Protecting the health of retirement plans during the COVID-19 crisis, Part I: Reducing or eliminating employer contributions
The COVID-19 crisis is creating major upheavals both in terms of people’s health and their retirement benefits. Employers and their employees are struggling to handle the stock market’s drastic downturn, the challenges of working remotely, the negative impact of declining business or total shutdown, and the isolation of sheltering in place.
Unfortunately, the coronavirus is also having a direct or indirect impact on an employer’s retirement plans. In part one of this three part alert, we will address how an employer can stop or reduce its contributions to its retirement plans. The second part will explore how employees may gain access to their retirement assets to handle the current financial struggles, and the third part will examine how to address the effects of layoffs, Family First Coronavirus Response Act (FFCRA) payments and the stock market decline.
Part I – Reducing or eliminating an employer contribution
Due to declining business, or in fact the temporary cessation of all operations, many employers are looking for ways to control expenses. To that end, employers are looking more closely at reducing or eliminating contributions to their retirement plans. Reducing or eliminating an employer contribution can be done; however, it needs to be done correctly and with an understanding of the consequences of such reduction or elimination. Furthermore, special rules apply if the employer is a party to a collective bargaining agreement.
The correct approach
401(k) Plans Matching Contributions
Many employers have already implemented or are planning to reduce or eliminate the matching contribution they have been making on employee salary deferral contributions to their 401(k) plans. If the 401(k) plan is drafted such that the matching contribution is discretionary, both in terms of the amount the employer will contribute and whether the employer will make a contribution, then no amendment is needed to the 401(k) plan document. If the employer has previously announced that it will be making a contribution, or historically the employer has been making such contributions, the employer should announce in advance that it will be reducing or eliminating the match. Employees should also be given the opportunity to change their salary deferral contributions.
If the matching contribution is not discretionary, then the 401(k) plan document needs to be amended to permit a reduction or elimination of the match. Such amendment will only have prospective impact. Rather than eliminating the ability to make a matching contribution, it is preferable to amend the plan document to make the match discretionary in order to provide the employer with the greatest flexibility with respect to matching contributions going forward.
It is important that employees should be given advance notice and the opportunity to change their salary deferral contributions. Please note that the document should be reviewed to be sure employees can change the salary deferral elections.
Safe Harbor 401(k) Plans
Many employers utilize a 401(k) plan design, which includes what is commonly referred to as a “Safe Harbor” contribution. A Safe Harbor contribution permits the plan to automatically pass the specialized non-discrimination testing required of 401(k) plans. There are two types of Safe Harbor contributions. The elimination or reduction of either of these contributions must be done in strict accord with the IRS rules. Because Safe Harbor contributions are mandatory, any changes to a Safe Harbor contribution require a plan amendment.
Safe Harbor Match
The first type of Safe Harbor contribution is the Safe Harbor match. To be a Safe Harbor match, each participant who makes a contribution to the plan must be matched dollar for dollar for the first 3% of compensation the participant defers and 50 cents on the dollar for the next 2% deferred. The match must be 100% vested
Safe Harbor Non-Elective Contributions
The other type of Safe Harbor contribution is the 3% non-elective contribution. Under this contribution, the employer would make a 3% of compensation contribution to all participants in the plan regardless of whether they made a salary deferral contribution The non-elective contribution must also be 100% vested.
Under the IRS regulations, an employer is permitted to reduce or eliminate a Safe Harbor Match or a Safe Harbor Non-elective Contribution only if it has included in its annual notice a statement that the plan might be amended to reduce or suspend such contributions or (if there is no statement to that effect) the employer is operating at an economic loss as described in Code Section 412(c)(2)(A). Under Code Section 412(c)(2)(A) and employer satisfies that requirement if:
- The employer is operating at an economic loss
- There is substantial unemployment or underemployment in the trade or business and in the industry concerned
- The sales and profits of the industry concerned are depressed or declining
- It is reasonable to expect that the 401(k) plan will be continued only if the amendment reducing or eliminating the Safe Harbor contribution is made.
The employer must provide participants with 30 days advance notice of the elimination of the Safe Harbor Contribution as well as an updated Safe Harbor Notice. The notice must explain:
- The consequences of the amendment, which reduces or suspends the future Safe Harbor contributions
- The procedures for changing salary reduction contributions
- The effective date of the amendment
In addition to the notice, participants must be given a reasonable opportunity to change their salary deferral contributions.
Pro-Rata Compensation Limit
Retirement plans are required to limit the amount of compensation they take into consideration for purposes of allocation contributions. For 2020, the limit is $285,000. The IRS has indicated that for purposes of calculating and allocating Safe Harbor matching contributions or Safe Harbor non-elective contributions, the $285,000 limit must be pro-rated if the 401(k) plan is amended to eliminate or reduce the Safe Harbor contribution. For example, if the 401(k) plan is amended to eliminate the Safe Harbor contribution six months into the plan year, the limit would be $142,500 (i.e., June 12 of $285,000).
Special 401(k) Testing
Section 401(k) plans are subject to special testing with respect to the salary reduction contributions and a separate test with respect to the matching contributions. Salary reduction contributions are subject to what is referred to as the actual deferral percentage test (ADP Test), which measures the average salary reduction contribution measured as a percentage of compensation of highly compensated employees (HCEs) against the average salary reduction contribution of nonhighly compensated employees (NHCEs).
Matching contributions in the 401(k) plans are subject to what is called the actual contribution percentage test (ACP Test), which measures the average matching contributions made for HCEs against the average matching contributions made for NHCEs.
Basically, an HCE is any employee who during the current year or the preceding year was a 5% owner of the employer; or who during the preceding year had compensation from the employer in excess of $130,000 (in 2020 as indexed) (and, if the employer has elected, who was in the top 20% of employees ranked on the basis of compensation). A NHCE is any employee who is not a HCE.
For purposes of testing, the salary reduction contribution of NHCEs can be measured on the current plan year (Current Year Testing) or on the prior plan year (Prior Year testing). The deferrals of the HCEs are always measured on the current year. The advantage of prior year testing is that the employer knows what the ADP or ACP of the NHCEs is and can restrict or cut back the contributions made by HCEs to pass the tests.
The use of the Safe Harbor match permits an employer to automatically pass the ADP and ACP Tests. The use of the Safe Harbor non-elective contributions permits an employer to automatically pass the ADP Test.
When an employer reduces or eliminates the Safe Harbor match or Safe Harbor non-elective contributions it must also amend its plan to utilize current year testing for ADP and ACP testing. Even if the change was made mid-year, the testing must be done for the entire plan year. Simplistically, there is no automatic pass for the portion of the year the employer made Safe Harbor contributions. The employer must, however, still make the Safe Harbor contributions for the period of the plan year prior to the reduction or elimination.
Profit sharing and money purchase pension plans
Employers who wish to eliminate profit sharing contributions can do so relatively easily. Typically, profit sharing contributions are discretionary and, therefore, the employer can decide whether to make such a contribution or not. If the profit sharing contribution for some reason is not discretionary, then the plan will need to be amended to make the contribution discretionary. If it is not discretionary, the contribution for the time prior to the amendment will need to be made in accordance with the plan provision in place prior to such amendment.
Money purchase pension plans are fairly rare these days. A contribution under a money purchase pension plan is mandatory. Therefore, if an employer wishes to reduce or eliminate the employer contribution to a money purchase pension plan, it must amend the plan. The employer must give advance notice to participants by issuing what is called a Section 204(h) Notice. This notice must be provided at least 15 days in advance if the plan is reasonably expected to cover fewer than 100 participants on the date the amendment is effective and at least 45 days in advance for all other plans.
There is some uncertainty whether a termination of the employer contribution to a money purchase pension plan results in all participants becoming 100% vested in their accounts. The safe course is to vest all participants.
Employers need to consider the impact that reducing or eliminating contributions will have on the morale of their employees. If done on a temporary basis, and if properly communicated, we have found that most employees understand and agree with the reasons for the reductions. In other words, a temporary reduction in plan contributions is usually perceived as a more tolerable alternative then a reduction in salaries or the elimination of employees. However, it is important to provide a clear and credible explanation as to what the changes are and why they are being made. In addition, if the reductions are permanent, or continue indefinitely, such changes are likely to impact job satisfaction, retirement readiness and employee morale.
The consequence of reducing or eliminating an employer Safe Harbor match or a Safe Harbor non-elective contribution is that the employer’s 401(k) plan may not pass the ADP or ACP testing. The result is that the employer may need to make additional contributions or distribute some or all of the HCE’s salary reduction contributions and matching contributions.
Top heavy testing
For smaller plans, the issue of being top-heavy is a potential problem. A plan is “top-heavy” for a particular plan fiscal year if more than 60% of the benefits in the plan are attributable to “key employees.” In very simple terms, a “key employee” is an employee who in the current plan year is:
- A 5% owner of the employer
- An officer of the employer having annual compensation in excess of $185,000 (for 2020)
- A 1% owner of the employer with compensation in excess of $150,000
If a plan is top-heavy, a minimum contribution must be made to all non-key employees who are participants on the last day of the plan year if a contribution is made to any key employees. A key employee’s own salary reduction contribution is treated as a contribution requiring a top-heavy minimum contribution.
The minimum contribution is equal to the lesser of 3% of compensation or the highest percentage of compensation contribution made on behalf of any key employee.
Safe Harbor plans which only made the Safe Harbor match or Safe Harbor non-elective contributions (and no other true employer contributions) are deemed to satisfy this top-heavy minimum contribution. Once the Safe Harbor contributions are eliminated, the employer will still need to satisfy the top-heavy minimum contribution requirement if the plan is top-heavy and if a contribution is made on behalf of a key employee (this includes the key employee’s own salary reduction contributions).
For an employer seeking to cut expenses, the mandatory top-heavy minimum contribution may be an unwelcome surprise.
Plans Covering Union Employees
Of course, any changes to a matching contribution, or any employer contribution which is made on behalf of employees who are covered by a collective bargaining agreement, must be negotiated with the union bargaining for those employees. The employer may not unilaterally make revisions to retirement plans covered by collective bargaining agreements without risking the filing of a grievance or unfair labor practice charge.
If an employer chooses to reduce or eliminate its contributions to the company’s retirement plans, the rules must be followed and the consequences of the revisions should be thoroughly understood.
For more information, please contact the attorneys listed below.