A framework for analyzing 401(k) plans with key HCE populations
Highly compensated employees (HCEs)¹ pose a unique challenge for 401(k) plan sponsors. For starters, they need considerable assets to meet their retirement income needs. At the same time, laws and regulations can severely limit what they’re able to save in their workplace plans. Together, the following five questions provide a starting point for diagnosing the opportunities and limitations higher-paid employees face in a 401(k) plan—and, ultimately, for offering a better solution.
401(k) problem-solving starts with insight—and insight calls for great data
As you’ll see, completing the steps in our problem-solving framework calls for a deep look at the status of a plan’s HCEs, the plan at large, and trends among other relevant plans. Where can you get all this information? The plan sponsor, the recordkeeper, your firm, and third-party research providers can all be valuable sources.
As part of your practice, you’ll need to identify which data sources are most useful and responsive. You’ll also need to be able to convert the intelligence you gather into effective analyses and convincing presentations.
1 How retirement ready are the plan’s HCEs?
The most universal measure of participant progress is the projected income replacement ratio at retirement. It’s common practice to use a 70% to 85% replacement ratio in a plan-level analysis.
Whatever ratio you choose as your main target, you must be able to show precisely how well the plan’s HCEs measure up based on their current 401(k) balances and contribution rates.
2 Do the 401(k) HCE limits allow for bigger contributions?
If the target HCE group is falling short of your retirement readiness benchmark, the answer is to help these individuals accumulate more assets.
The next step in your analysis is to look at how much each HCE participant and the plan sponsor are and could be contributing on a tax-advantaged basis.
There are two types of data you’re looking for here:
1 A comparison of the target participants’ employee pretax or Roth 401(k) deferrals and the yearly IRS employee contribution limit, which is $20,500 in 2022 (or $27,000 for participants who are 50 or older)
2 The difference between the total employer contribution for each target participant, including matching, profit-sharing, and other discretionary contributions. For 2022, the maximum contribution limit is $61,000 (or $67,500 for participants who are 50 or older); also, an employer’s maximum deduction is limited to 25% of annual compensation paid to the plan’s eligible employees
If the targeted HCEs are contributing below their personal limits, encouraging higher deferrals with an auto-increase feature or planning advice might make sense after considering the plan’s nondiscrimination testing (described below). And if the door is open for higher employer funding, then higher matching, profit-sharing, or discretionary contributions may also be in order.
3 Should we consider a supplemental plan?
Another route to efficiently boosting HCEs’ retirement assets is to consider adding a plan just for them.
A nonqualified deferred compensation plan (NQDC plan) or a cash balance plan can help key employees boost their retirement assets with no contribution required on their part. Either can be offered in addition to an existing 401(k) plan.
Adding such benefits may not be as straightforward as making an additional 401(k) plan contribution; however, they could be worth considering, especially if HCEs are being limited by IRS caps or if competitors are offering them. Keep in mind that special eligibility rules do apply to NQDC plans.
4 What’s the plan’s testing history and could a different strategy help?
Nondiscrimination testing is a fact of life for 401(k) plan sponsors. Some exploration into the plan’s pass-fail rate and how the results are handled is important when developing a strategy to help HCEs maximize their retirement plan savings.
One important indicator to look for is trouble with either actual deferral percentage (ADP) or actual contribution percentage (ACP) testing results.2
If either test reveals that money going into HCEs’ accounts is proportionately too high compared with non-highly compensated employees (NHCEs), then the plan sponsor must return the excess amounts. This provides a hit to the HCEs’ retirement savings and triggers income-tax liability for the amounts returned.
As an alternative, a plan sponsor who’s failed an ADP or ACP test can remedy it by making a one-time elective or matching contribution to NHCEs’ accounts, but this can get quite expensive depending on the number of participants and how often it occurs.
If the 401(k) plan has nondiscrimination testing issues, there are strategic testing approaches that could create more headroom for HCEs.
- A top-paid group election—A tactic that allows plans sponsors to base their ADP testing on the 401(k) deferrals made by their top 20% of earners, rather than the HCE group defined under ERISA. If used, this rule applies on a controlled group basis and must be included in the plan document
- Cross-testing—For employers who make profit-sharing contributions to participants’ 401(k) accounts, this involves creating groups of HCEs and NHCEs based on employment factors and basing annual profit-sharing allocations on a cumulative projected benefit at retirement age
Approaches like these call for insight and involvement from ERISA experts—an important reason to include them on your 401(k) problem-solving team.
5 If a safe harbor plan is in place, what’s it doing for HCEs?
For plans with a safe harbor design in place, this framework calls for an extra step. You need to determine how much the strategy is helping the targeted group.
A safe harbor 401(k) design gives HCEs the green light to save up to the annual IRS contribution limit—without jeopardizing the plan’s nondiscrimination testing results. Higher-paid employees benefit from the matching contribution and additional nonelective employer contributions mandated for safe harbor plans.
But for all its advantages, a safe harbor design can still leave some HCEs short of their retirement readiness goal, which is why the exploration of alternative testing strategies and supplemental plans is so important to this 401(k) problem-solving framework.
To make a bigger impact, be a trusted solver of 401(k) problems
Financial professionals with the skills and tools to understand and resolve issues with important participant segments can add substantial value to a retirement program and an advisory relationship. Adopting a set of reliable analytical frameworks—including, in this case, one to help increase retirement savings for HCEs—is an important step to becoming a trusted advisor and an in-demand 401(k) problem solver.
1 An HCE is an employee who received $130,000 or more in 2021 (unless the top-paid group election as described below is made) or owned more than 5% of the company at any time during the year or during the preceding year regardless of compensation. 2 These tests generally don’t apply to safe harbor plans.
The content of this document is for general information only and is believed to be accurate and reliable as of the posting date but may be subject to change. It is not intended to provide investment, tax, plan design, or legal advice (unless otherwise indicated). Please consult your own independent advisor as to any investment, tax, or legal statements made herein.