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A Slice of Savings

Jason Stephens, CIMA®
Director | CAPTRUST Nonqualified Executive Benefits

Highly Compensated Employees (HCEs) participating in a 401(k) retirement plan are restricted in the amount of contributions that they can defer on a pre-tax basis due to Internal Revenue Service limits. The maximum annual compensation limit for 2012, as defined by Internal Revenue Code (IRC) §401(a)(17) is set at $250,000. IRC §402(g) limits elective deferrals to $17,000 or less, while IRC §415(c)(1)(A) limits total contributions to a maximum of $50,000. Testing Limits established under the IRC, such as the Average Deferral Percentage Test (ADP) and the Average Contribution Percentage Test (ACP) can further limit contributions. While Plan Sponsors have some recourse in helping HCEs meet their full savings potential within a 401(k) plan, it can often be more advantageous to offer benefits for these individuals outside of the qualified plan setting. One plan design alternative that holds particular appeal given its ability to help Plan Sponsors proactively address their benefit programs’ effectiveness is commonly referred to as a “410(b) carve-out strategy.”

This concept takes its name from IRC §410(b) which conveys minimum coverage requirements for qualified retirement plans. Testing under 410(b) generally compares the percentage of non-HCEs benefiting from a 401(k) plan relative to the percentage of HCEs under what is known as the ratio percentage test. Plans that fail to exceed 70% under the ratio percentage test can turn to the average benefits percentage test and compare the average benefits to be received by the non-HCE group relative to the HCE group. Failure to meet the guidelines under either of these tests can result in the need for additional employer contributions into the plan or potentially loss of favorable tax treatment. Plans that pass minimum coverage testing must also satisfy nondiscrimination testing, or ADP and ACP tests. Employers who face restrictions here often exhibit similar demographic traits in their non-HCE group such as high turnover rates, large groups of hourly employees, or a relatively low wage base. Many of these companies take a paternalistic view of their benefits strategy and attempt to boost participation among non-HCEs as a means to ease limitations for the HCEs. Primary methods for accomplishing this can include conducting educational sessions or adding auto enrollment and/or auto escalation features. Based on the Plan Sponsor Council of America’s 54th Annual Survey of Profit Sharing and 401(k) Plans, these efforts have shown mixed success, as the data indicated that non-HCE deferral rates in 2010 averaged just 5.3%, which is similar to where those rates were in 20001. A growing number of Plan Sponsors have also turned to safe harbor programs which require a mandatory level of employer contributions in exchange for an exemption from ADP and ACP testing. For many companies, undertaking one or more of these initiatives can be costly, especially considering the biggest benefits are often derived by the most transient part of the workforce who have not displayed long-term loyalty.

As an alternative approach, under a 410(b) carve-out strategy, Plan Sponsors can elect to classify HCEs as ineligible from participating in the qualified plan by amending the plan document. This restriction would ensure that minimum coverage and nondiscrimination testing requirements are met. With no HCEs benefitting under the qualified plan, it is also permissible to exclude or make other classes of employees ineligible from participation. As an example, excluding hourly employees or another targeted group that has traditionally not contributed could reduce plan cost and complexity. HCE benefits could be restored through a new or existing nonqualified deferred compensation plan where deferral amounts, matching, profit sharing or other company contributions would avoid the aforementioned restrictions.

In conclusion, we welcome exploratory conversations surrounding the 410(b) carve-out approach with Plan Sponsors who desire more control over the direction of their benefit dollars or are concerned that their qualified plan is not meeting the needs of a large segment of their employee population.

1 Plan Sponsor Council of America. “54th Annual Survey of Profit Sharing and 401(k) Plans”