If your 401(k) plan is failing the Actual Deferral Percentage (ADP) test, then it’s time to consider some plan design changes. You need to figure out a way to encourage non-highly compensated employees (NHCEs) to save more retirement money in their 401(k) accounts while keeping benefit costs under control. This post will guide plan sponsors through some strategic (yet straightforward) benefit changes that can improve your plan’s chances of passing the ADP test next year.
1. Add a 401(k) match. If your plan doesn’t already have a 401(k) match, adding one will encourage employees to at least defer a minimal amount into their 401(k) accounts. More NHCE deferrals = better ADP test results.
2. Enhance the current 401(k) match. If your plan already has a match but it isn’t getting NHCEs to defer, then there are a couple of options:
– Increase the match: Maybe that 1% match just isn’t worth it for some folks. A 3% match is about average, and any increase can be factored-in when considering an employee’s total compensation package.
– “Extend” the match: The goal here is to increase the amount of compensation eligible for a match while not increasing employer costs. For example, if you currently match 50% of the first 6% deferred then consider amending the plan to match 40% on the first 7½% deferred. Both formulas have a potential match of 3% of compensation, but the latter encourages employees to save at a higher rate in order to earn the full match.
3. Add an automatic enrollment feature. An Eligible Automatic Contribution Arrangement (EACA) is a feature where new participants are automatically enrolled in the 401(k) plan at a uniform deferral rate, unless they elect to opt out. If your 401(k) plan is suffering the ADP failure blues because few new hires are deferring, then this is a great way to increase your ADP rate and encourage employees to save for retirement. There’s also the Qualified Automatic Contribution Arrangement (QACA) option, which is a safe harbor plan combined with an automatic enrollment feature.
4. Add a “safe harbor” plan design. If you adopt one of these IRS-prescribed benefit formulas, then you get a “free pass” on ADP testing. Safe harbor benefits are 100% vested immediately and you must provide notice of the safe harbor status to participants at least 30 days prior to the start of the plan year. The minimum safe harbor benefit formulas are:
– At least a 3% automatic (i.e., non-matching) employer contribution to each participant’s 401(k) account; or
– An employer match of at least 100% on the first 3% deferral plus a match of at least 50% on the next 2% deferral (i.e., a potential match of 4% of pay).
If you have a cross-tested profit-sharing plan or cash balance plan, then the 3% non-elective option is often the best choice since those benefits count towards the non-discrimination tests whereas the matching formula does not.
Each of the options above has variations and can be combined with the others. Combined with a thorough campaign to educate participants about the changes, they’ll improve your chances of passing the ADP tests next year and avoid having to refund HCE deferrals as taxable income.