Firms Should Examine Their 401(k) Plans for Savings

Most law firms, like other companies, offer 401(k) plans to their workers. And many firms, like other companies, are looking to reduce their costs. One way of saving cash is to make changes to the 401(k) plan ' but making changes requires advance planning and advance time is running short for firms with 2010 calendar year plans.

This article focuses on the firm's 401(k) plan. However, many law firms cannot look at the 401(k) plan in the abstract. Many firms have different retirement arrangements for staff, associates, and partners and can only pass the law's complicated nondiscrimination rules because of the interaction of these arrangements. This interaction can limit a firm's options, but do not necessarily eliminate them.

Basic 401(k) Plan Rules

At its core, the 401(k) plan is a way for employers to allow employees to save for their retirement and take advantage of available tax benefits in doing so. In traditional plans, the employee gets to save on a pre-tax basis, only paying tax years later when the savings and earnings that accumulated tax free are distributed. In “Roth” 401(k) plans, the employee saves on an after-tax basis, but earnings accumulate tax free, and there is no tax when the money is distributed years later.

The amount that the employee may save each year varies with an inflation index, but was $16,500 for calendar 2009. (The calendar 2010 number will be announced this month, after press time.) An employee who is at least age 50 may defer into his or her 401(k) plan an additional $5,500 per year. These deferrals are in lieu of the employee's salary and are not new outlays for the firm.

There is no requirement that the employer contribute anything to the 401(k) plan. However, many employers do contribute in order for the plan to pass the nondiscrimination tests (highly compensated employees ' “HCEs,” vs. nonhighly compensated employees ' “NHCEs”) and/or because the employees' contributions are rarely enough to provide for an adequate retirement.

The basic nondiscrimination test ' the average deferral percentage (“ADP”) test ' measures the average deferral as a percentage of compensation of the HCEs vs. that of the NHCEs. If the HCE ADP does not exceed the NHCE ADP by more than a specified amount, the plan is nondiscriminatory. Because HCEs generally are financially able to defer more than NHCEs, employers take various steps such as matching contributions or automatic enrollment to encourage NHCEs to defer greater amounts and/or make additional employer contributions (which get counted towards passing the nondiscrimination tests). Matching contributions and nonelective contributions generally require the employer to make a cash contribution.

Safe Harbors

If a plan initially fails the ADP test for a year, the employer may make additional contributions to the NHCEs or it may return some of the HCEs' deferrals so that the ADP numerical tests are satisfied. Besides the fact that this is an administrative headache, most firms do not, for obvious reasons, want to be in a position of limiting or returning HCEs' deferrals.

The law provides an easy (but costly) solution in the form of two alternative safe harbors. If the employer makes the safe harbor contributions, the ADP test is automatically satisfied.

Under the “matching safe harbor,” the employer must make a “matching” contribution to each NHCE's deferral. The matching contribution must be at least equal to 100% of the NHCE's deferrals up to 3% of the employee's compensation and 50% of the deferral between 3% and 5% compensation.

For example, assume Employee A has compensation of $50,000 for the year and defers $5,000 (or 10% of compensation). The employer match is determined as follows: 1) 3% x $50,000 is $1,500 + 2) 2% x $50,000 is $1,000 and 50% of $1,000 is $500. Thus, the employer matching contribution for Employee A is $2,000 ($1,500 + $500).

Under the “nonelective contribution safe harbor,” the employer's contribution is not dependent on whether the employee makes a deferral. The safe harbor requires the employer to make a contribution to each NHCE equal to at least 3% of the employee's compensation.

Assume you have two employees with compensation of $50,000. Employee A defers $5,000; Employee B defers $0. The employer would have to make the same contribution of $1,500 to Employee A and to Employee B. The employer's contribution would only depend on compensation, not on deferral.

Both safe harbors only require employer contributions for NHCEs. However, employers may make the same contribution (or less) for HCEs.

Automatic Enrollment

“Inertia” is a well-studied phenomenon. If an action is required, many people are not likely to take it. Translated to the 401(k) world, this means that a deferral is more likely if the plan has a set deferral percentage and the employee has to take action not to have the employer automatically defer some of the employee's compensation than if the employee has to take action to ask the employer to defer the compensation. The idea is to make elective deferrals an “option out” rather than an “option in.”

If employers can keep NHCEs from opting out of deferring part of their compensation, the plan is more likely to pass the ADP test. This is because the ADP is an average of all the NHCE's individual percentages including 0% for all those who do not defer anything.

If, even with automatic enrollment, the HCE percentage is too much higher than the NHCE percentage, the plan will have to resort to additional matching or nonelective contributions to pass ADP. But if automatic enrollment results in sufficient NHCE deferrals than the employer may find it does not need to offer matching contributions or make nonelective contributions.

For those employers that do not want to test for ADP, there is a special safe harbor that they can use. This automatic enrollment safe harbor is the same as the general safe harbor with respect to nonelective contributions. However, the matching contribution safe harbor is slightly cheaper than the general matching safe harbor in that it is 100% of the first 1% of compensation and 50% of the next 5% of compensation ' for a total of match of 3.5% of compensation rather than the general safe harbor required match of 4% of compensation. Use of the safe harbor also allows the plan to delay vesting in employer contributions for two years.

Cash-Saving Opportunities

Eliminate All Employer Contributions

Obviously, eliminating all employer contributions will save the firm cash. This approach will require the plan to pass the ADP test each year. A couple of approaches separate or together can make passing the ADP test easier:

• Adopt automatic enrollment. Studies have shown that 90% of employees will defer in such situations even without the encouragement of a match.
• Cap or eliminate the deferrals allowed for HCEs. The ADP test is based on the relationship between the percentage for NHCEs and the percentage for HCEs. If the percentage for HCEs is low, it is much easier for the plan to pass the ADP test.

The biggest downside of this approach is its impact on the long-term adequacy of retirement income. However, many employers took this step during 2009 (i.e., “froze” their contributions in order to save cash). They must now consider whether to continue the “freeze” in 2010.

Switch from a Nonelective Contribution Safe Harbor to a Matching Contribution
Safe Harbor

The nonelective contribution safe harbor is generally more expensive than the matching contribution safe harbor, especially in tough economic times. The employer must make a fixed 3% of compensation contribution under the nonelective contribution safe harbor regardless of employee action. In the case of the matching contribution safe harbor, the total contribution is only 4% of compensation (100% of 3% + 50% of 2%) in the worst case and then only to employees who actually make a deferral. A firm could achieve further savings if it limits any safe harbor contributions only to NHCEs.

However, the employer can lose much of these savings if the employer chooses to use automatic enrollment. Even though the matching safe harbor contribution is slightly smaller with automatic enrollment (3.5% of compensation as compared to 4% of compensation), a lot more NHCEs will be receiving it because of the higher number of NHCEs deferring because of the power of inertia.

Cut Back to the Minimum Safe Harbors

Some employers in the interest of providing adequate retirement income provide more generous matching contributions or nonelective employer contributions than is required to meet the safe harbors. Employers can save money by moving to the minimum required amounts.

Look at the Relationship Between the 401(K) Plan and Your Other Plans

Many law firms have structured very complex benefit programs to maximize the amount that partners can defer and minimize the amount that the firm needs contribute for others. Other firms have used generous 401(k) plans as part of a generous salary package for attracting young lawyers. With the economics of the law profession changing rapidly, it may be the time to invest in a more comprehensive review of the firm's retirement plans. Despite the up front costs of reconsidering the package, redesign could recover that cost quite rapidly.

Timing

The time to take these steps is now ' before notices need to be provided for 2010 and before employees make elections. For those with safe harbor plans, IRS regulations have always allowed the employer to switch from a matching safe harbor to ADP testing in the middle of the year; however, the pre-switch match still needs to be made.

In the case of the nonelective contribution safe harbor, employers up until recently could only switch mid-year to ADP testing if they had issued a “contingent” notice prior to the start of the year. The notice had to warn that the employer reserved the right to switch. The Treasury has proposed regulations that allow plans to switch out of the nonelective contribution safe harbor mid-year if the employer can show substantial business hardship. IRS has allowed plans to follow (rely on) the proposed regulations in 2009 even though the regulations are not final. Most of the employer comments on the proposed regulations have strongly urged Treasury to eliminate the business hardship test in the final regulation. Firms need not worry about that, however, if those that intend to use the nonelective contribution option issue the notice on a “contingent” basis. A “contingent” notice maximizes the firm's flexibility as it sees what happens in 2010.

An employer must generally provide the safe harbor notices at least 30 days and no more than 90 days prior to the start of the plan year. For calendar year plans, time is short to make money saving changes for 2010.

Stuart A. Sirkin is a member of Ernst & Young LLP's Performance and Reward Group in Washington, D.C. Prior to joining Ernst & Young, he held senior positions in the pension agencies at IRS, the Dept. of Labor, and the PBGC, and was on the staff of the Senate Finance Committee. He is a charter member of the American College of Employee Benefits Counsel and Co-Chair of the Defined Benefits Subcommittee of the Employee Benefits Committee of the ABA's Tax Section. The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young LLP

Most law firms, like other companies, offer 401(k) plans to their workers. And many firms, like other companies, are looking to reduce their costs. One way of saving cash is to make changes to the 401(k) plan ' but making changes requires advance planning and advance time is running short for firms with 2010 calendar year plans.

This article focuses on the firm's 401(k) plan. However, many law firms cannot look at the 401(k) plan in the abstract. Many firms have different retirement arrangements for staff, associates, and partners and can only pass the law's complicated nondiscrimination rules because of the interaction of these arrangements. This interaction can limit a firm's options, but do not necessarily eliminate them.

Basic 401(k) Plan Rules

At its core, the 401(k) plan is a way for employers to allow employees to save for their retirement and take advantage of available tax benefits in doing so. In traditional plans, the employee gets to save on a pre-tax basis, only paying tax years later when the savings and earnings that accumulated tax free are distributed. In “Roth” 401(k) plans, the employee saves on an after-tax basis, but earnings accumulate tax free, and there is no tax when the money is distributed years later.

The amount that the employee may save each year varies with an inflation index, but was $16,500 for calendar 2009. (The calendar 2010 number will be announced this month, after press time.) An employee who is at least age 50 may defer into his or her 401(k) plan an additional $5,500 per year. These deferrals are in lieu of the employee's salary and are not new outlays for the firm.

There is no requirement that the employer contribute anything to the 401(k) plan. However, many employers do contribute in order for the plan to pass the nondiscrimination tests (highly compensated employees ' “HCEs,” vs. nonhighly compensated employees ' “NHCEs”) and/or because the employees' contributions are rarely enough to provide for an adequate retirement.

The basic nondiscrimination test ' the average deferral percentage (“ADP”) test ' measures the average deferral as a percentage of compensation of the HCEs vs. that of the NHCEs. If the HCE ADP does not exceed the NHCE ADP by more than a specified amount, the plan is nondiscriminatory. Because HCEs generally are financially able to defer more than NHCEs, employers take various steps such as matching contributions or automatic enrollment to encourage NHCEs to defer greater amounts and/or make additional employer contributions (which get counted towards passing the nondiscrimination tests). Matching contributions and nonelective contributions generally require the employer to make a cash contribution.

Safe Harbors

If a plan initially fails the ADP test for a year, the employer may make additional contributions to the NHCEs or it may return some of the HCEs' deferrals so that the ADP numerical tests are satisfied. Besides the fact that this is an administrative headache, most firms do not, for obvious reasons, want to be in a position of limiting or returning HCEs' deferrals.

The law provides an easy (but costly) solution in the form of two alternative safe harbors. If the employer makes the safe harbor contributions, the ADP test is automatically satisfied.

Under the “matching safe harbor,” the employer must make a “matching” contribution to each NHCE's deferral. The matching contribution must be at least equal to 100% of the NHCE's deferrals up to 3% of the employee's compensation and 50% of the deferral between 3% and 5% compensation.

For example, assume Employee A has compensation of $50,000 for the year and defers $5,000 (or 10% of compensation). The employer match is determined as follows: 1) 3% x $50,000 is $1,500 + 2) 2% x $50,000 is $1,000 and 50% of $1,000 is $500. Thus, the employer matching contribution for Employee A is $2,000 ($1,500 + $500).

Under the “nonelective contribution safe harbor,” the employer's contribution is not dependent on whether the employee makes a deferral. The safe harbor requires the employer to make a contribution to each NHCE equal to at least 3% of the employee's compensation.

Assume you have two employees with compensation of $50,000. Employee A defers $5,000; Employee B defers $0. The employer would have to make the same contribution of $1,500 to Employee A and to Employee B. The employer's contribution would only depend on compensation, not on deferral.

Both safe harbors only require employer contributions for NHCEs. However, employers may make the same contribution (or less) for HCEs.

Automatic Enrollment

“Inertia” is a well-studied phenomenon. If an action is required, many people are not likely to take it. Translated to the 401(k) world, this means that a deferral is more likely if the plan has a set deferral percentage and the employee has to take action not to have the employer automatically defer some of the employee's compensation than if the employee has to take action to ask the employer to defer the compensation. The idea is to make elective deferrals an “option out” rather than an “option in.”

If employers can keep NHCEs from opting out of deferring part of their compensation, the plan is more likely to pass the ADP test. This is because the ADP is an average of all the NHCE's individual percentages including 0% for all those who do not defer anything.

If, even with automatic enrollment, the HCE percentage is too much higher than the NHCE percentage, the plan will have to resort to additional matching or nonelective contributions to pass ADP. But if automatic enrollment results in sufficient NHCE deferrals than the employer may find it does not need to offer matching contributions or make nonelective contributions.

For those employers that do not want to test for ADP, there is a special safe harbor that they can use. This automatic enrollment safe harbor is the same as the general safe harbor with respect to nonelective contributions. However, the matching contribution safe harbor is slightly cheaper than the general matching safe harbor in that it is 100% of the first 1% of compensation and 50% of the next 5% of compensation ' for a total of match of 3.5% of compensation rather than the general safe harbor required match of 4% of compensation. Use of the safe harbor also allows the plan to delay vesting in employer contributions for two years.

Cash-Saving Opportunities

Eliminate All Employer Contributions

Obviously, eliminating all employer contributions will save the firm cash. This approach will require the plan to pass the ADP test each year. A couple of approaches separate or together can make passing the ADP test easier:

• Adopt automatic enrollment. Studies have shown that 90% of employees will defer in such situations even without the encouragement of a match.
• Cap or eliminate the deferrals allowed for HCEs. The ADP test is based on the relationship between the percentage for NHCEs and the percentage for HCEs. If the percentage for HCEs is low, it is much easier for the plan to pass the ADP test.

The biggest downside of this approach is its impact on the long-term adequacy of retirement income. However, many employers took this step during 2009 (i.e., “froze” their contributions in order to save cash). They must now consider whether to continue the “freeze” in 2010.

Switch from a Nonelective Contribution Safe Harbor to a Matching Contribution
Safe Harbor

The nonelective contribution safe harbor is generally more expensive than the matching contribution safe harbor, especially in tough economic times. The employer must make a fixed 3% of compensation contribution under the nonelective contribution safe harbor regardless of employee action. In the case of the matching contribution safe harbor, the total contribution is only 4% of compensation (100% of 3% + 50% of 2%) in the worst case and then only to employees who actually make a deferral. A firm could achieve further savings if it limits any safe harbor contributions only to NHCEs.

However, the employer can lose much of these savings if the employer chooses to use automatic enrollment. Even though the matching safe harbor contribution is slightly smaller with automatic enrollment (3.5% of compensation as compared to 4% of compensation), a lot more NHCEs will be receiving it because of the higher number of NHCEs deferring because of the power of inertia.

Cut Back to the Minimum Safe Harbors

Some employers in the interest of providing adequate retirement income provide more generous matching contributions or nonelective employer contributions than is required to meet the safe harbors. Employers can save money by moving to the minimum required amounts.

Look at the Relationship Between the 401(K) Plan and Your Other Plans

Many law firms have structured very complex benefit programs to maximize the amount that partners can defer and minimize the amount that the firm needs contribute for others. Other firms have used generous 401(k) plans as part of a generous salary package for attracting young lawyers. With the economics of the law profession changing rapidly, it may be the time to invest in a more comprehensive review of the firm's retirement plans. Despite the up front costs of reconsidering the package, redesign could recover that cost quite rapidly.

Timing

The time to take these steps is now ' before notices need to be provided for 2010 and before employees make elections. For those with safe harbor plans, IRS regulations have always allowed the employer to switch from a matching safe harbor to ADP testing in the middle of the year; however, the pre-switch match still needs to be made.

In the case of the nonelective contribution safe harbor, employers up until recently could only switch mid-year to ADP testing if they had issued a “contingent” notice prior to the start of the year. The notice had to warn that the employer reserved the right to switch. The Treasury has proposed regulations that allow plans to switch out of the nonelective contribution safe harbor mid-year if the employer can show substantial business hardship. IRS has allowed plans to follow (rely on) the proposed regulations in 2009 even though the regulations are not final. Most of the employer comments on the proposed regulations have strongly urged Treasury to eliminate the business hardship test in the final regulation. Firms need not worry about that, however, if those that intend to use the nonelective contribution option issue the notice on a “contingent” basis. A “contingent” notice maximizes the firm's flexibility as it sees what happens in 2010.

An employer must generally provide the safe harbor notices at least 30 days and no more than 90 days prior to the start of the plan year. For calendar year plans, time is short to make money saving changes for 2010.

Stuart A. Sirkin is a member of Ernst & Young LLP's Performance and Reward Group in Washington, D.C. Prior to joining Ernst & Young, he held senior positions in the pension agencies at IRS, the Dept. of Labor, and the PBGC, and was on the staff of the Senate Finance Committee. He is a charter member of the American College of Employee Benefits Counsel and Co-Chair of the Defined Benefits Subcommittee of the Employee Benefits Committee of the ABA's Tax Section. The views expressed herein are those of the author and do not necessarily reflect the views of Ernst & Young LLP