Perspectives July 3, 2014

Helping Clients Avoid Failed ADP Tests

Many plan sponsors find some of their employees cannot take full advantage of 401(k) plans because of failed ADP tests.
Reported by

 

For the ADP (Actual Deferral Percentage) test, the Internal Revenue Service (IRS) requires 401(k) plans prove that highly compensated employees (HCEs)—those employees who earned more than $115,000 in 2013 or are a 5% (or greater) owner—do not defer significantly more than the non-highly compensated employees (NHCEs).  The test is fairly simple; plan sponsors’ third-party administrators (TPAs) determine the average percentage of compensation the HCEs defer, and compare it to the average the NHCEs defer.  If the spread of these two averages exceeds IRS guidelines, then the test fails.

Want the latest retirement plan adviser news and insights? Sign up for PLANADVISER newsletters.

The best way to avoid this issue is to attack it before it becomes a problem.  In a perfect world, advisers would lead educational seminars that every employee would want to attend with an outcome of 90% or greater participation in the 401(k) plan.  Even the most inspirational financial adviser would find it difficult to achieve this participation goal consistently (especially when there are multiple locations, staff members that live paycheck to paycheck, or employees who are infrequently in the office).

When a plan fails its ADP test there are typically two solutions:  1) provide refunds of deferrals to the HCEs (this is usually the owners and senior staff) adjusted for investment gains/losses or 2) provide additional contributions through the use of a QNEC (Qualified Non Elective Contributions) to the NHCEs.  Plan Sponsors are not usually happy with either alternative.

A more practical solution is for plan sponsors to be more proactive and operate their 401(k) plans to reflect the lower participation (until such time as this statistic changes).

Below are four ideas we have used successfully with our clients.  These are ideas you can suggest plan sponsors implement now to help make their plans more successful, and continue to demonstrate your value in the process.

1)      Interim Testing: Encourage your client to provide mid-year data to its TPA (we typically request data as of June 30 for calendar year plans).  The TPA will perform an interim ADP test that projects the full-year results.  If the results indicate a “failed” test, the plan sponsor will then have ample time to alert the HCEs and offer them the option of cutting back on their deferrals to avoid large refunds.  If the results are better than expected, they will have the opportunity to increase their deferrals.  Either way, there should be limited surprises at the end of the year.  Please Note:  In order for this analysis to be useful, the TPA should explain the test results and provide actual direction for increasing or decreasing contributions for the HCEs.

2)      Prior Year Testing Method: If performing the interim test is just not feasible (i.e., gathering the data is too difficult or time consuming for your client), another alternative is to change the ADP testing method in the plan document to use “prior year” results (instead of “current year”).  By using prior year testing, the NHCE average deferral percentage is known in advance, and dictates what the HCEs can defer this year.  For example, if the NHCEs defer on average 2.5% of their compensation in 2013, the HCEs can defer 4.5% on average in 2014.  Therefore, close to the start of every plan year, the HCEs know just how much they can defer (on average) before the ADP test will fail.  Please Note:  The ability to change to Prior Year from Current Year testing depends on the provisions of the plan document and whether another testing election change has been made recently.  Speak with the TPA to confirm. 

3)      Reflecting the best definition of compensation.  ADP tests simply compare the ratio of deferrals to compensation.  Which definition of compensation is used can have a significant impact on results.  If the plan document permits, the TPA can test the plan using both full W-2 compensation (reflecting compensation prior to the time some short-service employees became participants) as well as compensation from the date the participant actually entered the plan.  Depending on plan demographics, one definition of compensation may produce better results than the other.

4)      Borrowing from Peter to pay Paul.  The Borrowing Method reallocates a participant’s matching dollars (assuming the plan has an employer match) to his salary deferrals, assuming that the plan passes nondiscrimination testing on the match (the actual contribution percentage, or ACP, test).  The goal here is simple: if you can increase an NHCE’s deferral percentage, then the plan’s overall ADP test results will improve.  There are no additional employer contributions made but rather just a “book entry” change.  The worst scenario is that there is no change in the ADP test result.  The best scenario is that the ADP failure will be reduced or eliminated completely.  Please Note: When using this method, any employer match borrowed to improve ADP results must be made 100% vested immediately.

There is no silver bullet to definitely fix ADP test results, but there are numerous ways to mitigate failed results with minimal upset.   I am sure many of you have explored the use of a safe harbor 401(k) design (more about that in a later article), but unfortunately they can be cost-prohibitive and in any event, for existing plans, they cannot be implemented until the start of the 2015 plan year.  Hopefully, these ideas will add value to your client relationships and improve the experience they have with their 401(k) plans.

 

NOTE: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice.  

Any opinions of the author(s) do not necessarily reflect the stance of Asset International or its affiliates.
Products July 3, 2014

Helping DC Plans Improve Investment Outcomes

A manager of managers approach may help defined contribution (DC) plan sponsors offer more diversified investment options to participants without overwhelming them with too many options or increasing costs.
Reported by

 

A manager of managers fund aims to achieve its objectives by selecting differentiated managers and giving them a mandate to make investment decisions on behalf of the fund. The rationale is that diversification and balance can be better achieved by allocating assets to more than one manager, each with a distinct style. The manager of managers role is to select the managers, monitor performance and risk, and alter the composition of the fund to adapt to market conditions.

Never miss a story — sign up for PLANADVISER newsletters to keep up on the latest retirement plan adviser news.

Scott Brooks, head of defined contribution at SEI, explains the concept, using the example of small/mid-cap (SMID) funds. With the traditional approach, a plan sponsor may offer participants a SMID Value fund, a SMID Core fund and a SMID Growth fund to cover the risk/return spectrum. With SEI’s U.S. Small/Mid Cap Strategy manager of managers fund, participants can select the one fund and get access to 10 underlying sub-funds—which include some that defined contribution plan sponsors would typically never offer to participants, such as an opportunistic value fund or a real estate investment trust (REIT). “The participants only see one SMID fund [on their DC plan investment menu]; it makes participants’ lives easier,” Brooks notes.

Research from SEI shows defined contribution plan sponsors tend to offer far more investment fund options than the number actually used by the average participant. While it is important to offer participants the opportunity to diversify retirement assets, an overly complicated fund lineup can make it challenging for even well-informed investors to choose appropriately. SEI found that the disparity between offerings and participant demand is driving sponsors to consolidate the number of funds offered in the core lineup.

SEI has been serving defined benefit (DB) pension plans since the 1980s and started its manager of managers business in the ’90s. Brooks tells PLANADVISER, this approach lets smaller firms get access to the same number and caliber of investment managers that large firms are able to access. He explains that different asset managers have separate minimum asset requirements for investment accounts—say, $25 million to $50 million—so, it would take around $1.5 billion in assets to gain access to around 40 fund managers to achieve diversification. However, with SEI, firms with small retirement plans can access those same managers since their assets are pooled with those of other investors.

“Since SEI is a large-scale institutional investor, kind of like CalPERS, we can place sizeable assets with managers,” Brooks says. “Which also allows us to negotiate competitive fees.”

SEI recognized that this advantage would also be a benefit to defined contribution plans. It serves as a 3(38) investment manager for the plans, which, Brooks says, is the same concept as an outsourced chief investment officer (OCIO) for pensions, “but DCs don’t embrace that terminology.”

According to Brooks, there are three primary capabilities SEI can offer, including co-fiduciary oversight of the entire investment menu; target-date fund (TDF) offerings, including custom; and collective trusts providing manager of managers investment options. Big benefits for defined contribution plans, he says, include the potential for lower costs, as well as broad access to best-in-class asset managers. The manager of managers approach offers a similar level of alpha, but lower risk, for DC plan investments—DC is becoming more institutionalized, Brooks adds.

He stresses that what defined contribution plans get with a manager of mangers approach is an added layer of protection at no additional cost compared with what they currently offer participants. For example, he says, SEI’s large cap strategy’s cost of 50 basis points (bps) is very competitive compared with a single manager’s 55 bps to 60 bps cost, and the plan sponsor also gets co-fiduciary protection and better response to the market.

Brooks notes that at SEI, there are 100 people in the investment management unit whose job is to talk to managers every day and change investment portfolios according to what is changing with those managers. Without this oversight, it takes time for plan sponsors to make changes on their own. An investment committee that meets only once a quarter may not discover a problem until it has adversely affected the fund for a while, but SEI can quickly swap out funds because staff has been talking to other similar mangers, he says.

“The process [of changing investment funds] can be reduced from 270 days to conceivably as little as one day,” he adds. “If we found a Bernie Madoff, we could fire him the next day, whereas a committee may not have found [the problem] as soon and it would take longer to change.”

«