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How safe is that harbor?

Apr 14, 2009

Over the few years heading up to the recession that officially started last year, we saw it in the news on an almost weekly basis – some company was “freezing” its defined benefit plan, whether it was a complete freeze or some sort of softer freeze where either the plan was shut off to new entrants, or accruals of years of service were frozen and benefits only grew with the effect of pay increases. Now, the theme has changed and it’s no longer weekly. Virtually every day, we hear of another company reducing or entirely suspending the company match in its 401(k) plan.

Certainly, this is not illegal. In fact, as companies are working with more limited free cash flow and struggling to meet the expectations of analysts and shareholders, reducing temporarily or permanently the matching contributions is a cost saver. But, some of these same companies have been maintaining so-called safe harbor plans. In those, there is a gotcha. In this short article, we’ll review safe harbor 401(k) plans in general and discuss the problem that occurs when the plan sponsor needs to cut costs in those plans.

Testing

Generally, there are five ways for a 401(k) plan to satisfy requirements that the plan be nondiscriminatory in amount.

Some readers at this point might be wondering what the problem is. Either you have one of these special plan types or you don’t. As you might have guessed, each of these special plan types comes with its own set of requirements that are far more detailed than what we’ve shown above. In particular, the sponsor of one of those plans must notify participants in advance of the safe harbor design. And, that design may not be changed during the plan year in question without forfeiting safe harbor status (thus, ADP and ACP testing will be required).

Examples

Let’s consider a few situations to illustrate the problem. For our first example, suppose a company maintained a safe harbor plan design that included a “dollar-for-dollar” match on the first 5% of pay deferred (and thus satisfies, and in fact exceeds (4) above). The notice provided to employees in late 2008 for the 2009 plan year described the match that way. Part of the way through 2009, the plan sponsor determines that it needs to reduce its benefit costs and changes the design of the 401(k) plan to the minimum allowed in (4) above, thereby reducing its costs by essentially 1% of pay. Since the new design still satisfies the safe harbor requirements, all is well, right? Wrong! The notice for the plan year described the match for the plan year, and the company has changed that match. The requirements to be exempted from nondiscrimination testing are no longer satisfied because the match is different than that described in the notice.

In our second example, the sponsoring company provided a QACA as described in (5) above. Midway through the year, the plan sponsor, in an effort to cut costs, eliminates the matching contributions for all employees. The sponsor assumes that they satisfy the nondiscrimination requirements for the first half of the year because they had the QACA, and that for the second half of the year, they have no ACP test (because there is no match) and their ADP test is satisfied by the QACA deferral arrangement. Are they correct?

No. In fact, they are completely wrong. They have not operated the plan in accordance with their QACA notice or the 401(k) regulations and therefore will be required to perform a single ADP test and a single ACP test for the entire plan year. They are not allowed to treat the two parts of the year separately.

In our final example, our plan sponsor has been making duly elected qualified nonelective contributions (QNECs) of 3% of pay to satisfy the nondiscrimination requirements. Early in the year, the company decides that they cannot afford the 3% of pay contribution. They assume that they can simply stop the contribution and begin doing nondiscrimination testing as of the date that QNECs cease.

They are not correct either. Again, the plan year cannot be split in two. Further, according to informal comments made recently by several government officials, it may be that the only way to cease the QNECs without jeopardizing the plan’s qualification status is to terminate the plan.

Solutions

We wish that there were easy solutions to rectify this apparent problem. However, beyond waiting until the end of the plan year, there do not appear to be any. We bring this to the attention of our readers to alert plan sponsors who do choose to amend their safe harbor plans mid-year realize the testing that they face. For companies that do want to cut costs immediately, one way of doing so which generally will not hurt chances of remaining nondiscriminatory is to suspend matching contributions for HCEs.

Nobody ever said that the privilege of having a safe harbor plan doesn’t come with a price.