posted on:  4/17/2007     revised: 3/9/2010

Today's Wall Street Journal contains a Q&A section on retirement planning that focuses on a 401(k) plan problem. Jim Farrell, an employee of a Philadelphia business writes:

"Can the government prohibit me from making my maximum 401(k) contribution because other employees choose to participate at a much lower rate?

My human-resources manager informed me that our company's 401(k) plan failed what's called the "Actual Deferral Percentage" test. As a result, all of our "highly compensated" employees were permitted to contribute no more than $9,877.51 to the 401(k) plan for 2006. Even though the set maximum contribution is $15,000, we are prohibited by law from exceeding the "non-highly compensated" employees' contribution rate by more than 2%. She explained that this is a government effort to increase 401(k) participation by lower-income employees. Is this true?"

Kelly Green of the Encore/Focus on Retirement weekly feature of the Wall Street Journal responds with an excellent explanation of the problem but skims over the solution:

"Yes, it's true. To ensure that 401(k) plans don't favor higher-paid workers, the federal government limits how much highly compensated employees can contribute relative to workers with smaller paychecks. (For 2006, highly compensated workers are generally defined as those who earned more than $95,000 the previous year or were 5% owners of their company.) The upshot: Highly compensated workers get to take full advantage of their 401(k) plan only if lower-paid workers also have relatively high deferral rates -- the percentage of one's compensation in a 401(k).

For a 401(k) plan to be considered "nondiscriminatory," it has to meet specific requirements each year. Basically, a plan has to compare the actual deferral rate of higher-paid workers with that of lower-paid workers, says Mark Berggren, an attorney with consulting firm Hewitt Associates in Lincolnshire, Ill. There are various limits, spelled out in the Internal Revenue Code, on how much the "actual deferral percentage" of the higher-paid group can outpace that of the lower-paid group.

Employers that run into trouble with the limits are typically those with low participation rates among lower-paid workers, sometimes because of high turnover, Mr. Berggren says. Companies with deferral rates that are out of whack may ask highly compensated workers to trim their 401(k) contributions, remind lower-paid workers about the plan's tax advantages and any company match, or automatically enroll employees in the company's plan. If a 401(k) plan still winds up failing the test, it may have to refund a portion of the higher-paid workers' contributions.

Rather than keeping track of workers' deferral rates, some company plans choose to adopt what are called "safe harbor" provisions, such as matching 4% of workers' contributions or contributing the equivalent of 3% of their pay to their accounts, says Andrew Eschtruth, communications director of the Center for Retirement Research at Boston College. There are other requirements as well, including immediate vesting, he says. Last year's pension law created an additional safe-harbor provision tied to automatic enrollment that plans can adopt starting Jan. 1, 2008.

If your 401(k) contribution limit remains crimped, you may want to consider Roth individual retirement accounts or nondeductible IRAs."

I am often frustrated by financial publications that document the problem with citations and explanations of law but do not tell how to fix the problem. What caught my attention in this article was the lack of completeness and detail on a practical solution to the problem.  Jim who asks the question really does not care about the details of the tax law and his life is no better after the technical details have been explained to him. The proposed solution of considering a Roth of IRA is likely not what he wants to hear. What Jim wants is simply to make his maximum 401(k) plan contribution. There are hints of a solution here but no hard core step-by-step action plan that Jim can take back to his office. 

Here is a step-by-step solution that will likely fix the company's 401(k) plan problem:

1) Start by hiring an independent and experienced retirement plan adviser to review he 401(k) plan. This likely involves just a few hours of professional time with no further commitment. There is a good chance that the problem will become immediately apparent, but you will not hear this from your current 401(k) plan provider. The key, however, is to get a review from someone who does not sell 401(k) plans, otherwise you are really only getting an alternate sales proposal. The review should focus on a) what is the likely underlying cause of low employee participation, b) whether a 401(k) plan is the best choice for this employer, and c) what actions are possible to address this issue. In all likelihood, the problem of low employee participation does not exist within a vacuum of the 401(k) plan itself but may extend to other areas of employee behavior as well. A good business consultant has the experience necessary to sniff out these issues that could have a more far-reaching impact.

2) Make adjustments to the 401(k) plan design provisions as a result of this analysis. These changes are likely to include:

1. redefining the eligibility rules (probably designed to exclude classes of younger or temporary employees who are not interested in saving from the group).

2. include a default enrollment provision

3. change investments to more attractive options

4. add or modify loan provisions to improve ease of use

3) The facts of Jim's question imply that the company is paying too little on matching contributions and paying too much for plan administration. The company and its employees would be better served by changing this pattern so that the employees received a higher percentage of the company's total outlay and the plan administrator receives less. This might mean switching to a safe-harbor plan to lower fees and avoid 'top heavy" limitations as the article suggest and-/or changing 401(k) plan administrator to a lower cost provider. One question I would ask the employer right from the start is why are they not utilizing the safe harbor provisions already? The response would be revealing. Sometime the options (like employer matching formulas) that were  selected when originally setting up a 401(k) plan no longer make sense a few years later when the results become visible. This is especially common in small business 401(k) plans when both the business owner and the sales representative have minimal experience in making these plans work for the long term.

4) Add a viable retirement planning education program for the employees. This would include both mass communications (newsletters, e-mails, on-site seminars, etc.) as well as one-on-one contact between employee and an advisor. It is well established that when employees have access to professional advice, the participation rate in a voluntary contribution 401(k) plan increases. The federal government offers a 50% federal income tax credit for this service, so that the net cost is not as much as most businesses expect.

5) Take a fresh look at the overall design and funding pattern of all of the employer-sponsored employee benefit plans. Many companies find that a move toward a Section 125 flexible benefit cafeteria type design increases employee satisfaction and the employer contributions could be designed to help and encourage employees increase 401(k) plan contributions. In many cases a younger or married employee would rather redirect employer contributions that were previously paid for health benefits to additional 401(k) plan contribution if that option is available. The cafeteria benefit rules allow employees to "pick and choose" without causing discrimination problems as indicated in this 401(k) plan case.

6) Finally, consider the general corporate climate, especially with regard to communications between management and lower-paid employees. It is not uncommon to find that lower levels of 401(k) plan participation are correlated to distrust of employees toward upper management of the expectation of employees that this job is not expected to be a long term employment position. When employees consider the 401(k) plan to be primarily a benefit for the top management, participation rates can be expected to be low. When employee distrust is an issue, using an independent third party financial adviser is the best way to address employee concerns.

Of course, the authority to fix up an inefficient 401(k) plan rests with the management of the employer. There is no requirement for the company to offer a 401(k) plan at all and certainly there is no requirement to address these types of problems when they occur within a 401(k) plan. In rare cases, an employer could have a valid business reason to leave the 401(k) "as is" despite employee complaints. An employee who is an individual plan participant may not make these changes unilaterally.

keywords:   401(k) plan, retirement planning, retirement tax credit, Tax Increase Prevention and Reconciliation Act, Roth IRA

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Copyright 2010 by Tony Novak. Originally produced and published for the "AskTony" column syndication prior to 2007. Edited and independently republished by the author in March 2010. All rights reserved.