Defined Contributions Insights MagazineMarch/April 2008
Small Plan Formation
It's Time to Level the Playing Field
by David L. Wray
According to an EBRI study, 30 percent of small employers say they would be much more likely to offer a retirement plan if they were not required to make contributions (EBRI SERS, 2003). This is understandable as many small companies have uncertain cash flows, and a required contribution to a retirement program could jeopardize a company’s survival. Unfortunately, ERISA requires that small companies do just that.
Differences for Small and Large Companies
The rules for employer-sponsored defined contribution plans may look the same for large and small companies, but, in practice, the results are very different. Large companies can exclude from their plans up to 30 percent of their workforce and limit company contributions to those who make voluntary contributions or even make no company contribution at all. In contrast, small companies must contribute 3 percent of pay for every full-time employee over the age of 21 with one year of service.
This outcome stems from the top-heavy rules, one of the many government-imposed limitations and rules designed to ensure that company managers do not disproportionately benefit from 401(k) plan participation. Specifically, the top-heavy rules provide that if 60 percent of a plan’s assets are in the accounts of highly-compensated or key-employee participants (HCEs), then the company must make a 3 percent contribution to all eligible employees. In addition, the top-heavy rules are among the most complex regulations in ERISA. For example, the top-heavy test is more complex than the 401(k) anti-discrimination test. Also, the definition of those considered to be in the top-paid group is broad and includes more employees, which makes the test more onerous.
In practice nearly all companies with fewer than 50 employees will eventually fail the top-heavy test, even if they are not top-heavy initially. For companies with fewer than 25 employees, it is a virtual certainty. This is because small companies are owner-managed, so there is virtually no turnover in the company’s HCEs. In contrast, turnover within the rest of a small company’s workforce is usually very high — typically higher than turnover among similar employees at large companies. Large companies where the ratio of HCEs to non-highly compensated employees (NHCEs) is large are in no danger of failing the top-heavy test and can thus take advantage of all of the plan design flexibilities provided in the rules governing qualified retirement plans.
If a plan is top-heavy and does not comply with the required remedies, there are severe penalties: immediate disqualification of the plan, serious tax fines, and the possibility that the company may be liable for substantial make-up contributions and legal fees. For small businesses, the resources to cover these fines and reparations — especially those with 50 or fewer employees — may put the entire company at risk.
Supporting Data
The following chart (based upon a company with 20 NHCEs and four HCEs) demonstrates how small plans may become top-heavy over a four-year period. The chart assumes that four NHCEs quit and are replaced annually and that there is a one-year eligibility period. The turnover and eligibility assumptions are important because it is turnover among NHCEs that is a major cause of top-heavy test failure.
Top-Heavy Test Progression
First Year Second Year Third Year Fourth Year
Assets Assets Assets Assets
HCEs $42,400 $89,040 $140,344 $196,778
NHCEs $48,000 $90,900 $108,300 $125,361
Total Plan $90,400 $179,940 $248,644 $322,139
Top Heavy percent 46.90% 49.48% 56.44% 61.08%*
Chart: PSCA
*A plan is top-heavy when 60 percent of its assets are in the accounts of HCEs.
One company with 22 employees installed a 401(k) plan that matched 50 percent on the first 15 percent of pay — a generous program by any measure. Unfortunately, the plan sponsor discovered the top-heavy test only after it had been failed. The company had to pay $17,000 in legal fees to deal with the IRS in addition to a $28,000 corrective contribution to the plan on behalf of NHCEs. Fortunately they could afford to do so.
Conclusion
The good news is that hundreds of thousands of small employers across the United States have installed 401(k) plans. A recent informal poll by PSCA of major providers of small company defined contribution plans found that the number of employers with fewer than 50 employees offering plans increased by 75,000 between 2002 and 2007. However, there will always be small employers without plans until the top-heavy rules, which preclude plans by every small company unable to make a 3 percent annual contribution to every full-time employee over the age of 21, are repealed. Small companies must be able to make a financially realistic commitment if they are to offer a retirement program.
PSCA continues to work for the repeal of the top-heavy rules because it is unfair to deny the benefits of employer-sponsored retirement plans to employees of small companies because of a rule that imposes a standard of compliance and a required minimum contribution on small companies not required for large employers. It’s time to level the playing field.
David Wray is PSCA’s president