Custom retirement plan design may be right for your firm

By Joné E. Luizza, ERPA, QPA, QKA and David J. Kupstas, FSA, EA, MSPA

Imagine buying a car. There are so many types to choose from! A family with children might want a minivan or SUV. Someone on a budget may prefer an economy car. Still others might like an exciting sports car.

It is the same with workplace retirement plans. Some businesses will want to keep things simple with a relatively straightforward plan. Other firms may want to increase tax-deductible contributions or have more flexibility in how benefits are allocated among employees. These organizations would need a more advanced plan design.

If you went to an auto dealership that had only one type of car to sell, would you buy from that dealership? Not likely. Yet, all too often we come across businesses whose retirement plan design is one-size-fits-all. It’s not that they actively chose this type of plan. Rather, it’s what their financial professional sold them. Their “retirement plan dealer” had one kind of car on the lot, so that’s what the business got whether it was the right kind of plan for them or not.

Below are a few retirement plan designs that you may not be familiar with but that could be beneficial in helping a business achieve a particular goal.

Say goodbye to failed ADP tests

You likely know about 401(k) plans, under which an employee may make contributions from his or her paycheck called “salary deferrals.” Employers usually contribute to these plans as well in the form of profit sharing or matching contributions. If Highly Compensated Employees (NHCE), the plan will fail what is known as the Actual Deferral Percentage (ADP) test. If this happens, the law requires deferrals to be returned to HCEs or additional employer contributions to be made to NCHCEs.

A failed ADP test can be very frustrating to an HCE. Fortunately, there is a plan design called “safe harbor” that allows an employer to avoid the ADP test. In addition to satisfying certain notice and other requirements, a safe harbor plan must provide employees either of the following contribution types:

• A matching contribution equal to 100 percent of salary deferrals, up to 3 percent of pay plus 50 percent of deferrals between 3 and 5 percent of pay, for a maximum match of 4 percent of pay.
• A nonelective contribution of 3 percent of pay. Nonelective means the employee receives this contribution whether he defers from his own paycheck or not.

If one of these contributions is made, the company’s HCEs are free to defer as much as they want up to the $18,000 limit, unconcerned about whether NHCEs make significant contributions or not. Safe harbor contributions do carry some restrictions in terms of vesting schedule and eligibility conditions, but many employers are willing to make this tradeoff in order to avoid ADP testing.

Even though the 4 percent maximum match percentage is higher than the 3 percent nonelective percentage, the match can sometimes be cheaper if a lot of employees do not defer enough to receive the maximum match. Which safe harbor contribution we recommend depends on the circumstances. While a safe harbor match makes sense in certain situations, we normally recommend a 3 percent nonelective contribution.

More choice in contributions dollar recipients

Besides a match or nonelective contribution, an employer may make a profit-sharing contribution. The business does not need to have made a profit in order for there to be a profit-sharing contribution. If an employer decides to make such a contribution, a plan document will specify how the contribution is to be shared, or allocated, among the plan members. There are four major ways to allocate:

1. Uniform allocation, whereby each member receives the same percentage of pay or the same dollar amount.
2. Integrated, which resembles uniform allocation, except those whose pay exceeds a certain level of receive a slightly greater amount.
3. Age-weighted, under which older employees get larger contributions.
4. Cross-tested, where the employer has discretion in how the contribution is shared.

Reading those four options, you may wonder, “Why would anyone pick anything other than cross-tested?” Well, there is a catch. Unlike the uniform allocation and integrated designs, contributions in a cross-tested plan have to be run through a nondiscrimination test. The HCEs may not benefit to a significantly greater extent than the NHCEs. Also, there may be minimum “gateway” contributions some year – perhaps 4.5 to 5 percent of pay.

Despite these hurdles, the cross-tested design is almost always more favorable for the plan sponsor. If the employer would like to maximize contributions to the owner and minimize contributions to others, the cross-tested plan is the place to do it. If the employer is fine with giving similar levels of contributions to all employees, this, too, can be done in the cross-tested plan. The rules concerning cross-tested plans have become so flexible over the years that they are the first design we look at for any client. If you have a plan and your service provider did not at least consider cross-testing for you, you should ask why.

Table 1 is a simple example comparing a cross-tested plan to an integrated plan – a design commonly “sold” by those who do not specialize in retirement plans. The company has two owners, both older than 50, earning more than the $270,000 annual compensation cap. There are eight employees of varying ages and wage levels. The owners’ goal for themselves is to receive $60,000 in contributions from all sources – deferral, nonelective and profit sharing. In the integrated plan, the employees would need to be given $41,803 from the employer (not including deferrals) for the owners to achieve this goal, while only $16, 481 is needed in the cross-tested plan. That’s a savings of over $25,000!

Since $41,803 would be a big amount for this employer to contribute to NHCEs, the more likely scenario in the integrated plan is that it would scale back contributions both to owners and employees. The owners would be unable to enjoy the full contribution limits allowed under the law. We have had several cases where partners have been able to receive an additional $20,000 or more in contributions by changing to a cross-tested plan without having to raise employee contributions one cent!

Cash balance plans can lead to supersized deductions

For owners that have an appetite for bigger deductible contributions than the 401(k) allows, we recommend adding on a cash balance plan. Details of cash balance plans are beyond the scope of this article. Suffice to say, it is possible for an individual to be allocated an additional $100,000 or even $200,000 per year beyond what the 401(k) offers, depending on age and other factors.

Make sure you know your options

We have just described some of our favorite retirement plan options. There are numerous other plan designs that can help business owners achieve big tax savings, flexible contribution allocations and other favorable outcomes. Don’t settle for a simplified, mediocre plan design. Know your options and choose a plan type that’s right for your business.

Joné Luizza, ERPA, QPA, QKA, is director of Third Party Administration Services for ACG. She handles the team’s activity in serving plan sponsors and coordinating ACG’s client involvement, from plan conversion to the ongoing support of daily plan management.

David J. Kupstas, FSA, EA, MSPA, is ACG’s chief actuary. He possesses an intricate working knowledge of ERISA, as well as Internal Revenue Service (IRS) and Department of Labor (DOL) regulations as they pertain to plan administration and compliance and is a CPE instructor of CPAs.