plan contributions, especially deferrals, as well as the basis for necessary tests to maintain the qualified status. Compensation can also be complex and varied, even with the same employer.

In Case Study Three, for example, the company has different employee locations with different compensation methods, which is not uncommon in larger plans. Some employees in one location are paid hourly while others in another location receive salary. The hourly employees are paid weekly while the salaried employees are paid monthly. Therefore, the company in Case Study Three may need staff and systems to process the different payroll data and ensure they are following the plan document.

Calculation of compensation is also the third-most common error found the by the IRS in its error correction programs. To help plans follow the IRS rules, the IRS regulations allow plans to use safe


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harbor definitions of compensation, which usually start with compensation data shown on Form W-2. Employers can, however, select several different definitions of compensation, each of which is used in the plan for a different purpose.

COMPENSATION

26. COMPENSATION (Plan Section 1.14) with respect to any Participant means:

a. [ ] Wages, tips and other compensation on Form W-2. b. [ ] Section 3401(a) wages (wages for withholding purposes). c. [ ] 415 safe harbor compensation.

Exclusions Plan sponsors are also allowed to include or exclude certain components of compensation, such as elective deferrals and fringe benefits, as long as the definition of compensation does not disproportionately favor higher-paid employees. In this manner, sponsors have a degree of flexibility in limiting the eligible compensation that will be used by the plan for contributions.

Excluding certain types of compensation can lead to more administrative complexity as well as specific compensation nondiscrimination tests to prove that the definition does not favor highly compensated employees (HCE).

Advisors can work with service providers to explain the pros and cons of choosing to exclude different compensation:

Pros Cons

Pre-Participation

Compensation

(Compensation earned prior to becoming eligible and participating under the plan)

Can help control contribution costs

More complex for HR staff and payroll providers to administer

Specific Parts of Eligible W2 Compensation (Such as bonuses, overtime or commissions)

Can benefit specific groups of employees

Plan is no longer using a safe harbor definition of compensation, and plan must pass specific compensation nondiscrimination test to prove that the definition does not favor HCEs.


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Example

A car dealership sponsors a plan where there are nonhighly compensated commissioned salespeople whose base salary is lower than the commissions they receive. The owners (who are highly compensated employees) receive only W-2 pay and do not receive commissions. Excluding commissions in this type of plan will likely result in a compensation definition that favors the higher-paid employees and violate nondiscrimination requirements.

Maximum Compensation Limit The compensation definition also must include the IRC’s maximum compensation limit.1 Thus, even though a participant’s compensation may be above the limit for a certain year, only the limited amount of that compensation would be included for contribution and allocation purposes that year. For example, a participant’s compensation is $300,000 in a certain year. If the limit for the 2021 year is $290,000, only $290,000 of that compensation will be included for contribution and allocation purposes for the year.

Contributions Contribution provisions are not only major features of qualified plans; they also are very intertwined with plan sponsor goals. As a result, the plan types section of this unit will go into more detail on the types of contribution designs available to employers to meet their goals.

Employee Contributions Certain plan types, such as 401(k) plans, allow for employees to contribute amounts out of their compensation to a qualified plan on a pre-tax basis. Some plan types also offer an option of post-tax contributions. There are two different types of post-tax contributions. One is the designated Roth contributions and the other is after-tax employee contributions. The difference in these two is tax treatment of the earnings where Roth earnings may be tax free if certain requirements are met but after-tax employee contribution earnings are always taxed upon distribution. Although exempt from federal and state tax, employee contributions are still subject to Social Security and Medicare taxation.

Employee contributions are optional, with employees opting to have a certain dollar amount or percentage of compensation deducted from their paycheck and contributed to the plan. Because employee contributions are actually deferred compensation, they are subject to rules that safeguard employees’ monies. Some of these rules are:

• Employees must make a written election (can be electronic) to defer (unless the plan provides for automatic enrollment);

• Employees must have the option to stop or change contributions at their election;

1 IRC 401(a)(17)


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• Employee contributions are always 100 percent vested; • Employers cannot require more than one of year of service to be eligible for 401(k) pre-tax

elective deferrals and designated Roth contributions.

Employer Contributions Employer Matching

In their simplest form, matching contributions are made according to a formula based on employee contributions. For each dollar an employee elects to contribute to the plan, the employer will usually match an amount from ten to 100 percent of the elective deferrals up to a cap of either a dollar amount or a percentage amount.

Eligibility for matching contributions varies from plan to plan, with some employers electing to make matching contributions every payroll period and others requiring a one-year wait and/or end of year employment to reward longer service employees. Employers may provide for discretionary matching contributions that are determined on a year-to-year basis.

This is an important way to incentivize employee participation and employers only have to make a contribution to those who participate. This is a way to reward these employees instead of contributing to all employees, some of whom do not make contributions to the plan. More details on matching contributions can be found in the description of 401(k) plans in the Plan Types and Plan Design unit.

Profit-Sharing Contributions

Plan sponsors can elect to make a discretionary profit-sharing contribution, also known as a nonelective contribution, in addition to matching contributions. Unlike match contributions, a profit-sharing contribution is not tied to elective deferrals, and it rewards a broad base of employees for the company’s success, rather than only the employees who elected to contribute to the plan.

The profit-sharing contribution provides the employer with an additional, optional tax-deductible contribution. In plan designs for owner-driven plans (details in the Plan Types and Plan Design unit), a profit-sharing contribution can be an essential contribution to achieving maximized retirement savings goals for owners and principal employees.

Top-Heavy Contributions

Top-heavy contributions are a required contribution for all top-heavy plans. A plan is considered top-heavy when 60 percent or more of the assets belong to key employees. A top-heavy plan is common in owner-driven firms, and top-heavy 401(k) plans face special challenges, especially when the plan is top-heavy with only employee elective deferrals.

A top-heavy defined contribution (DC) plan is required to provide a minimum contribution of three percent of compensation for non-key employees. The required three percent may be reduced if the key employees receive a benefit of less than three percent in the plan year. Note that the minimum

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contribution is not required for the long-term part time employees who are allowed to defer under a 401(k) plan, unless the plan provisions provide so.

Fortunately, other employer contributions can be used to satisfy the top-heavy minimum (even if they are used to help pass another nondiscrimination test), including matching and profit-sharing contributions. However, if none of these amounts cover the entire top-heavy minimum contribution, the employer will be required to contribute the difference to assure that the eligible non-key employees receive the top-heavy minimum amount.

The top-heavy 401(k) plan is an especially good candidate for electing safe harbor status and making a safe harbor contribution, which will almost always satisfy the top-heavy required minimum.

Safe Harbor Contribution

The inclusion of the safe harbor contribution in the plan provisions requires the employer to make annual contributions to employees. Because an employer who makes a safe harbor contribution is generally exempt from annual testing, highly compensated employees can defer up to the legal maximum without fear of the plan failing annual tests. A safe harbor nonelective contribution can also satisfy the minimum required contribution for top-heavy plans. Therefore, safe harbor contributions are a good option for sponsors, such as the ones we see in Case Study One and Case Study Two, who want to allow principal employees to maximize their retirement savings.

Electing to be treated as a safe harbor plan has several advantages for the plan sponsor, but it also has complicated notice requirements and significant contribution obligations. Details on safe harbor contributions are included in the 401(k) plan section of Plan Types and Plan Design unit.

Contribution Limits and Other Requirements Qualified plans, including 401(k) plans, are subject to IRC limits and nondiscrimination requirements, regardless of the plan design. These include:

• IRC §415 limit on annual additions (contributions and forfeitures) to participant accounts of the lesser of 100 percent of compensation or the limits for the year;

• IRC §404 deduction limit of 25 percent of eligible compensation; • IRC §410(b) coverage testing (affects plans with excluded groups or last day allocations); • IRC §401(a)(4) nondiscrimination testing (typically an issue for cross-tested plans); • IRC §414(s) compensation tests (only if parts of compensation are excluded for allocations); and • IRC §416 top-heavy minimum contribution and vesting requirements.

More information can be found in the IRS’s “A Guide to Common Qualified Plan Requirement.”

http://www.irs.gov/Retirement-Plans/A-Guide-to-Common-Qualified-Plan-Requirements




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Advisor Takeaway Contributions can have a major impact in supporting plan goals as well as plan costs. Advisors should be familiar with different contribution provisions and consider the following when designing contribution provisions: is there a philosophy on making employer contributions; is the objective to maximize contributions to the principal employees; what is the objective and budget for nonprincipal employees, is there one or more group of employees who may not need the plan or who are unlikely to participate in the plan; how important is it that your employees be on track for an adequate retirement income; what is the company’s cash flow; what is the approximate budget for plan contributions?

Vesting The vested portion of the participant’s account is the portion owned by the participant and is the amount that will be paid to the participant upon a distributable event as defined by the plan document, such as termination of employment.

Plan sponsors must decide on a vesting schedule, which is how employees usually earn full ownership of their accounts based on the number of years of service completed with the employer. Therefore, vesting allows plan sponsors to reward employees’ continued service by steadily increasing ownership of the retirement benefits. There are required vesting schedules, although plan sponsors can choose different schedules as long as they meet the legal requirements.

The part of the account balance that is not owned by the participant, the nonvested portion, cannot be distributed to the participant, and is forfeited upon a distributable event. Forfeitures of non-vested monies can be used by plans to pay expenses, offset future plan contributions, or, more rarely, be allocated to plan participants. The adoption agreement, or the plan document, should specify how forfeitures are treated.

One-Hundred Percent Vesting Although the plan sponsor can decide on a vesting schedule that best fits the plan goals and objectives, there are specific contribution types that are always 100 percent vested, as well as, specific conditions that cause 100 percent vesting.

Because employee contributions represent payroll deferrals, they are always 100 percent vested. One hundred percent vesting is required for the following (among others):

• Employee elective deferrals (pre-tax or designated Roth contributions) • After-tax employee contributions • Rollover contributions • Safe harbor contributions (2-year 100 percent vesting for the safe harbor contributions that are

part of Qualified Automatic Contribution Arrangement, or QACA, which is covered in unit 1.2)


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The following conditions or events require 100 percent vesting of employer contributions:

• Plans with a greater than one-year eligibility service requirement • Plans that are terminated • Participants who terminated and the plan was determined to have a partial plan termination • Participants at normal retirement age

The plan sponsor can also choose to add the following additional events or conditions that would make participants 100 percent vested in employer contributions:

• Participants reach early retirement age • Participants become disabled • Participants die prior to normal retirement age

As a practical matter, plans typically vest participants 100 percent at early retirement on disability and on death. However, plan sponsors can specify vesting for these events.

A plan can change its vesting schedule by adopting an amendment with a new schedule. Under no circumstances can a participant’s vested percentage be reduced by the amended schedule. Additionally, participants with at least three years of service have the option of electing to remain under the pre-amendment schedule regardless of whether the new schedule would cause them to become vested sooner than the previous one.

Advisor Takeaway Vesting schedules add to a plan's administrative complexity for recordkeepers and TPAs, and can add to the plan's cost. However, employers often consider forfeitures advantageous for cost savings and therefore may prefer vesting schedules that do not vest participants 100 percent immediately. Many employers also like that vesting rewards longer service employees, and advisors should talk to employers about their plan goals and how vesting impacts those goals. Lastly, most service providers charge terminating participants to process their distributions, which take into account the vesting computation. It is important to remind employers that not all their contributions are subject to vesting, especially safe harbor contributions that are always 100 percent vested.


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Distributions Because the main purpose of retirement plans is still to provide benefits at retirement, participants and beneficiaries are not allowed to take money out until retirement or until they reach another distributable event.

Other distributable events for any qualified plan are:

1. Normal retirement age 2. Termination of the plan 3. Required minimum distributions (RMD)

Distribution provisions that may be adopted as part of the plan design are:

1. Death (subject to the required minimum distribution rules) 2. Disability 3. Termination of employment 4. In-service distributions and hardship withdrawals 5. Qualified childbirth or adoption expenses (up to $5,000)

In-service distributions are optional plan provisions that allow distribution while a participant is still employed. In-service distributions can also include distribution for assets that have been in the plan for a specific period of time (two to five years) or for a specific stated event, such as a layoff or illness.

Roth accounts must be "qualified Roth accounts" when they are distributed to be treated as a tax-free distribution. In general, this means that the participant must be 59 ½ years of age and monies in a Roth account must be "seasoned", or at least five years old. These rules are complex, and participants should consult with their tax advisor before taking a distribution of Roth monies.

Distribution Taxation Generally, a participant or beneficiary pays no tax on qualified plan benefits until they are actually distributed, even if they are fully vested and could be distributable upon the participant’s election.

Taxation of distributions is a complex area of the law, and plan sponsors should not only work with qualified service providers on distribution processes and procedures, but also encourage participants to work with their own tax advisors before making distribution decisions.

Because the rules are complicated, participants are required to receive notices about their distribution, their rollover options, and taxation impacts. TPAs and recordkeepers typically provide these notices to participants, but retirement plan advisors can assist participants by explaining their distribution options.

In general, participants can elect to continue to defer taxation on the monies by keeping their money in the plan (as long as it is over a minimum amount), or by rolling over distributions to another qualified plan or an IRA within 60 days of the distribution.


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If participants elect to take a distribution of their qualified plan monies, they will be subject to taxes on those amounts (other than the distribution of Roth sources), both in terms of withholding taxes at the time of distribution, and in paying any additional taxes due with their personal tax return. If they are younger than 59½, they may be subject to an additional excise tax of ten percent.

Loans and Hardship Withdrawals Loans and hardship withdrawals are optional plan provisions that allow participants to access their retirement savings while still employed and before they reach normal retirement age. If included in the plan's provisions, they must be available to all participants on a nondiscriminatory basis.

Plan sponsors can elect to tie the two provisions together. For example, loan availability can be subject to the hardship withdrawal requirements in the plan.

In 401(k) plans, these features can increase plan participation, since participants know they have access to their accounts if they need the money before retirement. Participant loans have the added advantage of the participant paying interest back into the participant’s tax-deferred retirement savings, rather than paying interest to a lender. However, both provisions can be difficult and complicated to administer. Service providers who administer these features for plan sponsors typically charge participants a separate fee to cover the costs of loans and hardship withdrawals.

Because the primary purpose of the tax benefits of a qualified plan is to encourage employers and employees to save for retirement, loans and hardship withdrawals are subject to specific rules to assure that withdrawn monies are repaid timely or taxed to the participant appropriately.

Loans If a plan permits loans, participants may borrow money from the plan, as long as they follow the required repayment terms and loan amount limitations imposed by the law2 and by the plan.

Under the law, participant loan amounts are limited to the lesser of 50 percent of the vested account balance or $50,000, with some exceptions.3 Repayments of principal and interest must be made at least quarterly (but are often set up with payroll deduction repayment) over five years (unless the loan is for the purchase of a principal residence) at a reasonable rate of interest.

Failure to repay the loan according to its written terms can result in the loan amount being taxable to the participant and subject to the early distribution excise tax of 10 percent if the participant is younger than 59½.

The plan can limit the loan amounts and require stricter loan terms than the regulations specify. The plan document must contain the terms of the loan program or there must be a formal loan policy or

2 ERISA §§406 and 408 and Internal Revenue Code (IRC) §72(p) 3 http://www.irs.gov/Retirement-Plans/Loan-Limits-Apply-to-All-Plan s

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procedure adopted by the employer. In addition, loans must be non-discriminatory and made available to all eligible employees.

After certain emergencies such as COVID-19, hurricanes, floods or earthquakes, Congress will temporarily increase the loan limits and repayment timing. Special care should be taken to know the impacted plans and the time frames for each of these situations because the rules may vary.

Hardship Withdrawals Hardship withdrawals are legally available to certain types of qualified plans. For plan types that allow them, the plan sponsor can choose to add it as a provision to the plan. Hardship withdrawals, unlike timely repaid participant loans, are subject to taxation and possible excise tax penalties. They should, therefore, be an option of last resort for a plan participant.

The plan document must state the rules for making hardship withdrawals from the plan and the Plan Administrator must use objective criteria when determining whether a distribution meets the plan’s requirements.

Similar to the rules for loans, after certain emergencies, Congress will be more liberal with the hardship withdrawal rules for a period of time. Again, care should be taken to know the rules for a specific situation as they go vary.

Advisor Takeaway Advisors should discuss loans and hardship withdrawal provisions with plan sponsors and plan fiduciaries. Because these provisions are optional, plans whose goal is for participants to save for retirement do not have to offer them. However, many participants will not defer if they believe they cannot get their money out until they retire or leave the company. Loans and hardships have a track record of encouraging participation. Loan provisions in particular can be tailored to a plan's employee demographics, offering one loan at a time, requiring payroll deduction repayment and/or limiting loan amounts.

Although these options increase costs for administration, fees are charged to the participants taking the loan or the hardship withdrawal, so they don’t affect participants not taking loans or hardships. In owner-driven plans, advisors should caution owners and partners to administer their loan programs for themselves, just as they do for the other plan participants.


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Rollover Contributions Into a Plan A rollover contribution occurs when a qualified plan accepts a participant’s distribution from another qualified plan, simplified employee pension (SEP), individual retirement account (IRA), 457(b) or 403(b) plan.

By rolling the distribution into another qualified plan or IRA, the employee continues to defer the payment of taxes that would otherwise be applicable at the time of the distribution from the prior qualified plan. Since the employee owns the rollover account from the time it is created, the account is fully vested at all times. Often a plan will permit the employee to withdraw all or any portion of the rollover contribution while still employed.

Legally, not all retirement plan types allow for accounts to be rolled into the qualified plan. If the plan document does allow for rollovers into the plan, the plan sponsor can then choose to add it as a provision to the plan. The provisions will also detail how rollovers can be accepted: which types of plans, when, and under what conditions.

The details of "where and when" with regard to rollovers is complicated, but the IRS chart in the course resources can help participants and plan sponsors navigate the rules.

Advisors should check with service providers to see if rollovers are allowed by the plan document, and HR staff should know to contact service providers before accepting rollover contributions.

Rollover contributions may be accepted for employees before they fulfill eligibility requirements for participation under the plan. In these instances, the employee is treated as a limited participant for rollover account purposes only. After the money is rolled into the new plan, it is subject to the rules and regulations of that plan. A separate account is set up and maintained for the employee.

Advisor Takeaway There are advantages to participants in allowing rollovers into the plan from another plan or IRA:

• Participants can consolidate their retirement accounts. • Generally, investing in a 401(k) is more cost effective than investing in an IRA. • Participants can take advantage of loans and hardship withdrawal provisions of the qualified

plan. • Participants have access to professionally managed 401(k) investments

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Other Distribution Rules

Required Minimum Distributions The basic rule is that distributions should begin during the participant’s lifetime—a limitation imposed by Congress in exchange for favorable tax treatment.

“The entire account balance must be distributed prior to the required beginning date; or the entire account balance must be distributed over the lifetime or life expectancy of the participant, or over the joint lifetime/life expectancy of the participant and the beneficiary.”4

For everyone except those who own more than five percent of the company, the rule prior to the 2020 year is that the first distribution must have taken place by April 1 of the calendar year following the year in which the participant turned age 70½ or when he retired, if later. This is the "required beginning date." Five percent owners do not have the option to delay the distribution past 70½ if they continue to be employed. Effective for participants with birthdays after June 30, 1949 the SECURE Act increases the age from 70 ½ to 72. Please note that due to the CARES Act, there are no required minimum distributions required for the 2020 year.

Failing to make a required minimum distribution means the participant pays a penalty of 50 percent of the required distribution. Therefore, advisors should work with service providers to determine participants who may be subject to required minimum distribution rules.

Qualified Birth or Adoption Distributions The SECURE Act added a new type of distribution known as the Qualified Birth or Adoption Distribution as an option for plans. If a plan opts to include this provision, a distribution of up to $5,000 may be distributed, without the 10% additional excise tax applying, for each event. The amounts withdrawn may be redeposited to the plan at a later date.

4 IRC 401(a)(9): http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/RetirementTopics-Required-Minimum-Distributions-(RMDs)

http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topics-Required-Minimum-Distributions-(RMDs)





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Missing Participants ERISA requires that the plan be for the exclusive benefit of participants and beneficiaries. If the plan fiduciaries cannot distribute plan monies to a participant because they cannot locate them, they must follow specific rules5 to make reasonable efforts to locate the missing participant.

There are specific rules that allow the plan sponsor to set up missing participants IRAs to distribute vested account balances. If these “safe harbor” rules are followed, the plan sponsor can meet their fiduciary responsibility to the participant and have no liability once the funds have been distributed from the plan.

Advisors should work with the Plan Administrator and service providers to set up a process for dealing with missing participants.

5 IRS Website: http://www.irs.gov/Retirement-Plans/Missing-Participants-or-Beneficiaries

http://www.irs.gov/Retirement-Plans/Missing-Participants-or-Beneficiaries


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Unit 3: Plan Types and Plan Design Case Studies Case Study One: Sole Proprietor start-up IT company with one owner and two employees who wants to start a new plan. The company doesn’t have a lot of cash flow yet, but they are growing fast and will have more money in the future.

Case Study Two: Professional firm (Partnership) has three partners/owners and 25 employees. They have a stable cash flow and have a 401(k) plan. Two of the partners have children working for the company. The firm shares office space with another firm with whom they do business.

Case Study Three: A manufacturer previously sponsored, but now has terminated, a defined benefit pension plan. They currently sponsor a 1,500-participant 401(k), plan and the key executives have a top-hat non-qualified plan. The 401(k) plan was designed for middle management and rank and file employees who work in multiple locations nationwide. About 50 percent of employees are deferring and sometimes the plan fails testing. The plan currently has a match contribution of 50 percent up to six percent.

Guiding Questions • Based on the information you got from the plan sponsor how should a new plan be designed for

the startup presented in Case Study One? • Case Studies Two and Three currently sponsor 401(k) plans, so how do you find out if the

current plan provisions meet the goals and objectives for the respective plans? If they need to be redesigned, what options should they consider?

Introduction As we’ve seen, the first step in reviewing plan types and plan designs with a plan sponsor is to review the employer's goals to determine what plan design works best. This involves the plan sponsor’s objectives for the company, its owners and shareholders, and its employees. Smaller employers tend to want plans that benefit the owners or partners, while larger employers want plan designs that help to attract and retain employees and provide good participant outcomes. All employers would prefer low cost, simple plan designs, but the goals of benefiting principal employees and/or retaining employees can result in higher costs and plans that are more complex. Other considerations when selecting a plan and its features are related company ownership issues and business cash flow and budget.

If a plan is already in place, it is also important to ask the plan sponsor:

• What do you like or dislike about your plan? • What percentage of your employees is making 401(k) employee contributions? • Do you want to increase this percentage? • Do you regularly fail annual plan testing?


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• What type of employer contributions do you make to your plan? • Do you offer Roth contributions? • Do you offer automatic enrollment?

Many of the answers to these questions will depend on the type of plan sponsored, company size, industry and employee demographics.

Profit-Sharing Plans Profit-sharing plans are qualified DC plans with the following features:

• Discretionary employer contributions up to 25 percent of eligible compensation • Withdrawals allowed after monies remain in the plan for a specified period of time, not less

than two years

Standalone profit-sharing plans are useful as initial plan designs for employers who want a qualified plan without the complexity of 401(k) employee deferrals and 401(k) nondiscrimination tests. However, profit sharing contribution allocations will generally not provide a significant portion of the employer contribution for principal employees.

PROS: CONS:

• No required employer contributions;

• Contributions are 100% flexible -they can be zero in any year;

• Easy to administer; • No 401(k) nondiscrimination

testing.

• No employee contributions for employers who want employees to be involved in the plan;

• Broad-based contribution allocations; • Limited design flexibility.


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401(k) Plans: Eligibility and Contributions A 401(k) plan is a DC profit sharing plan design that allows for employee elective deferrals. The unique attributes of 401(k) plans are: pre-tax and designated Roth contributions (elective deferrals from payroll), which may be matched by the employer, additional nondiscrimination tests to assure that elective deferrals and match contributions are not discriminating in favor of highly compensated employees, and restrictions on elective deferral distributions.

Eligibility 401(k) plans may not impose more restrictive eligibility requirements than age 21 and one year of service for elective deferrals.

Effective with 2021 year, plans must allow long-term part-time employees to be eligible to defer to the plan. As described earlier, long-term part-time employees are those who are credited with more than 500 hours of service in three consecutive years.

To encourage employee elective deferrals, 401(k) plans will frequently provide for more liberal eligibility options for deferrals with more restrictive eligibility reserved for employer contributions. 401(k) plans also often use separate eligibility requirements for elective deferrals, match and employer contributions.

By design, 401(k) plans using automatic enrollment features typically have no eligibility requirements and immediate entry upon hire.

New 401(k) plans or qualified plans adding a 401(k) feature can choose to bring in all employees employed on the effective date of the plan, while all other employees hired after the effective date are subject to the eligibility rules of the plan. This encourages existing employees to defer, especially if the employer applies the same eligibility exception to the matching contribution.

Exclusions

HCEs who have executive benefit plans (non-qualified plans) might be excluded from a 401(k) plan designed to benefit middle management and rank and file employees, like the plan in Case Study Three. The plan sponsor in Case Study Two might choose to exclude the children of the partners, who are considered HCEs. In both cases, including the HCEs could cause the plan to fail nondiscrimination coverage testing and/or increase the company's required plan contribution to ensure tests will pass.

Excluding HCEs will usually help pass required coverage testing, but excluding nonhighly compensated employee (NHCE) groups is much more complex and may cause coverage tests to fail. Therefore, advisors should work with service providers before discussing exclusions of employee groups with plan sponsors.

Auto-Enrollment

In plans with auto-enrollment, instead of opting in to a plan, participants are automatically enrolled when they are hired (or meet a stated eligibility requirement in the plan) and are given an option to opt


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out. Auto-enrollment is a provision only available for 401(k) plans and there are many auto-enrollment designs. This will be covered in the Participant Outcome Unit.

Generally speaking, auto-enrollment has the benefit of increasing plan participation and improving participant outcomes. However, because of the higher number of plan participants, it can increase employer contributions. Advisors should work with the fiduciaries on how auto-enrollment can help them achieve plan goals.

Contributions Employee Contributions

Elective deferrals can be made on a pre-tax basis or as designated Roth contributions. Elective deferrals, both pre-tax and designated Roth contributions, are subject to the actual deferral percentage (ADP) test.

Roth Contributions and Accounts

Roth contributions are deferrals made on a post-tax basis. The earnings are not subject to income tax if withdrawn after the first Roth deferral was contributed at least five years prior, and if the employee is older than age 59½, dies or is disabled.

Participants may designate a portion of their contributions as designated Roth contributions, as long as the plan allows for Roth accounts. When a participant decides to make a designated Roth contribution, the plan must provide separate accounts because of the different tax calculations involved. These are called “Roth Accounts.”

Some plans legally allow participants to convert all or a portion of their pre-tax contributions to Roth accounts. Participants have to pay tax on the conversion amount, but then the account's earnings accumulate tax-free.

Therefore, if sponsoring a plan that allows Roth designs, Plan Sponsors must decide whether they want to offer Roth option to the participants. If yes, will they allow participants to convert existing account balances to Roth accounts?

Roth 401(k) Contribution Advantages and Disadvantages

Roth accounts encourage participation because it allows participants to have the tax-free earnings. It offers participants a qualified plan Roth option, which doesn’t have contribution limitations of Roth IRA.

The primary advantage of a Roth 401(k) contribution over a Roth IRA contribution is that the Roth 401(k) contribution is not subject to the income restrictions of contributions to a Roth IRA.

The earnings on designated Roth contributions can be withdrawn tax-free if the Roth 401(k) rules are followed by the plan.

However, Roth 401(k) accounts are subject to the required minimum distribution (RMD) rules for participants who are older than age 70½ (72 for years starting in 2021), while Roth IRAs have no RMD.


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These contributions are combined with pre-tax elective deferrals in testing the IRC §402(g) dollar and catch-up contribution limits.

The major impediment to Roth 401(k) accounts with designated Roth contributions in 401(k) plans is the administrative complexity and expense of providing for separate accounts with different tax rules.

Contribution Limits

Elective deferrals are also limited in order to prevent discrimination against NHCEs.

Some of these rules include:

• Elective deferrals limited each year by IRC §§401(a)(30) and 402(g) rules; • Elective deferrals by HCEs potentially limited by the ADP test and can be returned to the HCE if

the plan fails the ADP test; and • Only matching contributions may be tied to elective deferrals.

If a participant is age 50 or older in the current calendar year, the participant can defer up to an additional amount in catch-up contributions. Catch-up contributions are not counted toward any limits or in nondiscrimination testing.

401(k) plans can also impose plan-defined limits on elective deferrals and after-tax contributions. These are usually set up in the adoption agreement or the plan document to prevent nondiscrimination test failures.

The annual limits can be found in the IRS website.

Contributions and 401(k) Testing

Contributions to 401(k) plans are subject to two specific nondiscrimination tests: actual deferral percentage (ADP) and actual contribution percentage (ACP). The ADP/ACP tests are unique to 401(k) plans, and failed tests can cause employees to have to pay tax on their elective deferrals.

The ADP test compares the average deferral rates of HCEs to the average deferral rates of NHCEs. In general, the average deferral for the HCEs cannot be more than two percent greater than the average deferral for the NHCEs. For example, if the HCEs defer an average of nine percent of pay, and the NHCEs are deferring an average of five percent of pay, the test would fail. If the HCEs were deferring an average of seven percent of pay or less, the test would pass.

However, the plan sponsor can take measures proactively to prevent failed tests in its plan design. Boosting NHCE elective deferral rates can be accomplished by adding a match, by offering ways for NHCEs to access their 401(k) accounts while they are participants, or by adding automatic enrollment provisions. Additionally, the plan document may restrict the amount or percentage that an HCE may defer into the plan. However, if the employer provides a safe harbor 401(k) contribution, the ADP and possibly the ACP tests are deemed to be satisfied.


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Matching Contribution

In general, a 401(k) plan will not pass the nondiscrimination tests (ADP/ACP) if only HCEs elect to defer, or if HCEs defer at a much higher rate than NHCEs. It is critical that a majority of NHCEs make elective deferrals in order to allow the HCEs to contribute at the level they desire and pass nondiscrimination testing. To encourage NHCEs to participate, plans are designed with incentives.

The most common type of incentive is a contribution that matches a percentage of some or all of each dollar deferred. As we’ve seen, matching contributions are subject to ACP nondiscrimination test.

Two typical matching formulas are:

• 50 percent of elective deferrals up to six percent of compensation; and • 100 percent of elective deferrals up to three percent of compensation.

Although both matching amounts result in the same dollar amount of match contributions, an employee must elect to defer six percent of compensation in the 50 percent formula to get the maximum match. Because participants tend to make their deferral contributions decisions based on the maximum match amount, the "stretch match" has emerged. The stretch match matches 25 percent of deferrals up to 12 percent of compensation to encourage employees to save more than six percent of pay.

To boost participation, the match should also be a fixed amount, preferably made with each payroll, as the employees defer. Offering a discretionary match at the end of the year based on company profitability, or requiring last day of the year employment for any match, are less likely to increase NHCE’s elective deferrals throughout the plan year.

Similarly, nontraditional matching formulas not directly tied to elective deferrals, such as those based on years of service or levels of compensation, reward long service employees, but do little to motivate NHCEs to save. These contributions are also subject to additional nondiscrimination testing. Because they do not motivate employees to save, and have additional testing requirements, they are not as common as traditional matching formulas in 401(k) plans.

Another technique to encourage NHCE elective deferrals and to help plans pass nondiscrimination testing is automatic enrollment, described in the Participant Outcome Unit.

Other 401(k) Employer Contributions

Safe-Harbor Contributions

As we’ve seen, elective deferrals, both pre-tax and designated Roth contributions, are subject to a specific nondiscrimination test - the ADP test. Matching contributions are subject to a nondiscrimination test called the ACP test.

Safe harbor employer contributions can help plans pass the ADP/ACP test, but are more popular with owner-driven plans that can afford the fixed employee contributions required by safe harbor rules. Safe harbor plans are not as common in participant-driven, larger plans.


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An employer who makes a safe harbor contribution is exempt from the ADP and, generally, the ACP test for that year. A safe harbor nonelective contribution can also satisfy minimum required contributions for top-heavy plans. Therefore, top heavy 401(k) plans should almost always add a safe harbor contribution to their 401(k) plan. Employers who have had failing nondiscrimination tests year after year and are willing to take on a higher fixed contribution to avoid the failure, are good candidates for safe harbor plans.

Plan Sponsors must give advance notice of their intention to make the safe harbor matching contribution before the beginning of the plan year. Plans using the safe harbor nonelective provision do not have to provide advance notice and may adopt the provision up until the last day of the subsequent plan year.

• Other safe harbor requirements include: o An employer contribution of either: o Basic matching formula (100 percent match up to three percent of elective deferrals)

plus 50 percent match on the next two percent of elective deferrals), or o Enhanced matching formula (a matching formula that is equal to or greater than the

basic formula); or o Nonelective formula (three percent of compensation)

The three percent nonelective contribution will be increased to 4% if the safe harbor status is elected within 30 days of the end of the plan year or after the end of the plan year. Plans have up until the due date for returning excess contributions to adopt a safe harbor plan for that year.

• 100 percent vesting on all safe harbor contributions • The same withdrawal restrictions as elective deferrals • A contribution for all eligible participants, with no “last day of the plan year” allocation

requirement • Annual written notice to participants before the beginning of the plan year when safe harbor

matching contributions will be made (the notice is generally not required for the safe harbor nonelective contributions)

A 401(k) plan with a matching formula just under or above the safe harbor required match should also consider electing safe harbor status. Other 401(k) plan sponsors need to analyze the cost of the safe harbor contributions versus their current fixed contribution obligation and determine if the election will make financial sense for them and their employees.

Although the safe harbor can be more expensive than a traditional match or profit-sharing contribution and reduce the flexibility of a traditional profit sharing contribution, it has potential advantages such as:

• Satisfying the top-heavy minimum requirements for a top-heavy 401(k) plan • Enhancing employee participation if the plan has a safe harbor match.


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Example

In Case Study Two, the partners want to maximize their retirement savings. If they choose to make a safe-harbor contribution to the plan, they will be able to contribute the maximum deferral amount without failing testing.

The following chart is a summary of the advantages and disadvantages of electing to be treated as a safe harbor plan:

Advantages Disadvantages

Automatic pass on ADP test and possibly on ACP test

Detailed notice requirements

Safe harbor nonelective contribution can satisfy top-heavy

Notice must be given before the beginning of the plan year for matching safe harbor contributions

Higher deferrals for HCEs 100% vesting required on safe harbor contributions

Allows for additional employer and employee contributions

Higher required contribution levels

Choice of match or nonelective contributions Difficult to eliminate safe harbor provisions


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401(k) Plans:

Distributions and Withdrawals In general, 401(k) plans are subject to the same distribution and withdrawal rules as qualified profit-sharing plans, which are described in the Plan Provisions Unit.

Because 401(k) plans include additional contribution sources not typically found in profit sharing or other DC plans, there are additional distributable events that apply to these plans.

Some of those sources include:

• Employee pre-tax elective deferrals • Designated Roth contributions • Employer matching • Employer profit sharing or other employer contribution • 401(k) safe harbor contributions

401(k) contribution sources may be distributed at the following events:

• Severance from employment • Age 59½ • Required minimum distributions • Death or disability (same as pension and profit-sharing plans) • Corrective distributions (failed tests) • Certain circumstances such as a merger, acquisition or spin-off

Qualified childbirth or adoption expenses

Special rules apply for plan terminations, in particular, there cannot be a successor plan, and the distribution must be in the form of a lump sum as defined for this purpose.

Hardship Withdrawal In 401(k) plans, prior to 2019, only elective deferrals were eligible for hardship withdrawals. However, effective in 2019 plans have the option to allow other sources of money to be withdrawn for hardship (QNECs, QMACs, Safe Harbor Contributions and the earnings on these sources and elective deferrals). There are also special hardship withdrawal rules. The plan is required to define the hardship withdrawal in the plan document as meeting two requirements:

• The withdrawal can only be made for an immediate and heavy financial need (needs test); and • The withdrawal does not exceed the amount required to satisfy the financial need (amount

test). The plan can select one of two methods to determine if a participant meets the above requirements:


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• Facts and circumstances; or • Safe harbor definition.

Safe harbor standards for hardship considerably simplify plan administration, which is why most plans have the hardship safe harbor reasons in their plan document.

Hardship Withdrawals Safe Harbor Rules

Under the safe harbor standards for the needs test, the expense is deemed to be for an immediate and heavy financial need if it is for one or more of the following reasons:

• Medical care for the participant, spouse, dependents or primary beneficiary • Purchase of the participant’s primary residence • Tuition, fees, room and board for post-secondary education for the next 12 months for the

participant, spouse, dependents or primary beneficiary • Preventing eviction from or foreclosure on the participant’s principal residence • Burial or funeral expenses for the participant’s deceased parents, spouse, dependents or

primary beneficiary • Repair of the participant’s principal residence for damage qualifying for casualty deduction

under IRC §165 • Expenses incurred in a federally declared disaster areas such as floods or hurricanes

To qualify for the safe harbor standard, the participant also has to meet the following amounts test:

• Amount may not exceed the amount of the need plus estimated taxes and penalties on the withdrawal;

• Participant has taken all other currently available distributions under the plan. Please note that the requirement to take a loan was in effect prior to 2019 but is no longer required but may be retained as an optional plan provision.

Lastly, prior to 2020, participant elective deferrals were required to be suspended for six months after the hardship withdrawal is made. Effective as of January 1, 2020 deferrals may not be suspended after a hardship withdrawal is taken.


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Advisor Takeaway 401(k) plans are the retirement plan of choice for many companies because they are flexible enough to meet the goals of participant-driven as well as owner-driven plans. The larger company in Case Study Three may be more interested in maximizing participant outcomes than focusing exclusively on the owners or key employees. They may want to consider a traditional 401(k) with automatic enrollment and a matching contribution. Because of their large size, they are less likely to consider a safe harbor design. Advisors should always work with qualified service providers to determine the best features to meet the specific plans goals and objectives.

The IRA Plans: SEP, SIMPLE IRA and SIMPLE 401(k) Employers who want to provide an employee retirement plan, but do not want to take on all of the administrative burden of a traditional qualified 401(k) plan, can elect to sponsor one of three types of IRA plans: simplified employee pension plan (SEP), the SIMPLE IRA or the SIMPLE 401(k). SIMPLE plans were introduced to offer further simplified retirement savings alternatives for small businesses.

All of the IRA plan alternatives consist of individual accounts for each participant. Often these plans are not subject to the qualified plan eligibility, vesting, contribution and testing requirements.

Because the plan consists of individual employee accounts, employees are always 100 percent vested and accounts are accessible for withdrawals, subject to some restrictions. Employees have the right to select their IRA investment provider, or in the case of the SIMPLE 401(k), the employer will offer a group of investment choices.

Generally, SIMPLE IRA and SEP have no plan documents, just a short form outlining the requirements. Additionally, these two plans have no annual government filing requirements to the IRS or DOL, if certain conditions are met.

Like safe harbor 401(k)s, both SIMPLE plan designs require minimum employer contributions that exempt the plans from the ADP and ACP testing of traditional 401(k) plans.

While SEPs and SIMPLEs are less costly and easier to administer, their lower contribution limits and easy access to the accounts may not provide as much in retirement savings as a traditional qualified plan. However, for an employer looking to provide benefits to employees in an inexpensive way, they are a valid design alternative, especially if small employers are not looking to maximize principal employees’ retirement contributions.

SEP-IRA SEPs are most similar to an employer-sponsored profit-sharing plan. The employer may adopt the SEP up until the due date of its tax return. In general, an employer who sponsors a SEP may not sponsor any other qualified plans.


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Eligibility

The eligibility requirements for a SEP are different from qualified profit-sharing plans and SIMPLE plans, which can actually make them more complicated for employers to administer.

Contributions

Only employer contributions are permitted; they are discretionary and can be made up to 25 percent of eligible payroll subject to the dollar limits for that year. No employee or matching contributions are allowed.

Vesting

Contributions are 100 percent vested.

Distributions and Withdrawals

Participants have the right to withdraw monies at any time, subject to the pre-59½ excise tax and income tax.

Requirements

SEPs are subject to the top-heavy requirements and must provide a minimum allocation of three percent of compensation if they are top-heavy.

Rollovers

Employees can roll the SEP accounts into traditional IRAs, another SEP, or into a qualified plan, if the plan provisions allow for it.

SIMPLE IRA The SIMPLE IRA was created to provide a 401(k) style IRA plan with employee elective deferrals and employer matching or nonelective contributions. The SIMPLE IRA may only be sponsored by an employer with no more than 100 employees. Generally, if the employer chooses to sponsor a SIMPLE IRA, it may not sponsor any other qualified plans during the same calendar year as the SIMPLE plan.

Contributions

Employee contributions (in the form of elective deferral) are permitted. Employer contributions are mandatory, but employers have a choice of:

• qualified nonelective employer contribution of two percent of compensation (subject to qualified plan compensation limits); or

• matching contributions of 100 percent up to three percent of compensation.

Employees can elect to stop deferring at any point during the year, but the employer may require that they wait until the following year to resume elective deferrals.


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Limits

Elective deferral limits are lower than 401(k) plans and employer contributions are restricted. Limits for deferrals and catch-up contributions are set every year by the IRS. For limits, check the IRS website.

Vesting

As with all IRA plans, all contributions are always 100 percent vested.

Distributions and Withdrawals

Withdrawals within the first two years are subject to a 25 percent excise tax instead of the standard 10 percent excise tax on early distributions prior to age 59½.

Requirements

SIMPLE IRAs are exempt from nondiscrimination testing and top-heavy requirements.

Rollovers

Employees may not roll over to a traditional IRA or a qualified plan until the two-year period of time since their initial participation has elapsed.

SIMPLE 401(k)

SIMPLE 401(k) plans are a cross between a SIMPLE IRA and a traditional 401(k) plan. The SIMPLE 401(k) has not caught on in the marketplace, largely because employers who want 401(k) plan features will choose a traditional 401(k) for the increased contribution limits, even with the increased administrative requirements and costs. Those employers who want simpler rules with lower costs will often choose a SIMPLE IRA or a SEP.

They are subject to the same 100-employee restriction and the exclusive plan rule of SIMPLE IRAs, and it may not be sponsored with any other qualified plans during the same calendar year.

SIMPLE 401(k) rules are identical to those of the SIMPLE IRA, except for the following:

• Eligibility of one year of service and age 21; • Distributions are not subject to the two-year 25 percent excise tax of SIMPLE IRAs, but instead

uses the standard 10 percent tax on early distributions; • The distribution limitations on elective deferrals and QNECs apply; • Annual filing of Form 5500 is required; • Participant loans are allowed; • Coverage rules of IRC §410(b) apply; and • IRC §415 limitation applies to the SIMPLE 401(k) plan.


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Advisor Takeaway

The retirement plan advisor is mostly likely to run into a SEP or a SIMPLE plan that was set up for a start-up company like the firm in Case Study One. Because they are less expensive to administer, they are attractive to start-up firms. However, companies who grow beyond the limits of their IRA plan, especially those where the owners or partners want to contribute more than $13,500 to $16,500 (for those who are catch-up eligible) must wait until the beginning of the next plan year to adopt a 401(k) plan, due to the exclusive IRA plan rule.

The other problem typically seen in SIMPLE IRAs is that employers do not realize the plans have a required contribution component and often have not made those contributions to the plan. Advisors should carefully ask questions of an IRA plan sponsor to determine if they may need to seek expert help to correct plan errors before adopting a 401(k) plan.

Although 401(k) plans are more complicated to administer, they allow more flexibility in design for both owners and employees to save for retirement – even when the firm is just starting out like the IT firm in Case Study One. Some plan administration and fiduciary responsibilities can be delegated to qualified service providers, which the retirement plan advisor can explain to a plan sponsor.

Defined Benefit and Cash Balance Plans Traditional defined benefit (DB) plans provide a guaranteed benefit at the plan’s defined normal retirement age. Employer contributions necessary to fund these benefits are calculated by an actuary. Because the law limits benefits at retirement, there is no specific contribution limit as there is in a 401(k) or profit-sharing plan. As a result, annual contributions can be higher than what would be permitted in a 401(k) plan.

Participants do not have individual accounts; the plan pays benefits from a single trust account. Benefits can be based on compensation, years of service, or a combination of the two. By law, the plan must offer benefit payments as a monthly income at retirement. The plan document controls if participants can also elect a lump-sum retirement payout. Participants terminating before retirement are entitled to a prorated portion of their retirement benefit called an accrued benefit.

As in traditional DB plans, cash balance DB plans provide a guaranteed benefit at a plan defined normal retirement age and have no specific contribution limits. However, in a cash balance plan, the participant receives an annual allocation or “pay credit” which is used to define the amount of their retirement benefits. The participant is also guaranteed a rate of return in their account. If the plan assets lose money, the participants are still guaranteed their hypothetical account balances and the guaranteed rate of return. The participant can take a lump sum of their hypothetical account balance. Participants terminating before retirement are entitled to the vested percent of their hypothetical account balance.


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Hybrid Plans A hybrid plan is a qualified retirement plan that combines DB and DC plan features. In general, hybrid plans provide participants with individual account balances and then either provide a defined retirement benefit (DB/DC combination) or convert participant accounts into theoretical retirement benefits for nondiscrimination testing (cross-tested plan).

Cross-tested designs are frequently added to safe harbor 401(k) plans in an owner driven firm. They are less common in participant-driven companies, with the exception of employers who want to target specific groups of employees using different contribution amounts and are willing to commit to fixed contributions each year.

This type of plan design in owner-driven firms provides older, HCEs with a significant portion of the employer’s qualified retirement plan contributions. The significant contributions also make these designs more common in the small plan employer sector. They are often used to provide retirement benefits to older owners who are either just starting a small business or who are looking to save for retirement in five to 15 years.

The designs that incorporate DB plans will also allow a much larger retirement plan deduction than the deduction for a stand-alone DC plan. However, the annual required contribution obligations of these plans are significant, and these arrangements should only be designed for employers with stable cash flows.

Cross-Tested Plans An employer who wants to direct more of the contribution to the principal employees may choose a profit-sharing plan with a cross-tested design. This type of design can offer more contribution flexibility, although it requires a minimum contribution for NHCEs in order to pass required nondiscrimination testing.

In cross-tested plan designs, the employer makes a flexible profit-sharing contribution, typically to a safe harbor 401(k) plan and allocations are based on specific employee groups rather than solely on compensation. As long as the allocation passes the nondiscrimination tests, the plan document can identify groups of employees and contribute a different amount (or percentage of pay) to each group.

The cross-tested design hinges on the same factors as all hybrid plans (i.e., that the principals are on average older and more highly compensated than the non-principals).

Cross-tested plans must pass IRC §401(a)(4) nondiscrimination tests each year. The tests are based on both ages and salaries of eligible employees. As a result, changes in the employee population can cause a previously passing test to fail. Employers should understand that a failed test will result in either contributing more money for some non-principal employees, or cutting back allocations to some principal employees.

It is most likely that minimum contributions to non-principals will range between three percent of pay and five percent of pay. However, plans with a safe harbor provision can count the safe harbor contribution towards top-heavy and cross tested minimum contribution.


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Combination Plans DB or cash balance plans can be adopted in addition to a safe harbor 401(k) plan for owner-driven firms, like the partnership in Case Study Two, that want to maximize their retirement savings in a short period of time.

The term “DB/DC combination plan” comes from the idea that the plans can be combined for purposes of nondiscrimination testing. The primary advantage to these designs is that individuals are not limited by the contribution limits of 401(k) plans. In fact, contributions to these plans can exceed $100,000 per year for a single participant, depending on the participant’s age and distance from retirement. They also take advantage of plan demographics in maximizing contributions for participants closer to retirement.

Their disadvantages include:

• a larger, fixed contribution • more complex and expensive administration • plans sensitive to changes in employee demographics that can undermine the original goals of

the design.

They also require a larger contribution (7.5 percent of pay or more) on behalf of NHCEs than a safe harbor 401(k) (three percent of pay) or even a cross-tested 401(k) (five percent of pay).

Advisor Takeaway A partnership like the one in Case Study Two, that has a stable long-term cash flow and wants to speed up retirement contributions for the partners, might want to consider a DB/cash balance or hybrid combination plan design (i.e., a plan with both DB/cash balance and DC components).

Both plan designs are based on employee demographics, and both require a fixed annual contribution. However, if the partners in Case Study Two want to speed up their retirement savings, a DB/DC combination design can allow them to contribute more each year than a cross-tested design would. Advisors should be aware that older NCHEs and/or younger HCEs could undermine the purpose of a DB/DC design. These types of plans are also more complex and expensive to administer.

Because the DB/DC combination has little contribution flexibility, the IT company in Case Study One may want to take advantage of the contribution flexibility offered by a 401(k) safe harbor or 401(k) safe harbor cross-tested design. Advisors should remind owners like those in Case Study One that the plan still requires a fixed contribution, but it will likely not be as large as the fixed contribution in the DB/D combination design.

Advisors should focus on plan goals for owner-driven plans and be prepared to discuss how plan designs can increase their retirement savings. Always be aware of company cash flow and employee demographics. Given the complexity of owner-focused designs, advisors should work with qualified


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service providers to assist in designing hybrid plans. Under the course resources, you can find a table that summarizes the advantages and disadvantages of the various plan types.

Adoption Agreements Advisors usually work with service providers who handle document compliance.

Service providers who can assist fiduciaries with document compliance include TPAs, recordkeepers and ERISA attorneys. In plans with adoption agreements, TPAs or recordkeepers will typically draft the plan in conjunction with the fiduciaries and the advisor, and an ERISA attorney reviews the plan documents. However, retirement plan advisors should be familiar with how the document, especially the adoption agreement, reflects the plan features selected to meet the plan's goals.

Most qualified plan documents, or "pre-approved" plans, consist of an adoption agreement and a base plan document. The advantage to these plan document types is that the document provider has received IRS approval for the plan provisions, and plan sponsors can adopt them knowing that they have an IRS opinion letter approving the document language.

The adoption agreement will typically reflect the plan provisions selected by the plan sponsor that best fit the plan goals. Much of the language in the base plan document is text required under either ERISA, the IRC or its regulations.

Example The base plan document will include an explanation of participant claims and appeal rights under ERISA, as well as documentation of ERISA fiduciary roles and responsibilities. IRC requirements, such as the maximum dollar amounts under IRC 415 and nondiscrimination testing under IRC 401(a)(4), are also explained in the base plan document.

The adoption agreement will actually name the fiduciaries who are responsible for the plan. The adoption agreement will have also specified the options for percentages and amounts of employee and employer contributions, including safe harbor contributions that could exempt the plan from ADP/ACP nondiscrimination testing.

Although most 401(k) plan adoption agreements offer many different choices in their provisions to meet plan goals, the language in those provisions cannot be changed without invalidating the IRS pre-approval. As a result, larger employers may choose to use an ERISA attorney to draft an individually-designed plan with customized language designed to meet their plan goals. These plans are almost always submitted to the IRS for approval, although they are not legally required to be submitted to the IRS for a determination letter.


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Qualified Domestic Relations Order All qualified plans must provide language in their document to protect participants’ spouses and beneficiaries. A qualified domestic relations order (QDRO) is an example of this protection. A QDRO provides for the payment of all or a portion of the participant’s account balance to an alternate payee in the event of divorce, typically a spouse or a dependent, and must satisfy the requirements of IRC §414(p) and ERISA §206(d).

In general, TPAs and recordkeepers have procedures to deal with QDROs on behalf of plan sponsors. Any plan sponsor who receives a domestic relations order should work with a qualified service provider or ERISA attorney.

Plan Amendments When a plan is adopted, its provisions are not permanent. The plan sponsor can elect to amend the provisions, as long as the amendment doesn’t violate the rules that prohibit cutting back benefits that are guaranteed under ERISA, such as vested account balances.

Legislative and regulatory changes will require that a plan be amended, possibly even that the entire document be amended and restated.

Remedial amendments may also be adopted when the IRS is reviewing a plan. Regardless of the type of amendment, the amendment must be signed and dated to be valid. If it is intended to apply for the previous plan year, it must be signed and dated within a defined remedial amendment period.

Plan Sponsor Amendments When plan sponsors elect to amend the plan document, the primary concern should be to avoid reducing participant benefits and violating anti-cutback rules.

Amendments to pre-approved plans with adoption agreements may still rely on the original opinion letter, as long as the amendment is to select another alternative available in the adoption agreement.

If the amendments make "material" changes to the plan, it must be accompanied by notice to participants in the form of a Summary of Material Modification (SMM) to the Summary Plan Description (SPD).

Legislative Remedial Amendments An extended remedial amendment period is given to sponsors when amending documents for legislative changes. During this period, the employer is granted extended reliance on the most recent determination or opinion letter.


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In recent years, these legislative remedial amendment periods have been lengthened due to the pace of the changes in qualified plan rules. To deal with frequent legislative change, the IRS has set guidelines for periodically amending and restating documents and submitting them for review. The review process is somewhat different for individually designed plans with a favorable determination letter versus document provider plans with an opinion letter, but the impact on the employer is the same.

As a result, employers should factor in the cost of these restatements when adopting a qualified plan. Expenses can be minimized by adopting a pre-approved plan, where the sponsoring organization will take on the task of amending the documents. However, there will still likely be a cost to adopt the amended document, even when it is a pre-approved document. Lastly, the plan must be amended for all legislative and regulatory changes before it can be terminated and benefits distributed.

Advisor Takeaway Although the periodic amendment and restatement of plan documents is considered a burden both administratively and in cost to the plan sponsor, this required amendment represents an opportunity to review optional plan provisions that may be outdated and/or no longer fit the plan's goals and objectives. It is also an opportunity to review provisions that are difficult to administer and do not impact plan goals. Plan features that often increase administration costs and HR staff time include eligibility, vesting and compensation definitions. Advisors can add value by asking service providers, plan sponsors and HR staff what optional provisions could be changed to make the plan run more smoothly.


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Unit 4: Participant Outcomes Case Studies Case Study One: Sole Proprietor start-up IT company with one owner and two employees who wants to start a new plan. The company doesn’t have a lot of cash flow yet, but they are growing fast and will have more money in the future.

Case Study Two: Professional firm (partnership) has three partners/owners and 25 employees. They have a stable cash flow and have a 401(k) plan. Two of the partners have children working for the company. The firm shares office space with another firm with whom they do business.

Case Study Three: A manufacturer previously sponsored, but now has terminated, a defined benefit pension plan. They currently sponsor a 1,500-participant 401(k) plan, and the key executives have a top-hat nonqualified plan. The 401(k) plan was designed for middle management and rank and file employees who work in multiple locations nationwide. About 50 percent of employees are deferring, and sometimes the plan fails testing. The plan currently has a match contribution of 50 percent up to six percent.

Guiding Questions • What would be an appropriate goal for the plan in Case Study Three in terms of coverage and

participant outcomes? • What about Case Studies One and Two and their goals for participant outcomes? • What strategies can be used to support successful participant outcomes?

Introduction The corporation in Case Study Three has a 401(k) plan with voluntary deferrals, and they match 50 percent of deferrals up to six percent of compensation. Traditional 401(k) designs like the one in this case study can encourage participants to save up to six percent of their pay but they require participants to actively enroll in the plan. In this type of plan, participation will typically vary from 40 percent to 70 percent of the employees. However, this participation rate is often much higher among middle and upper management employees, and much less among rank and file employees.

As a result, the retirement plan committee in this company may be concerned about the rank and file employees’ ability to be able to retire at the plan’s normal retirement age. This ability of participants to retire is often called “retirement readiness.” When retirement readiness is talked about in 401(k) plan design, it can also be referred to as focusing on “participant outcomes.” Focusing on participant outcomes is important to the plan sponsor for three primary reasons:

1. The plan and participants’ goal should be to have adequate retirement income to retire as planned

2. When participants are able to retire, it enables the employer to do workforce management


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3. Enable employer to manage healthcare costs

Fiduciaries do not have a fiduciary duty under ERISA to provide retirement readiness to their employees, but it is increasingly becoming a fiduciary best practice. As plan sponsors (like the company in Case Study Three) become more focused on improving participant outcomes in their plans, they will ask advisors to help them adopt techniques to increase participation in the plan. When adopting these techniques, the plan sponsor and the advisor will be fulfilling a core purpose of ERISA: operating the plan on behalf of participants and beneficiaries.

Advisors can work with fiduciaries to improve participant outcomes by explaining the following:

• Retirement readiness goals • Participant education • Online tools • Participant education vs. investment advice • Behavioral finance concepts • Auto-enrollment designs • Re-enrollment options

Retirement Readiness Goals Before discussing education and plan design ideas on how to improve retirement readiness, advisors should ask plan sponsors about their goals for their participants. These goals can differ between different size firms and even among members of the retirement plan committee in one company.

A small, owner-driven plan like the one in Case Study One, or the partner-driven plan like Case Study Two, will likely be focused more on the owners’ and partners’ retirement goals, as well as on the qualified plan tax benefits. They are not as focused on other employees’ retirement outcomes. They usually expect advisors to work with their participants on education and enrollment (and possibly with investment advice if the advisor is an investment advice fiduciary), but they are less attracted to auto-enrollment designs or re-enrollment strategies.

Participant-driven plans tend to be more focused on retirement readiness, but contribution costs are still a significant factor. A CFO at a committee meeting was asked if he was concerned about his company’s participants’ outcomes, and he replied, “I am concerned about MY retirement outcome. Otherwise, my main concern about the plan - other than my fiduciary duties - is keeping plan contributions and costs reasonable.” The HR director at the same meeting had a different view: “We ARE concerned about employees’ retirement readiness. So, what can we do within our budget constraints?”

These different viewpoints illustrate the challenge advisors face in working with committees and participants on participant education, automatic enrollment, and re-enrollment strategies. The first step in implementing these strategies effectively is for advisors to help identify plan goals by asking the following questions:


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Strategy Questions

Participant education

• Why do you have a plan? Do you feel the plan is meeting that goal?

• Do employees understand the plan and appreciate the value it provides?

Reenrollment

• What are your employee demographics (number of employees, ages, salary levels, average turnover)?

• Is adequate employee retirement income a goal of your firm? • Do you have a way of knowing who is on track for an adequate

retirement income?

Autoenrollment

• Do you know what percentage of your employees are invested in the plan’s default investment?

• What percentage of your employees are making 401(k) contributions? Do you want to increase this percentage? What is your average deferral percentage contribution for the non-key employees?

• Are you willing to make regular contributions to the plan? Are you willing to make mandatory (required) contributions to the plan?

• Do you have a philosophy on making employer contributions (employees should be required to contribute themselves in order to receive an employer contribution, or prefer to benefit a broad base of employees)?

• Is your company cash flow relatively predictable?

Participant Education Participant education, typically provided by the plan advisor in annual or periodic meetings throughout the year, has been the traditional method for providing information about the plan and its investments. In recent years, education has also been available through online tools, videos, and mobile apps. Education by an advisor can convey the reasons that the plan sponsor has adopted a plan and how the plan is designed to reach employees’ retirement goals. These meetings can also educate employees on how the plan works and help them to appreciate the value of the plan benefits. Some advisors offer one-on-one meetings with participants, but this option becomes more difficult and increasingly costly in larger companies.


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Some studies have shown that one-on-one meetings with participants result in increased deferrals and better investments.6 However, other surveys have shown that 44 percent of participants felt that they were getting more information than they could understand, and 65 percent indicated that they did not read all of the information that was provided to them.7 As a result of these surveys, and recent research into participant behavior, there is increasing consensus that education is not improving retirement outcomes for most participants in 401(k) plans.

Advisors should remember the fiduciary rules when offering one-on-one participant education services. A non-fiduciary advisor can provide plan and investment education without becoming a functional or inadvertent fiduciary. However, remember the important distinctions of investment advice versus investment education. If you are offering investment advice, as opposed to offering education under the education safe harbors, you may be considered an investment advice fiduciary.

Participants often request investment advice, and plan sponsors may see an investment advice fiduciary advisor as an advantage in achieving their plan goals. You should always check with your financial institution before offering investment advice to participants in plans or serving as a fiduciary advisor to the plan.

Lastly, if offering a matching contribution, it is critical that the match be “marketed” to the employees in the enrollment process. During enrollment and participant education meetings, retirement plan advisors can stress that employer match amounts are similar to guaranteed investment returns on their deferred dollars. Employees who understand the benefits of the match are much more likely to make elective deferrals.

Behavioral Finance Research Shlomo Benartzi and Richard Thaler have led the way in researching how participants behave when faced with complex “opt-in” choices like those presented by a 401(k) plan. In a 401(k) plan, participants have to select a payroll contribution amount, choose an investment allocation for their account and do both while attempting to figure out how much money they may need in retirement. This would be a difficult task for the most sophisticated participants, and it is made even more complicated by the need to “do” something that involves several steps. As a result, many participants do not enroll in their plans due to inertia, even when there is “free money” available to them in the form of an employer match.8

6 Brown, Jeffrey R. & Liang, Nellie & Weisbenner, Scott. “Individual account investment options and portfolio choice: Behavioral lessons from 401(k) plans.” Journal of Public Economics 91.10 (2007): 1992-2013. Print. 7 Ibid. 8 Benartzi, Shlomo and Thaler, Richard H., Heuristics and Biases in Retirement Savings Behavior. Journal of Economic Perspectives, Forthcoming. Available at SSRN: http://ssrn.com/abstract=958585

http://ssrn.com/abstract=958585



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In their paper “Heuristics and Biases in Retirement Savings Behavior,” Benartzi and Thaler point out how participant financial behavior often can be irrational, like not “opting-in” in retirement plans offering substantial benefits and leaving “free money” on the table:

“One extreme example of reluctance to join an attractive retirement plan comes from the United Kingdom, where some defined benefit plans do not require any employee contributions and are fully paid for by the employer. They do require employees to take action to join the plan. Data on 25 such plans reveals that only half of the eligible employees (51 percent) signed up.

Another extreme example involves those … employees who are 1) older than 59 ½ years old, so they face no tax penalty when they withdraw funds from their retirement account; 2) have an employer match; and 3) are allowed by their employer to withdraw funds from their retirement account while still working. For this group of employees, joining the plan is a sure profit opportunity because they can immediately withdraw their contributions without any penalty, yet they get to keep the employer match. Nonetheless, Choi et al. find that 40 percent of these individuals either do not join the plan or do not save enough to get the full match.”9

This irrational behavior cannot be overcome by increased education, even when there are significant incentives to participating, such as an employer match. However, participant outcomes can be dramatically increased by taking advantage of the power of behavioral inertia.10 If participants can be automatically enrolled in a plan with an “opt out” option, they are far less likely to leave the plan, and their participation rates dramatically increase.

Automatic Enrollment Research For employers concerned about retirement readiness, advisors can begin the autoenrollment conversation with Benartzi’s and Thaler’s research. Auto-enrollment provisions take advantage of the participant behavior they have identified. In autoenrollment 401(k) designs, participants are automatically enrolled in the plan when they are hired at a deferral percentage specified by the plan. Participants are given an option to opt out, but because opting out require participant action, inertia takes over, and participants stay in the plan at their auto-enrolled deferral amounts.

Benartzi and Thaler explain the dramatic benefits of automatic enrollment:

“In one plan Madrian and Shea studied, participation rates under the opt-in approach were barely 20 percent after three months of employment, gradually increasing to 65 percent after 36 months of employment. When automatic enrollment was adopted, enrollment of new employees jumped to 90

9 Ibid. 10 Ibid.


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percent immediately and increased to more than 98 percent within 36 months. Automatic enrollment thus has two effects: participants join sooner, and more participants join eventually.”11

Automatic Enrollment Provisions In an effort to simplify automatic enrollment provisions in 401(k) plans, the Pension Protection Act (PPA) established three types of automatic enrollment arrangements in 401(k) plans. They are:

1. Basic automatic contribution arrangements (ACAs); 2. Eligible automatic contribution arrangements (EACAs); and 3. Qualified automatic contribution arrangements (QACAs).

ACAs are 401(k) plans that allow for automatic enrollment, but the plan document specifies the level of auto-enrollment. There is no legal requirement for a minimum or maximum level of enrollment. There is no matching contribution required; however, it is common to see these plans with a matching contribution. ACA plans, like EACAs and QACAs, do need to provide participant notices about the autoenrollment feature.

EACAs are the same as ACAs with two exceptions: They must allow participants to opt out of auto-enrollment within 90 days (or sooner if the plan provides) of having deferrals withheld from their paychecks. The amounts withheld and eligible for return to the participant are known as “permissive withdrawals”. The notice must explain this provision to participants. In addition, EACAs allow employers to extend their ADP/ACP compliance testing deadlines until six months after the plan year end, 6/30 in a calendar year plan.

QACAs combine auto-enrollment features and 401(k) safe harbor plan features. As a result, QACAs who meet the requirements are not subject to ADP/ACP testing. The other advantage of QACAs is that, unlike safe harbor 401(k) contributions, QACA matching or employer nonelective contributions are not required to be vested until the employee has completed two years of service. The required employer contributions are an enhanced match or a qualified nonelective contribution. Required QACA contributions are explained below.

The following chart summarizes the various features of the three types of automatic contribution arrangements:

11 Benartzi, Shlomo and Thaler, Richard H., Heuristics and Biases in Retirement Savings Behavior. Journal of Economic Perspectives, Forthcoming. Available at SSRN: http://ssrn.com/abstract=958585




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Some of the important automatic enrollment provisions established by PPA include:

• Notices must be given to participants before the first automatic elective deferral pay period explaining how automatic enrollment works and how to opt out;

• Plans adopting EACAs receive an extended six-month deadline to run ADP and ACP tests and correct a failure (this extends the deadline from March 15 to June 30 for calendar year plans);

• Plans adopting EACAs must allow participants to request a refund of their automatic elective deferrals within the first three months of their first automatic elective deferral; and

• Plans adopting QACAs will automatically comply with the ADP and possibly the ACP test, and if no other type of contribution is offered, the plan will be considered not top-heavy.

Most participant-driven plans elect ACA or EACA designs. Although the EACA option requires a 90-day opt out option, it does allow the plan six months (as opposed to two and one-half months) after the end of the plan year to do their ADP/ACP compliance testing.


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The QACA Automatic Enrollment Level and Contribution A QACA is a type of hybrid safe harbor 401(k) that includes an automatic enrollment feature. QACA plans must follow:

• A notice requirement • The option to opt out • The automatic enrollment level, described below • The required employer contributions described below will automatically comply with the ADP

test and possibly the ACP test.

A plan that complies with the QACA requirements will be deemed to be not top-heavy if there are no other employer contributions.

Automatic Enrollment Level

All new participants and those without a current elective deferral election on file must be automatically enrolled in a QACA at least at three percent for the first year of deferral with an auto-escalation of one percent a year. The automatic enrollment escalation levels can be greater than these amounts, but cannot exceed ten percent of compensation in any year. This is what the minimum deferral for one participant would look like:


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Required Employer Contributions

The QACA is further satisfied if the plan sponsor makes either a matching contribution or a Qualified Nonelective Contribution (QNEC). The match must be at least 100 percent of the first one percent deferred plus 50 percent of the next five percent deferred. The QNEC must be at least three percent of compensation. Note that if the nonelective safe harbor provision is adopted within 30 days prior to the end of the plan year or later, the three percent is increased to four percent. Unlike existing safe harbor 401(k) designs, the QACA employer contribution need not be fully vested until two years of service.

All existing distribution restrictions and notice requirements applicable to safe harbor 401(k) plans continue to apply to the QACA safe harbor.

The primary advantage of a QACA design is the two years of service for the vesting in the employer’s safe harbor contribution. However, most participant-driven plans do not elect to be safe harbor plans and do not want to commit to the annual safe harbor contributions. Secondly, auto-escalation of auto-enrollment has become more common in ACA and EACA designs and is not unique to a QACA plan. As a result, QACA designs are less common than other auto-enrollment plan designs.

Automatic Enrollment Design Advisors should consider the pros and cons when discussing auto-enrollment designs with plan sponsors and retirement plan committees. They should also remind the fiduciaries that adopting or changing to an auto-enrollment design will require a plan amendment and notices to employees about the change as well as opt out notices.

Secondly, advisors should work with the fiduciaries on auto-enrollment and their plan goals. Do they want to auto-enroll only new employees and not go back to existing employees who are currently in the plan? What about employees who are deferring at a rate below the auto-enrollment rate--should those employees be auto-enrolled at a higher rate after the change to the plan? Do they want to combine auto-enrollment with re-enrollment (see the following section) and “reset” employees’ deferrals each year to the auto-enrollment rate?

Automatic Enrollment Notice Requirement Employers adopting any of the three automatic contribution arrangements are required to provide a notice to all eligible employees explaining their rights under the plan. It must be provided within a “reasonable” time period prior to the first pay period in which amounts will be automatically withheld and prior to each subsequent plan year.

The notice must include language informing the participants of their right not to defer or to defer an amount different from the automatic enrollment amount and the time period in which to make such


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election. The notice must also describe the default investment should participants fail to make an affirmative investment election.

There is a penalty of $1,000 (updated each year for cost of living adjustments) per day to the plan sponsor for failure to satisfy this notice requirement.

Automatic Enrollment Pros and Cons Below are auto-enrollment designs and their pros and cons:

Auto-Enrollment at Six Percent (or Higher) of Pay Instead of Minimum Three Percent of Pay

PROS:

• Better participant outcomes; because of participant inertia, most participants stay at three percent if there is no auto-escalation provision, and three percent of pay is likely to be inadequate for retirement readiness.

• Recent information indicates that opt out rates are not significantly higher at six percent than at three percent.

• Auto-enrollment frequently results in 80 percent to 90 percent plan participation by employees, increasing the likelihood that the plan will pass the ADP compliance test.

CONS:

• Higher matching contributions. Advisors should be prepared to discuss the increased match costs, especially with CFOs who are concerned about company budgets. Tying the increased match to potentially lower future healthcare costs is a good discussion point when committees are considering adding autoenrollment or increasing their percentage from three to six percent.

• Increased risk of plan errors. The error risk is real for any plan with an autoenrollment provision, because it requires coordination between HR, payroll, and the recordkeeper to assure all employees are being auto-enrolled. If participants are not auto-enrolled, or incorrectly auto-enrolled, the plan sponsor must contribute to the plan for participants’ “missed deferral opportunity.”

Auto-Escalation

PROS:

• Even better participant outcomes than with auto-enrollment alone because participants’ deferrals are automatically increased each year. Originally auto-escalation was done at one percent per year, but recent research indicates two percent per year escalation does not increase opt out rates and provides excellent participant outcomes.

• Recent information indicates that opt out rates are not significantly higher in plans using auto-escalation.

CONS:


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• Even higher matching contributions. Advisors should be prepared to discuss the increased match costs, especially with a two percent per year escalation provision, which can significantly increase each year with auto-escalation. Advisors can work with TPAs and recordkeepers to do projections based on plan demographics for CFOs and committee members who are concerned about company budgets.

• Even higher risk of plan errors. The error risk when using auto-escalation is more than when just using auto-enrollment because it requires both auto-enrolling participants and setting up payroll and recordkeeping systems to increase deferral rates every year. Timing can be complicated – does the plan call for auto-escalation on the anniversary of the employee’s date of hire, or on a specific date for all employees every year? Doing the escalation on a date of hire basis can mean 365 potential auto-increase amounts to keep track of. The plan sponsor’s contribution to the plan for participants’ “missed deferral opportunity” when an error is made may be exponentially higher than it would be without auto-escalation.

Re-Enrollment As research has shown, almost 50 percent of participants feel overwhelmed by information they receive during education meetings.12 One-on-one meetings are more effective, but become increasingly expensive and unworkable in larger firms.

To address this issue, most 401(k) plans offer “asset allocation funds, such as Target Date and Balanced Funds, explained in the ERISA Plan Investment Management Module. Many plans make asset allocation funds their default investment alternative for participants who don’t select their own investments. With these automatic, professionally managed investments, participants have an “automatic” investment choice that works to provide meaningful participant outcomes. Even more importantly, these alternatives follow the proven behavioral finance method of “make it automatic, make it easy.”

With the advent of new investments, the concept of “re-enrollment” is gaining ground. Re-enrollment notifies participants that they will automatically be reinvested in the plan’s asset allocation funds in a specified period of time (typically 60 to 90 days) and allows them to opt out of this re-enrollment and continue with their current investments, or select new investments. The goal is to improve outcomes by automatically investing participants in asset allocation funds appropriate for their age and their retirement goals.

It’s important to emphasize to participants that they are not required to re-enroll, and that by taking no action, they are choosing the default investment alternative. This process is not unlike the health care enrollment process that takes place, except that the default for inaction is not last year’s choice, but instead, professionally managed asset allocation funds selected and monitored by plan fiduciaries and their hired expert service providers.

12 Fidelity Investments. ‘Do-It-Yourself’ Investors are Not Doing Themselves a Favor: Investing Retirement Savings Continues to Challenge Most Workers,” Points of View Benefits and Policy Insights (2013).


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As with any plan decision, fiduciaries should be prudent in their decision to use reenrollment.

Step 1

The first step is to request reports from the plan’s service providers showing how participants are currently invested. In many instances, these reports may show participants who have not made investment selections appropriate to their age. These reports should show:

1. Percentage of employees invested 100 percent in equities; 2. Percentage of employees invested 100 percent in fixed income investments; 3. Percentage invested in funds that are not age-appropriate; 4. Percentage of employees invested in the asset-allocation default alternative

Step 2

The second step is for fiduciaries and their service providers to review their plan documents and summary plan descriptions (SPDs) to make sure that re-enrollment would be allowed under the current document and that there are no limitations on automatically investing participants in the default asset allocation fund. Plan documents or SPDs that say only participants can make investment decisions or changes would have to be amended to allow for automatic investing through reenrollment.

Step 3

Once the decision has been made to go forward with re-enrollment, the third step is to clearly communicate to participants that their 401(k) investments will be changing unless they take action. It is a best practice to send two or three notices to participants at reasonable intervals before the re-investment takes place. Participants should also be informed that they can change their automatic investment at any time, and advisors should be prepared to work with participants who may want education on other investment choices.

Re-enrollment Pros and Cons Fiduciaries do not have a duty to perform re-enrollment. On the other hand, reenrollment can result in improved participant outcomes, which benefits participants and is therefore consistent with fiduciary responsibility under the ERISA exclusive purpose rule.

Advisors working with fiduciaries should explain the pros and cons of reenrollment:

PROS:

• Improved participant outcomes through professionally managed investing. Reenrollment can result in more than 50 percent of participants invested in age appropriate asset-allocation funds.

• Opt out works better than opt-in as proven by behavioral finance research. The re-enrollment approach takes advantage of participant inertia to improve outcomes.


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• Re-enrollment can “reset” investments for participants who have been in the plan for a number of years and have never changed their investment allocation. It can also encourage those who have not yet joined the plan to do so. When paired with auto-enrollment, the plan could potentially increase participation to over 90 percent at the same time that those new and existing participants are put into professionally managed retirement investments.

• Participant outcomes are improved, even when re-enrollment is not paired with auto-enrollment. Therefore, companies that are concerned about using autoenrollment due to the cost of the increased match can benefit from reenrollment without increasing the matching contribution.

CONS:

• Paternalism is a concern cited by many fiduciaries. Many employers feel that 401(k) plans offer choice, and participants should be able to take advantage of that choice. “Forcing” them to defer or invest in a default alternative takes away that choice in these employers’ view. Advisors can remind fiduciaries that participants still have choice in auto-enrollment and re-enrollment strategies; they can opt out or change their deferrals and investments at any time.

• Costs should be carefully monitored by fiduciaries when undertaking reenrollment. Recordkeepers should disclose to fiduciaries what the expenses are for the process, and fiduciaries should document their decision to pay more fees to gain the benefit of better participant outcomes. Re-enrollment is often done in conjunction with a conversion to a new recordkeeper so costs can be shared across the entire conversion process.

• Alternative investments, such as stable value funds, GICs, self-directed brokerage accounts (SDBA) and company stock make re-enrollment more complicated. An option is to exclude company stock from the re-enrollment process so participants are not forced to sell stock to re-invest in the default alternative. SDBAs are typically excluded from re-enrollment as well. Stable value funds and other fixed investments may have a cost when they are sold, called a “market value adjustment” (MVA) which can reduce participants’ account values. An option for these investments is to not include them in the initial re-enrollment until the market value is positive, or when the investment has been held by the plan long enough to not be subject to an MVA.

Measure Plan Effectiveness and Participant Outcomes As part of their prudent process, fiduciaries can measure success of their plan in terms of participant outcomes by using reporting and gap analysis tools. Advisors can assist fiduciaries by providing these tools to the committee and to the participants.

At the plan level, fiduciaries can receive reports and work with their advisor to measure:

• Participation rates; • Deferral rates; • Retirement readiness.


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Retirement readiness can be measured using “gap analysis,” which is a tool that calculates the participant’s deferral rate, projected investment return, and current account balance, and projects these amounts to retirement age. The tool can show if the participant will have enough to retire based on their current compensation, and how much of that pay (70 percent to 100 percent) they may need in retirement.

Fiduciaries should be cautioned that these tools are an approximation of retirement needs, which can vary widely from participant to participant. There are also many gap analysis tools in the marketplace. Advisors can help fiduciaries evaluate gap analysis tools. Advisors can also assist sponsors to customize their reporting and their gap analysis tools based on their employee demographics.

Participant gap analysis tools also vary widely, and may not take into account outside assets, IRAs, and lower (or higher) spending post-retirement. However, participants who take advantage of gap analysis tools can get an approximate idea if they are on track for retirement, and seek out the plan advisor to help them increase savings or change their investments to reach their retirement goals.

Example The fiduciaries in Case Study Three are concerned about participant outcomes, not only because they have a larger plan, but also because they previously had a defined benefit plan that provided guaranteed benefits at retirement. They have asked you to help them create similar retirement outcomes for participants in the 401(k) plan. You can explain that gap analysis tools can help identify participants’ retirement needs and if they are on track for retirement. You can also explain that automatic enrollment designs can help with participant retirement readiness, but you make sure that you have worked with the service providers to calculate the potential increase in matching contributions to address budget concerns.


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Advisor Takeaway

Advisors can assist plan fiduciaries in meeting the retirement goals of their participants by discussing plan designs based on behavioral finance. Behavioral finance research shows that participants are better off with “opt out” features rather than “opt-in” features. As a result, automatic enrollment and re-enrollment in the plan’s QDIA can produce better participant outcomes than just participant education in a traditional 401(k) plan. Advisors can assist fiduciaries in measuring participant outcomes by working with service providers to produce reports showing deferral rates, investment choices and gap analysis results. Creating retirement readiness for participants is a key goal for a qualified retirement plan.


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Unit 5: Service Provider Selection Case Studies Case Study One: Sole Proprietor start-up IT company with one owner and two employees who want to start a new plan. The company doesn’t have a lot of cash flow yet, but they are growing fast and will have more money in the future. The plan sponsor has a brother who is a third-party plan administrator (TPA) and he wants to hire him.

Case Study Two: A professional firm (partnership) has three partners/owners and 25 employees. They have a stable cash flow and have a 401(k) plan. The plan sponsors said they already know they would like to hire one of the sponsors’ spouse’s company as a recordkeeper.

Case Study Three: A manufacturer previously sponsored, but now has terminated, a defined benefit pension plan. They currently sponsor a 1,500-participant 401(k) plan, and the key executives have a top-hat non-qualified plan. The 401(k) plan was designed for middle management and rank and file employees who work in multiple locations nationwide.

Guiding Questions

• How do you explain your plan management services as an advisor to the plan sponsor? • What service providers can be hired to perform each role? • What can be a prudent process for selecting service providers?

Introduction The first step when talking to plan sponsors about service providers is for you to remind them that one of their duties is to seek expert assistance with the plan.

Remember that plan fiduciaries have three core ingredients to a prudent process:

• The duty to investigate; • The duty to maintain records; and • The duty to obtain expert assistance where necessary.

A necessary consequence of administering a plan is to have a number of ministerial functions. Service providers, including the plan’s advisor, are experts who can work with fiduciaries to help operate the plan on behalf of the participants and beneficiaries. Service providers can be hired to perform activities in a fiduciary or in a non-fiduciary capacity.

Service providers responsible for carrying out the administrative ministerial functions are not fiduciaries as long as they do not exercise any authority or control over the plan. The plan sponsor and/or the named fiduciary retain fiduciary liability.


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Non-Fiduciary Service Providers Non-fiduciary service providers typically include plan advisors, recordkeepers, custodians, third-party plan administrators (TPAs), ERISA attorneys, and accountants. Who plan fiduciaries will hire as non-fiduciary services providers will vary based on business characteristics, as well as plan design.

Therefore, it is important for advisors to understand the needs of the plan, as well as the role of each service provider, to assist the plan fiduciaries in selecting service providers that address the needs of the plan.

Retirement Plan Advisors Retirement plan advisors operate as the “hub” of the retirement plan wheel. They can be fiduciary or non-fiduciary service providers. When working in a non-fiduciary capacity, they assist in educating fiduciaries, work with retirement plan committees, and coordinate the various plan service providers, especially recordkeepers and TPAs.

As with all plan (fiduciary and non-fiduciary) service providers, they are subject to fiduciary prudent selection and oversight, and if their fees or commissions are paid by the plan, fiduciaries must also evaluate the reasonableness of their fees.

The size of the plan, the financial sophistication of the Plan Sponsor, the nature of the plan’s assets and the complexities of the plan’s investment policy will often dictate if the Plan Administrator might engage fiduciary advisors and other fiduciary investment consultants.

Recordkeeping and Plan Administration It is important to distinguish between plan administrative services and recordkeeping services. Retirement plan administration includes compliance, reporting, and disclosure and any other ministerial administrative functions delegated to the contract administrator by the Plan Administrator. In general, the recordkeeper keeps track of activity within the participant accounts.

Although many firms (including large national recordkeepers) offer both administrative and recordkeeping services, there are administrative firms, typically called third party administrators (TPAs), who only do administration, and recordkeepers, typically insurance companies and mutual fund firms, who perform recordkeeping services. There are also independent recordkeepers, both nationally and regionally, who offer both recordkeeping and TPA services without being part of an insurer or a mutual fund company. Lastly, many recordkeepers can perform both administrative and recordkeeping functions, or just do recordkeeping. These arrangements are described later in this unit.

Plan administration functions include:

• Determining eligibility • Performing nondiscrimination testing • Performing top-heavy testing required under IRC §416


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• Monitoring limits such as the compensation limit, deferral limit, deduction limit, annual additions and catch-up contribution limit

• Calculating and allocating employer contributions, including safe harbor contributions • Reviewing operational practices for compliance with the plan document and all regulations • Preparing required participant notices and disclosures (with the exception of those provided by

the recordkeeper) • Preparing governmental forms such as the Form 5500 series reports • Responding to client calls and handling special situations that are raised by the plan sponsor • Managing the process associated with participant withdrawals and distributions, including

vesting, QDROs, loan and withdrawal eligibility.

Recordkeeper functions include:

• Money in (contributions, loan repayments, transfers or rollovers) • Money out (transfers, distributions, loans or other withdrawals) • Balancing fund positions according to participant elections • Updating systems with daily investment pricing • Providing participants with account access • Reporting to both participants and plan sponsors, including required items such as fee

disclosures, QDIA

Plan Administrator Vs. Third-Party Administrator (TPA)

The terms Plan Administrator and third party administrator (TPA) are often confused. The Plan Administrator is the named person (or persons or entity) who has fiduciary responsibility under the plan. TPAs are hired, usually by the Plan Administrator, to provide only ministerial services to the plan. A TPA is generally not a fiduciary.

Independent CPA (Accountants) A Plan Administrator may employ an accountant to provide audited or unaudited financial statements and payroll information. Accountants may also assist in the confirmation of the plan sponsor’s taxpayer status, identification of owners and officers of the business, and serve as an additional source of information regarding affiliated companies under common control.

Plans with more than 100 participants generally must attach an independent qualified public accountant’s report to the Form 5500 expressing the accountant’s opinion of the audit results. The independent CPA who audits the plan is separate from the accountant who works with the plan sponsor.


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Actuaries Some administrative service providers employ or retain enrolled actuaries to perform required calculations and certify the various reports associated with defined benefit plans. For example, actuaries determine the minimum, maximum, and required contributions for a defined benefit plan and certify those calculations by signing the necessary Schedules of the plan’s Form 5500 filing.

Additionally, where a defined benefit plan is covered under the termination insurance program of the Pension Benefit Guaranty Corporation, an actuary signs and certifies the premium calculations. An actuary may also be engaged to represent the plan during an IRS or DOL audit.

ERISA Attorneys Depending on the nature of the engagement with the client, the responsibilities of the sponsor’s attorney may extend from providing an interpretation of the retirement plan provisions to creating the legal plan documents, summary plan descriptions and other employee disclosures and forms. Attorneys also may be involved in preparing the forms required when requesting an IRS review of the plan for qualification purposes and be designated as the plan sponsor’s representative.

Additionally, the client’s attorney is typically consulted during plan level changes, such as a plan termination or plan merger, or sponsor level changes, such as a change in ownership or tax structure. An attorney may also be engaged to represent the plan during an IRS or DOL audit.

Bundled vs. Unbundled Arrangements When selecting a service provider, a Plan Sponsor typically has to decide whether to use a bundled or unbundled service arrangement. And, as a retirement plan advisor, plan sponsors will ask you for information regarding the advantages and disadvantages of each type of arrangement. Let’s start with the definition of each of these terms.

Bundled Arrangement A bundled arrangement is when a single vendor provides “one stop shopping” for all services needed by a plan. This may include investment, recordkeeping, administration, and education services. The provider’s platform may include nonproprietary funds in addition to its own funds. The individual cost for each service is typically not broken down, but instead, presented as a single fee.

In general, there are two types of bundled arrangements:

• Plan fiduciaries can work directly with the bundled service provider without an advisor or a TPA. In this case, the bundled provider may fulfill all three roles, but many of these arrangements are selected by large participant-driven plan fiduciaries who work with consultants.

• The consultants typically work with the fiduciaries in either a fiduciary or nonfiduciary capacity.


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The other alternative is for the plan fiduciaries to work with an advisor and use bundled recordkeeping and TPA services.

Unbundled Arrangement In an unbundled arrangement, the plan sponsor hires different providers to perform plan services. This type of arrangement permits a plan sponsor to pick and choose from among different providers in each service area. It is typically comprised of a TPA, a recordkeeper and an advisor who assists the plan sponsor and coordinates the service providers. The unbundled approach can be used by both small and large plans, but it can mean more coordination work for the advisor and the HR staff of the plan sponsor. In larger participant-driven plans, it is common for consultants to be hired to help assemble the team of providers.

Bundled Providers Unbundled Arrangements

• Provide efficient contribution and distribution processes; Have advanced technological resources and system integration; Have one-stop shopping for investments, administration, and compliance for plan sponsor and participants.

• Allow fiduciaries to mix and match providers according to their plan’s needs;

• Permit a specific single provider to be removed and replaced without having to disrupt all facets of plan;

• Can involve an independent TPA firm to provide customized plan

Advisor Takeaway Given the complexity of the roles of plan service providers who have to be prudently hired and monitored by plan fiduciaries, the retirement plan advisor is critical in assisting the fiduciaries with “who’s who” of plan services.

For example, the start-up firm in Case Study One may want to compare an unbundled arrangement with a local TPA and a recordkeeper-only service with a bundled provider who would provide both services. Many start-up firms prefer the hands-on service of a local TPA, and the advisor can assist in finding an unbundled recordkeeper who will work with start-up plans.

If the fiduciaries of the larger participant-driven plan in Case Study Three are working directly with a bundled provider, they may be looking for an experienced advisor or investment consultant to assist specifically with retirement plan committee support or with plan investment review.


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ERISA Prudent Selection and Monitoring Hiring a service provider in and of itself is a fiduciary function. Basic fiduciary duty under ERISA §404(a) tells us that plan fiduciaries must select and monitor service providers in accordance with the ERISA’s prudent man standard of care.

Unfortunately, there is little formal guidance as to what constitutes a prudent search or monitoring process. One of the challenges for advisors is, therefore, to understand what guidance does exist, and then consider industry best practices and expert insight to develop a process. The DOL provides informal guidance on selecting and monitoring service providers on their website.

Hiring a Service Provider When considering prospective service providers, advisors can assist plan sponsors in identifying potential service providers and providing each of them with complete and identical information about the plan and what services the plan is looking for. Only by providing complete and identical information will fiduciaries be able to make a meaningful comparison between potential service providers and guarantee a prudent process is being followed.

For a service contract or arrangement to be reasonable, service providers must provide certain information to the fiduciaries about the services they will provide to the plan and all of the compensation they will receive. This information will assist the fiduciaries in understanding the services, assessing the reasonableness of the compensation (direct and indirect), and determining any conflicts of interest that may impact the service provider’s performance.

Some items fiduciaries need to consider when selecting a service provider include:

• Information about the firm itself: financial condition and experience with retirement plans of similar size and complexity;

• Information about the quality of the firm’s services: the identity, experience, and qualifications of professionals who will be handling the plan’s account; any recent litigation or enforcement action that has been taken against the firm; and the firm’s experience or performance record;

• A description of business practices: how plan assets will be invested if the firm will manage plan investments, or how participant investment directions will be handled; and whether the firm has fiduciary liability insurance.

A plan sponsor should document its selection (and monitoring) process. When using a retirement plan committee, such as in participant-driven plans, the advisor can educate committee members on their roles and responsibilities in selecting and monitoring service providers.

http://www.dol.gov/ebsa/publications/401k_employee.html

http://www.dol.gov/ebsa/publications/401k_employee.html


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Documenting the Prudent Hiring Process: Request for Proposal It is a best practice to use a written Request for Proposal (RFP) that is sent out to possible service providers to assist the plan sponsor in making a prudent service provider selection. The retirement plan advisor can assist the fiduciaries in creating the RFP, compiling a list of potential service providers to send the RFP to and managing RFP distribution.

The RFP process will likely differ between owner- and participant-driven plans.

Smaller owner-driven plans can use a simpler and shorter RFP, but they should still consider several service providers as part of their prudent process. Larger, participant-driven plans should use a more detailed RFP with established, clearly outlined criteria. In both cases, the RFP should include all relevant assumptions and provide the same assumptions to all potential service providers. To leave out an important assumption or vary the details can invalidate a prudent comparison of providers and could lead to a conflict of interest in the selection process.

The RFP typically includes a request for the following information:

• Clear statement of expectations: what will the vendor be expected to do and what will be the standards for performance?

• Description of the vendor’s organization • Descriptions of all vendor services and capabilities that apply or may apply to the specific plan

and its participants • Experience with plans of similar size and complexity • Information that provides insight into the vendor’s quality of service and client satisfaction • Information on fidelity bond and fiduciary insurance if applicable • Verification of current licensing where licenses are required • Copies of all contracts and agreements, including comprehensive fee schedules • Experience and qualifications of professionals who will be servicing the account • Information on any complaints, litigation, or disciplinary or regulatory action against the vendor

or its personnel, past or pending • Information on the firm’s experience and/or performance history

When assisting with an RFP, advisors should contact their financial institution for guidance.

Once the RFP is complete, it should be sent to potential service providers. The decision on whom to send the RFP to is part of the service provider selection and must be based on the needs of the plan and be in the interest of the plan participants and beneficiaries. It is unethical and may cause a conflict of interest to exclude a service provider from the RFP process based on personal relationships.


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Provider Selection Once the RFP is sent out to several service providers, the advisor can assist the plan sponsor or the committee in managing and compiling the responses. It is important to do an “apples to apples” comparison of service providers in terms of services offered and fees charged, which is why a professional retirement plan advisor is an important part of the process.

Although there is not an official prudent process of selecting a provider through an RFP, best practices include:

1. Fiduciaries should review RFP responses and service contracts to determine if service providers can meet the goals and objectives of the plan. The review should include the following:

a. Detailed listing and description of services to be provided b. Detailed listing and description of client responsibilities c. Detailed description of any fees or other compensation, regardless of source, in accordance

with DOL §408(b)(2), including 12b-1 fees and other revenue sharing d. Detailed listing and description of tasks to which the vendor will be a fiduciary, and any limits

of the vendor’s fiduciary responsibility for each task e. Fiduciary indemnification or hold harmless provisions f. Procedures and controls for maintaining asset safety, such as a secure data transmission

procedure g. Procedures and controls for avoiding prohibited transactions, such as verification of

distribution eligibility and monitoring timeliness of contribution deposits h. Description of responsibilities regarding participant notices and disclosures i. Proprietary fund requirements j. Recordkeeping system, “money in” and “money out” capabilities k. Directed or discretionary trustee services l. Participant education and enrollment services m. Support for auto-enrollment and participant outcome analysis n. Online access and services for sponsors and participants o. Unbundled (using a TPA) vs. bundled services

2. Establish reasonableness of fees with respect to the vendor’s compensation and determine that the compensation is reasonable.

3. Evaluate finalists.

In a participant-driven plan, once the fiduciaries have selected the finalists that best meet the plan goals and objectives, finalists generally give a presentation to the retirement plan committee.

In an owner-driven plan, the finalists may or may not give a presentation to the fiduciaries and the advisor. If not, the fiduciaries can meet with the advisor to review the RFP responses.

In both processes, as part of a prudent process, fiduciaries should independently verify information provided before making a final selection:

a. Check references b. Verify registrations and licensing, such as Securities and Exchange Commission


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(SEC) or Financial Industry Regulatory Authority (FINRA) registration

a. Check with available sources, such as SEC, FINRA, and State Departments of Insurance, if there are any complaints or disciplinary actions involving the provider

b. Verify performance data through third party information services where appropriate

Establishing Reasonableness of Fees As we can conclude from the RFP process, fees are just one of several factors fiduciaries need to consider in deciding on service providers and plan investments. When the fees for services are paid out of plan assets, fiduciaries should understand the fees and expenses charged and the services provided.

Reviewing their services and the fees they charge for those services is a critical part of the process. Therefore, advisors and fiduciaries can use the three-part test of the reasonableness of expenses, as summarized by the “Three C’s” - Cost, Compensation, and Conflicts:13

1. The total expenses must be reasonable (Cost). 2. That portion of the total expense paid to each service provider must be reasonable

(Compensation). 3. That portion of the total expense paid to fiduciaries must be paid in a way that does not

violate the conflict of interest rules (Conflicts).

In comparing estimates from prospective service providers, fiduciaries with the assistance of advisors, should ask which services are covered for the estimated fees and which are not. It is important to keep in mind that bundled service providers might present a number of services for one fee, while unbundled provider may charge separately for individual services Fiduciaries should compare all services to be provided with the total cost for each provider and consider whether the estimated cost includes services the plan fiduciary did not specify or want.

Some service providers may receive additional fees from investment vehicles, such as mutual funds, that may be offered under an employer’s plan. For example, mutual funds often charge fees to pay brokers and other salespersons for promoting the fund and providing other services. There also may be sales and other related charges for investments offered by a service provider. The information provided by service providers should include a description of all compensation related to the services to be provided that the service providers expect to receive directly from the plan as well as the compensation they expect to receive from other sources.

13 Swisher, Pete. 401(k) Fiduciary Governance: An Advisor’s Guide. Arlington: American Society for Pension Professionals and Actuaries, 2012. Print.


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Monitoring a Service Provider After careful evaluation during the initial selection, the fees paid to service providers should be monitored to determine whether they continue to be reasonable. The Plan Sponsor and/or the Retirement Plan Committee should establish and follow a formal review process at reasonable intervals to decide if they want to continue using the current service providers or look for replacements. When monitoring service providers, actions to ensure they are performing the agreed-upon services include:

• Evaluating any notices received from the service provider about possible changes to their compensation and the other information they provided when hired (or when the contract or arrangement was renewed)

• Reviewing the service providers’ performance based on the plan checklist and written expectations established for the selected provider

• Independently verify information provided by vendors • Reviewing reports provided • Verifying all fees charged, including revenue sharing and ERISA budget account amounts • Asking about policies and practices (such as trading, investment turnover, and proxy voting) • Following up on participant complaints

Documentation Fiduciaries can demonstrate that they followed a prudent process by retaining the documents and records of conversations and meetings when selecting and monitoring service providers.

The fiduciary file should contain the RFP (or prudent process worksheet for a smaller owner-driven plan), all vendor responses including those not selected as finalists, finalists’ presentations and committee or owner records of how they selected the final service providers, including the retirement plan advisor.

Periodic retirement plan committee (typically quarterly) or sponsor (usually annually) meeting minutes should reflect reviews of all service providers and decisions to make any changes to service providers if they are not following the fiduciary requirements for the plan.


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Advisor Takeaway The sponsor in Case Study One can use a retirement plan advisor to assist with service provider selection, especially because they are a starting a plan for the first time. The advisor should review the ERISA prudency rules and work with the sponsor to create an RFP. Because the plan is small and new, the RFP can be customized to focus on the sponsor’s objectives. The advisor can assist in the selection process by suggesting service providers who have experience with start-up plans and explaining the pros and cons of bundled and unbundled arrangements.

The fiduciaries in Case Studies Two and Three have existing plans, so the first step for the retirement plan advisor is to ask how the current service providers were prudently selected, and how they are being reviewed. Advisors can also ask fiduciaries if they have documented the selection and monitoring of their current service providers. If the fiduciaries are considering replacing service providers, or changing bundled or unbundled arrangements, the advisor and fiduciaries should discuss the RFP process and what should be included in the RFP.

The advisor can assist the fiduciaries in sending out the RFP and gathering the responses, as well as assisting in the finalist presentation process. In Case Study Three, the advisor may also be working with a consultant, who takes on some of the tasks in the service provider selection process. As in Case Study One, the fiduciaries in Case Studies two and Three should have used a prudent process to select the advisor and have documentation of the advisor selection process assisting in the finalist presentation process.

chapter 2 erisa plan management (part 1) unit 1: plan

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