The Internal Revenue Service maintains procedures designed to assist plan sponsors in preserving the tax qualified status of their retirement plans. With respect to prototype and volume submitter plans, the IRS procedures require that such plans be restated every six years. Under the current cycle, such plans must be restated no later than April 30, 2016. As a result, the majority of plan sponsors should review their qualified plans within the upcoming months, if they have not already done so, and make decisions regarding plan provisions.
The upcoming April 30, 2016 deadline for the restatement of prototype and volume submitter documents provides not only the occasion for plan sponsors to update their plans in accordance with legal requirements, but also an opportunity to consider possible changes to their plans’ provisions. This article sets forth some considerations for plan sponsors when presented with updated prototype documents by their plan document vendors. These considerations represent common trends and best practices and are not intended to be an exhaustive list of the changes a plan sponsor might consider.
Automatic Enrollment and Escalation
Automatic enrollment is a popular development in the 401(k) industry. Through automatic enrollment, new or current participants may be treated as having enrolled at an established contribution percentage. The participant must be provided a notice describing the terms of the automatic enrollment feature and offered the option to change the automatic percentage or elect no contribution at all. If the automatic enrollment feature is designed to be an “Eligible Automatic Contribution Arrangement”, participants may be offered the option to withdraw the amounts automatically deferred from their pay within the first 90 days after the date of the first contribution. In addition, a plan may include a “Qualified Automatic Contribution Arrangement” or “QACA” and, in so doing, avoid the 401(k) nondiscrimination testing provided certain requirements are met. This form of automatic enrollment requires an initial 3% automatic deferral rate, and automatic escalation of the default rate for each of the following three years.
More recently, plans have trended toward providing automatic escalation regardless of whether the plan is intended to comply with the QACA requirements. Automatic escalation can further serve to assist participants with accumulating retirement savings by “smoothing” the increase over time to a meaningful contribution rate. Regardless of the form of automatic enrollment chosen, automatic enrollment, through the power of inertia, can significantly increase participant retirement savings.
Over the past several years, plan sponsors have generally shortened their plans’ vesting periods. The law permits plans to either provide for a graduated vesting schedule for employer contributions of not more than six years or no vesting for three years, with all employer contributions being vested at the end of the three-year period. One reason plans have trended toward shorter vesting schedules is to offer benefits consistent with competitors and attract talented employees. Another reason is that many plans are “safe-harbor” plans. A safe-harbor plan avoids non-discrimination testing and the potential limitation of the amount that highly compensated employees and owners can contribute provided that the plan meets the safe-harbor employer contribution requirements. Safe-harbor employer contributions must be fully vested.
The trade-off for shorter vesting schedules, or no vesting schedule, is that employers lose the benefit of forfeitures. When a participant who is not fully vested terminates employment, his or her non-vested account balance is credited to a forfeiture account. Forfeiture amounts are generally allocated to the remaining active participants or used to pay plan expenses that would otherwise be paid by the employer or charged directly to participant accounts. Forfeitures are also commonly used to offset the employer’s contribution to the plan. There are limitations on the extent to which an employer can lengthen the vesting schedule with respect to current participants. However, there is no prohibition on changing the vesting schedule for new participants.
How About Safe-Harbor?
Since the last prototype restatement cycle, there have been several significant trends with respect to plan contributions. One major trend is the continued proliferation of safe-harbor 401(k) plans. Safe-harbor 401(k) plans offer employers a free pass on the non-discrimination requirements. In translation, this simply means that business owners and highly-compensated employees can contribute up to the maximum contribution dollar limit ($18,000 for 2015 and $24,000 for participants age 50 or older under a plan’s “catch-up” provision) without the threat of having the amount of contribution limited to a lesser amount or returned to them. The trade-off is that eligible non-highly compensated employees must receive either a fully vested employer contribution of three percent of their compensation or a fully vested matching contribution not less than 100% of the first three percent they contribute plus 50% of the next two percent they contribute. Safe-harbor plans are very popular and any employer that has problems with the non-discrimination tests should very seriously consider a safe-harbor 401(k) design.
Roth Continues to Expand
Roth contributions can be very appealing due to the fact that although employee contributions are made on an after-tax basis, such amounts and the earnings attributable to Roth contributions are not taxed upon distribution. In order for a distribution to be a “qualified Roth distribution,” certain requirements must be met including the requirement that the participant maintain a Roth account for a minimum of five years.
Employers may also include an in-plan Roth rollover or conversion provision. Under such a provision, a participant may elect to convert pre-tax accounts, whether or not currently distributable, to Roth accounts. Of course, the participant is required to recognize income on the converted amount. However, future earnings on the converted amount will be distributed tax-free provided the Roth requirements are met. Through IRS guidance, the conversion rules were expanded to allow the conversion of amounts attributable to pretax contributions to be converted to Roth amounts regardless of whether the participant is eligible to receive a distribution of such amounts.
Plan Governance and Fiduciary Practices
The restatement process is also a good time to review your plan’s governance and fiduciary practices. The Department of Labor (the “DOL”) has significantly increased its plan audit activity in recent years. As part of its review process, the DOL is examining fiduciary committees and asking for copies of committee bylaws and/or charters, meeting minutes, information relating to monitoring plan vendors and evidence of fiduciary training to name a few. The DOL will examine whether plan fiduciaries understand and have reviewed the fees paid by the plan. It is highly recommended that plans of all sizes have a committee in place that meets regularly and conducts itself in a manner that satisfies the high expectations of the DOL.
Reconsider and Confirm or Revise
Plan sponsors have grown accustomed to periodic plan updates and restatement cycles. But too often the restatement process is a rubber-stamp ceremony, with little discussion surrounding the existing plan provisions. During this restatement cycle, plan sponsors should take the time and give thought to their plan’s terms and provisions and discuss optional provisions with their advisors. This is also a good time to review your plan’s governance and fiduciary practices. The restatement process can serve as an opportunity for plan sponsors to reconsider existing plan provisions and operation and implement new features that align with their goals and needs and the goals and needs of their employees.