Don’t Leave Them Stranded
Highly compensated employees (HCEs) saving for retirement face both the Internal Revenue Service (IRS) limits on their individual contributions and the limits effectively imposed on them by their plan’s need to pass nondiscrimination testing.
“It makes it difficult for employees with high earnings to achieve what they want to achieve [with their retirement savings],” says Chad Johansen, director of sales at Plan Design Consultants Inc., a third-party administrator (TPA) in San Mateo, California.
If a plan has trouble passing testing, that typically means it fails every year, says John Dulay, a financial adviser at True North Retirement Partners of Raymond James & Associates in Chicago. “Then you consistently have to refund highly compensated employees some of their contribution money,” he says. “That forces them to include this distribution with their next tax filing, and you are decreasing the amount they’re able to put aside for retirement savings.” This puts highly compensated employees at a disadvantage, because they need to save considerably more for retirement than rank-and-file employees, Dulay says.
This is why sponsors need help on how to maximize HCEs’ opportunity to save for retirement, while also ensuring their plan can pass nondiscrimination testing. “Unless an employer has the right plan design, it will be forced to tell these high earners, ‘As much as you want to save for retirement, you are going to be limited in your ability to do that,’” Johansen says.
In making 401(k) plan design decisions, an employer has to balance HCEs’ desire to maximize retirement savings with the need to give rank-and-file employees a fair savings opportunity. “You can’t disadvantage an employee so that you can get a better plan [for an executive],” says adviser Stephen Davis, CEO of Safe Harbor Asset Management in Huntington, New York.
Sources talked about several options for maximizing HCE savings:
• A safe harbor 401(k) plan. As a basic step, sponsors usually elect to create a safe harbor plan. That eliminates the need for the retirement plan to pass the two strictest nondiscrimination tests. “They essentially are buying their way out of the average deferral percentage (ADP) testing and the top-heavy testing, which, in the small-plan market, is where plans often can fail,” says adviser Christopher Compton, principal at Compton Financial Group in Towson, Maryland. In small plans, he says, “We often see a pretty significant income discrepancy between the highly compensated employees and the non-highly compensated employees” that makes passing testing challenging.
Becoming a safe harbor plan allows HCEs to reach the IRS individual maximum annual contribution limit—$18,000, plus $6,000 in catch-up contributions for people ages 50 and older—“that they otherwise might not be able to make,” Compton says. “It’s not that it increases the maximum they may contribute: It allows them to reach the limit,” he says. “If the question is, ‘How do we drive contributions to highly compensated executives?’ without a safe harbor, we find it an almost insurmountable challenge.”
Employers have three options to qualify for the safe harbor, says adviser Bill Heestand, president of Heestand Co. in Portland, Oregon. They can make a 4% safe harbor match for participants, a 3% nonelective contribution to all eligible employees, even if they themselves make no contributions, or a 3.5% qualified automatic contribution arrangement (QACA) match done in tandem with automatic enrollment.
Making those safe harbor contributions can cost employers substantial money. “A 3% nonelective contribution to everybody is probably the most expensive,” Heestand says. “A QACA match is probably the second most expensive.”
Still, Johansen says, many business owners find it worthwhile, both for maximizing their own retirement savings and the tax deductions for their business. “They are looking for the greatest tax efficiency and the most effective contribution strategy,” he says. “The end result is, you have to give dollars to somebody—either the IRS or your employees.”
A cross-tested profit-sharing addition. Employers that want to go a step beyond having a safe harbor 401(k) plan often add a specific profit-sharing element. Known as a “new comparability” plan or “cross-tested” plan, this plan design also helps boost HCEs’ retirement savings. “It works extremely well when a company has an older demographic of highly compensated employees,” Compton says of qualifying as a cross-tested plan.
Johansen cites an example that illustrates how the cross-testing for this plan design focuses on the comparable present value of the employer contribution made to employees of different ages. “If you give a 25-year-old a $1 contribution and you give a 55-year-old highly compensated employee a $1 contribution, the 25-year-old’s dollar is worth more, because it has more time to grow,” he says. “Therefore, you can tier the benefits more toward the highly compensated employees, who tend to be older,” and give a larger contribution to older employees.
With a profit-sharing element in a plan’s design, employees still face the $18,000—$24,000 for those ages 50 and older—individual contribution limit, Dulay says. But the combined employer/employee contribution limit—$53,000 for participants younger than 50 and $59,000 for those 50 and older—gives an employer the opportunity to make profit-sharing contributions that close the gap toward those limits.
“If an employee had a 4% match and made the maximum match up to the $265,000 IRS compensation limit, that’s $10,600 in employer match money and $18,000 an employee [i.e., one under age 50] is deferring. You’ve got room as an employer to put in more money, up to $53,000. That’s where the profit sharing can be used, to fill up that bucket.”
There is really no downside for employers “because they don’t have to make a contribution if there are no profits,” Davis says.
• A cash balance plan. Kevin Donovan, managing member of Pinnacle Plan Design LLC in Tucson, Arizona, works with many high-earning owners of closely held businesses. They are increasingly combining a 401(k) plan with a profit-sharing and a cash-balance plan. “Some business owners say, ‘We want to maximize what we can contribute, but we want to have only one plan,’” he says. “If you have one plan, you can’t maximize the contribution. When we look at the scenarios for closely held businesses, the combination plan is really the ‘soup du jour.’”
Cash-balance plans can help highly compensated employees considerably. A sponsor has more flexibility to select which employees get employer contributions, Johansen says. “A cash-balance plan gives an employer the opportunity to reward HCEs at a higher level than in a 401(k) or profit-sharing plan,” he says. “In a cash-balance plan, you have to cover only 40% of the staff, so you can strategically pick what groups of employees have contributions made to their accounts.”
Normally, in the combination plans, the top company executives get the vast majority of employer contributions going into the cash-balance plan, Donovan says. “If it is just a 401(k) profit-sharing plan, the highly compensated employees can get only a total of $53,000 or $59,000 [from the employer and employee] contributed to their account each year, depending on their age. Adding a cash-balance plan allows them to get above those numbers,” he says. “A 50-year-old can get as much as $140,000 yearly that the employer contributes on behalf of the employee into the cash-balance plan.”
However, employers considering cash balance plans do need to think carefully about the realities that accompany adding a defined benefit (DB) element to their retirement plan offering, sources say. “Once you’ve adopted the defined benefit plan, you have to keep funding it, year after year,” Heestand says. “The company has to be in a good cash-flow and profit position, so that future market shocks aren’t really influential in whether the employer can continue funding the defined benefit liability.” The sponsor also bears the investment risk for the defined benefit part of the plan.
• A nonqualified plan. Some employers decide to take the additional step of offering a nonqualified deferred compensation (NQDC) plan, which allows an employer to define the eligible participants as it wishes. “You no longer have to offer it to everybody, as you do with a qualified plan,” Johansen says.
For highly compensated employees given the chance to participate, NQDC plans offer the option to defer substantially more compensation for their retirement savings and not pay taxes on that money until subsequently withdrawing it. The IRS does not restrict how much money a nonqualified plan participant may set aside, but some plans have a contribution limit.
Employers have considerable flexibility on nonqualified plans’ design, Dulay says. “Nonqualified plans, because they are not subject to the Employee Retirement Income Security Act [ERISA], may be designed in thousands of different ways,” he says. “It depends on the goals of the company. If the company has the goal of creating a ‘golden handcuff’ or an extra incentive for highly compensated employees, a nonqualified plan will work well.” For example, an employer may make a large nonelective contribution on behalf of some executives and stipulate a vesting schedule that gives them an extra incentive to remain at the company.
And while these plans are not formally funded, which would make them subject to ERISA, some employers choose to put aside funds for their nonqualified plan.
On the downside, the employer’s tax deductions work differently for a nonqualified plan, Johansen says. “It is unlike a 401(k) or profit-sharing plan, where the employer funds it and the business gets a deduction each year,” he says. “In the nonqualified world, when an employer funds those dollars, it goes on the company’s balance sheet, and the deduction comes only when an employee takes the money. That’s when the company can take it off the balance sheet.”
For many of Donovan’s business-owner clients, that delay in getting the business tax deduction takes away most of the appeal of a nonqualified plan. “In the large-company arena, they are not as concerned about their [businesses’] taxes as they are about providing this benefit to key employees,” he says. “In the closely held business arena, if they are not getting a deduction, there is almost no point.”
And for HCEs, nonqualified plans can benefit their retirement savings but also come with a risk, Heestand says. If the employer subsequently declares bankruptcy, nonqualified plan participants may not get any of the assets they have accumulated in that plan. “They don’t get paid out for the nonqualified plan, because it’s a general asset of the company and the money is not protected from creditors,” he says.
“There’s risk to employees,” says Dulay. “They have to understand that and be comfortable with that.”