Non-discrimination testing is a pain.
When employees aren’t participating in the 401(k) or saving enough, non-discrimination testing can severely limit how much highly compensated employees (HCEs) can contribute. This is a source of great frustration for plan administrators – especially in sectors like hospitality and food services where participation and savings rates are typically much lower among hourly staff. In cases like these, the firm might have to return money to HCEs and executives. This money counts as taxable income. A sudden, unexpected influx of taxable income could push them into a higher tax bracket, which would be very frustrating for everyone involved.
If you find yourself with this problem, don’t worry.
Limits imposed by non-discrimination testing are tough to overcome, but far from impossible. We’ll walk you through three highly effective strategies for overcoming these limits and acing your non-discrimination tests.
Safe Harbor is an easy way of getting around most non-discrimination testing. It’s also rather expensive.
Safe Harbor 401(k) plans are automatically exempt from three out of the four non-discrimination tests: ADP, ACP, and Top Heavy tests. Not only does this save you the time and hassle of having to go through testing every year, but it also means HCEs can more easily max out their 401(k)s.
So how does one qualify for a Safe Harbor exemption? These are the two most common scenarios:
Safe Harbor may still be tempting, but there are more affordable options.
Getting more employees to participate in the 401(k) can really move the needle on contribution limits for your HCEs.
ADP and ACP test calculations include all eligible employees – not just those that are participating in the plan. This means low employee participation can severely limit how much HCEs can contribute, as the contribution rate of an employee who is eligible, but not participating is 0%. Therefore, boosting participation rates is a powerful way to help HCEs contribute more of their income.
So just how does one boost participation rates? In our experience, these are the two most powerful ways:
The 401(k) is important to employees’ financial well-being. Getting employees to understand this is important, but by itself it’s not enough.
Employees need to be alerted when their eligibility is approaching. They also need to be informed of what they need to do to join the plan.
Sounds easy enough, right?
Not so fast.
How this information is communicated before and during enrollment makes a huge difference in how successfully it boosts participation rates. Handing them a packet of financial jargon and requiring them to make elections isn’t the way to go.
Communications about the 401(k) need to be simple and easy to understand. That means communicating financial concepts using everyday language.
It also means making communications accessible to employees. Employees might not have access to a desktop device, so communications should be mobile friendly. That means sending SMS alerts in addition to emails.
Companies should also consider communications for non-English speakers. Many companies – especially hotels, restaurants, and other service companies – employ native Spanish speakers. For companies such as these, it’s important to communicate important but difficult topics in the language which their employees are most comfortable using.
The number one reason employees cite for not participating is that it’s too hard to enroll. Here at ForUsAll, we offer a virtual advisor named DAVE to reduce friction and overcome employee inertia. DAVE is approachable when describing how the plan works. He uses simple language that participants can digest at their own pace. He even speaks Spanish for those employees who need it! Talk to us today to learn more about DAVE and how radically simplifying the onboarding can help you boost participation.
2. Automatic Enrollment
Automatic enrollment is one of the most powerful tools for increasing 401(k) participation.
According to Vanguard, plans that automatically enroll participants when they become eligible had participation rates of 93%. By comparison, plans that required employees to opt-in had participation rates of just 47%.
This feature is especially helpful at enrolling young and low-income workers, who are traditionally the hardest groups to engage with the 401(k). When automatic enrollment is involved, 88% of employees earning less than $30,000 participated, versus just 18% when employees are required to opt-in.
The same study found that the same is true for employees under 25. 90% participate when enrolled automatically, versus just 30% when required to opt in.
Just this feature alone can make a huge impact on HCE contribution limits, but it’s not without its drawbacks. Automatic enrollment usually leads to lower savings rates.
Luckily, this doesn’t necessarily have to be the case. We’ll discuss a few strong savings rate boosters in the next section.
Raising participation rates is a huge first step, but if employees are only saving a sliver of their paychecks, it’s probably not enough. The next step is to get them to save more.
There are two features which do an excellent job boosting savings rates:
The problem that most companies run into with automatic escalation is that their default savings rates are just too low. According to Vanguard, most plans with automatic enrollment set the default rate at just 3%.
This isn’t nearly enough for employees to hit their retirement goals. And it definitely isn’t enough to balance the plan and make non-discrimination testing a non-factor.
Thankfully, there’s a simple fix.
Just start new participants with a higher savings rate. But won’t this have a negative impact on employee participation, since more of their paychecks will automatically be deferred?
As it turns out, the answer is “no.”
According to a study by top academics, higher default savings rates have little-to-no effect on employee participation. Setting a smarter default is an easy way to double your employee savings rates with little-to-no loss in participation.
But even 6% isn’t high enough. To meet retirement goals, employees should increase their savings rates as time goes on. Unfortunately, research shows that most employees just leave their savings rate at the default.
Luckily, there’s an easy fix for this too.
2. Automatic Escalation
Automatic escalation is when employee savings rates increase by set amounts over set intervals. For instance, savings rates might increase by 1% every year.
When combined with better employee communications, automatic escalation is especially powerful. Simply informing employees that their default savings rate of 6% is below the average 401(k) savings rate uses a very powerful concept known as social proof. This gets employees bought into the concept and keeps them participating in the plan.
By making non-discrimination testing a non-factor, highly compensated employees will be able to max out their 401(k) contributions. On top of that, your employees will be much closer to securing a comfortable retirement. In short, everyone will be happier!
All of the strategies mentioned above are proven and will get you well on your way towards having a 401(k) loved by employees and executives alike. But of course, doing any of them will take a lot of work.
If you’d like to boost participation and savings rates without doing all the work, give us a shout. We’ll happily help you do that, and potentially lower your 401(k) fees while we’re at it!
David Ramirez, CFA, is a recognized 401(k) expert with over 20 years of experience in 401(k), ERISA, cash balance plans, and ESOPs. A UC Berkeley graduate, he played a pivotal role at Financial Engines, a 401(k) advisory firm founded by Nobel Laureate William Sharpe, Ph.D., where he was a portfolio manager who helped manage over $50B in 401(k) assets. His clients included some of the largest Fortune 500 companies and state governments.
Give your employees more than just a 401(k), join the movement.
