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Small Businesses Favor Safe Harbor 401(k) Plans

Plan sponsors weigh avoiding annual testing against employer-contribution costs

A sailboat sails across the water at sunset.

Sixty-eight percent of small business 401(k) plans use a safe harbor design to avoid annual compliance testing.

The finding was reported in a 2016 study of 2,767 plans, averaging 25 participants and $947,000 of plan assets, published Nov. 30 by Mobile, Ala.-based Employee Fiduciary, a provider of 401(k) services for small businesses.

The IRS treats safe harbor plans as satisfying annual nondiscrimination rules for deferrals and matching contributions under the actual deferral percentage (ADP) and actual contribution percentage (ACP) tests. They also are not subject to so-called top-heavy rules.

"When 401(k) testing fails, it's usually business owners that bear the brunt of the consequences," along with highly compensated employees, said Eric Droblyen, president and CEO of Employee Fiduciary. "Small businesses tend to fail more because business owners generally have a larger percentage of plan assets. They often receive the largest 401(k) refunds when the ADP/ACP test fails and they must generally make a 3 percent contribution to non-owners when the top-heavy test fails."

He added, "Given these consequences, it's little wonder why business owners find safe harbor 401k plans attractive."

Safe Harbor Options

Safe harbor 401(k) plans, Droblyen explained, typically require an employer to make either an eligible matching or nonelective contribution to participants.

Under a safe harbor matching contribution, two options are available:

  • Basic match. Employer provides 100 percent matching on the first 3 percent of an employee's deferred compensation plus a 50 percent match on deferrals between 3 percent and 5 percent (up to a total of 4 percent of an employee's compensation).

  • Enhanced match. Employer provides an alternative formula that must be at least as much as the basic match at each employee-deferral percentage tier. A common formula is a 100 percent match on the first 4 percent of deferred compensation.

Under a safe harbor nonelective contribution:

  • 3 percent contribution. Employer provides a contribution of at least 3 percent of each plan-eligible employee's salary, even if an employee is not making elective deferrals.

For the above safe harbor matching and nonelective contributions, employees must be 100 percent immediately vested. These contributions can be limited to non-highly compensated employees—those earning less than $120,000 in 2016 and 2017.

The enactment of the Pension Protection Act of 2006 introduced a newer type of safe harbor 401(k) plan, the qualified automatic contribution arrangement (QACA). These plans automatically enroll in the plan any eligible employee who fails to make an affirmative enrollment election at a specified deferral rate. Such plans include the following features:

  • A 100 percent match on the first 1 percent of compensation deferred and a 50 percent match on deferrals between 1 percent and 6 percent (up to 3.5 percent of an employee's compensation).

  • A default-deferral rate that must start at no less than 3 percent of the employee's compensation and increase at least 1 percent annually to no less than 6 percent (with a maximum of 10 percent of compensation).

QACA safe harbor contributions can be subject to up to a two-year cliff vesting schedule, under which the employee has no vested interest in any employer contributions until the employee completes the required years of service.

[SHRM members-only toolkit: Designing and Administering Defined Contribution Retirement Plans]

Profit-Sharing Contributions

The study found that 85 percent of small business plans allow employers to make discretionary profit-sharing contributions, and that profit-sharing contributions are most commonly combined with a 3 percent match-based safe harbor 401(k) plan design.

Regardless of a 401(k) plan's safe harbor status, Droblyen said, profit-sharing contributions must satisfy nondiscrimination testing under tax code Section 401(a)(4) to show that the benefits provided to highly compensated employees are proportional to those provided to non-highly compensated employees.

Other Approaches

Small businesses shouldn't think that their only option for avoiding compliance issues is to roll out a safe harbor plan, said Esther Trapadoux, a content marketer at San Francisco-based retirement plan advisors ForUsAll, which provides plan services for small businesses. The firm has an online Safe Harbor 401(k) Cost Calculator showing how much a safe harbor plan will add to payroll costs.

"The safe harbor plan, for the most part, should really be a last resort since it's expensive for plan sponsors," she said, noting that only about 33 percent of the firm's 200 small business clients currently use a safe harbor approach. By continuously monitoring plans for compliance, plan sponsors and their advisor "can intervene early enough in the year to correct problems so they can avoid having to go the safe harbor route."

For instance, "We had a customer earlier in the year that thought their only option was a safe harbor 401(k) plan—because they kept failing the nondiscrimination test," Trapadoux said. "They were close to shutting down the plan completely since they didn't think they could afford safe harbor contributions." Instead, "They were able to put in place a plan that focused on helping more employees join the 401(k) plan and boost their savings rates."

For plans with more than 20 employees, she added, plan sponsors "should focus on improving plan design and employee engagement first to overcome nondiscrimination test hurdles," using features such as automatic enrollment and an appropriate match formula to drive up participation rates.

Impact of Automatic Features

Last year's Annual Defined Contribution Benchmarking Survey from consultancy Deloitte and the International Foundation of Employee Benefit Plans found that 40 percent of 401(k) plan sponsors have adopted automatic enrollment features to satisfy the QACA safe harbor conditions defined by the Pension Protection Act, and that, overall, 62 percent of plans of all sizes have adopted automatic enrollment.

Beyond safe harbor plans, adoption of automatic features continues to transform defined contribution plans. The Society for Human Resource Management's 2016 Employee Benefits report found that 38 percent of SHRM members' organizations now have automatic contribution for new hires as part of their defined contribution plan, and 21 percent have annual auto enrollment for current employees not participating in their plan. In addition, 19 percent provided annual automatic escalation of participants' salary deferrals.

Bank of America Merrill Lynch's latest semiannual Retirement Plan Wellness Scorecard, released in November, shows that automatic enrollment:

  • Increased participation to 78 percent among employees ages 21 to 27.
  • Increased participation to 88 percent among those ages 28 to 34.

"Having the right plan design features leveraged by engagement practices can shape employees' long-term investment strategies as well as improve participation among younger generations," said John Quinn, head of the firm's institutional product and platform management in New York City.

Similarly, the 2016 Inside America's Savings Plans report, released in November by Ascensus, a 401(k) plan administration firm, found that the average participation rate for 401(k) plans without auto enrollment was 69 percent, rising to 78 percent for plans with auto enrollment and 81 percent for plans with both auto enrollment and auto increase features.

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