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A Modern Alternative to the Safe Harbor PlanHow to Reduce the Cost of 401(k) Plans By Redirecting Contributions to the Highly Compensated GroupWilliam L. MacDonald
Human Resource (HR) professionals are positive by nature and resilient by necessity—until the president calls to ask why he received an unexpected taxable return from his 401(k) contributions. As they say, ‘there’s some ‘splainin to do.’
In a typical voluntary 401(k) plan, the majority of rank and file employees either contribute only a minimal percentage of their income, or they do not elect to contribute to the plan at all. In a recent report by the Center for Retirement Research at Boston College, it was noted that up to 89 percent of eligible participants chose to not contribute the maximum to their defined benefit or contribution plan; up to 25 percent do not contribute at all.
Impact of ADP/ACP Test Strangely, those HCEs who want to make a maximum contribution to the plan are precluded from doing so because the plan fails the ADP (average deferral percentage) or ACP (actual contribution percentage) test. The ADP/ACP test is one of the most significant tests because most 401(k) plans are compelled by law to address its consequences or consider its outcome throughout the year. For example, failure to meet the filing deadline can cause a plan to incur stiff penalties, including disqualification of the plan. A plan favors a group of highly compensated employees when it is not beneficial to rank and file employees. For example, if a plan matches only contributions of those employees who contribute large sums to the plan each year, then it will favor the HCE group; it is the HCE Group that can afford large contributions and, thus, receives the employer matching contribution. As a result, the HCE Group gains the greater plan benefit than the rank and file.
Fairness Measured
The bottom line is this: We want to re-design the plan to motivate rank and file employees to defer compensation which, in turn, makes it possible for the HCE Group to defer more, overcome the gaps, and reach a sustainable retirement. You may question: “Are we trying to spend unnecessary dollars on the rank and file to design the plan so it will also be attractive to the highly compensated?”
Key to Success Unquestionably, the employer must find a way to implement a cost-efficient strategy to benefit these HCEs. Their talent and expertise is likely the key to business success. Smart companies will do everything in their power to retain and reward equitably, especially in an environment where there is a dearth of senior talent. In compensation and retention situations, the plan administrator often recommends the creation of a “safe harbor” plan; that is, for the price of a safe harbor employer contribution, the applicable discrimination tests on employee deferrals (ADP), as well as matching contributions or actual contribution percentage (ACP) tests, are deemed satisfied. Thus, HCEs are permitted to make the maximum allowable compensation deferral without the need for the plan to pass the discrimination tests. However, this solution carries a fairly steep price tag. Let’s cite the two safe harbor contribution approaches:
What’s more, under a safe harbor plan, employer contributions (for all employees) are fully vested when made, which leaves employers with little or no retention leverage. While this strategy solves the contribution dilemma, it also does not meet the reasonable cost criteria so important to the employer. Chart I
Narrowing Gaps―Nonqualified Plans One solution to retirement shortfalls is the use of a nonqualified deferred compensation plan (NQDC). NQDC plans are employer-sponsored retirement plans, or other deferred compensation arrangements, that do not meet the tax qualifications under Internal Revenue Code Section 401 for qualified plan requirements. These plans allow an employee to defer the receipt of taxable wages or bonuses until a future year when (hopefully) the employee is in a lower tax bracket, thereby paying less in taxes when compensation is received. When compared to qualified plans, NQDC plans are far easier to establish. However, specific rules must be followed in order to achieve the objective of deferring an employee’s taxable compensation. In fact, all nonqualified plans must satisfy the following three requirements: 
Chart II
Clearly, a nonqualified plan provides a cost-effective alternative that allows an employer to:
Four Million Dollar Advantage Chart III below compares the costs of a nonqualified deferred compensation plan for HCEs with the costs of a typical safe harbor plan. The example is based on a 300-employee group with 20 HCEs, and a total annual payroll of $19.5 million. In this case, a NQDC plan can be installed with a total outlay that is only 35% of the cost of the safe harbor plan. The impressive result is $4.65 million in savings in direct costs over a 10-year period. Further to this example, the employer offers a 5% contribution to the HCEs, which could be a match, compared to a 3% safe harbor contribution to all 300 employees. At a modest handle rate of 6%, the NQDC plan provides the company another $367,744 in indirect savings over that same period. Chart III
Based on the numbers alone, the NQDC solution for highly compensated employees makes sound business sense with the added benefit of current tax deductibility. Now for full benefit security, we recommend the Management Security Plan as a desirable alternative.
Management Security Plan The primary differentiator between the Management Security Plan and the traditional nonqualified deferred compensation plan is the manner in which investment gains are taxed. Contributions are made with after-tax dollars, however, all earnings accumulate, tax deferred on the pre-tax amount. This outcome is reached through a tax restoration loan built into the program. Review Chart IV below: Chart IV
*Assumed 40% tax rate. Structured properly, distributions from the MSP are not subject to current taxation. Equally important, the MSP includes a non-taxable life insurance benefit. And it is powered by an institutionally priced variable universal life (VUL) policy, which creates its tax-advantaged status. A summary of MSP benefits:
In summary, the attractiveness factor in retirement benefits affects corporate performance and sustainability. Quite naturally, top talent will always gravitate to the most appealing compensation and benefits package offered. Whether it is a combination of 401(k) plans, buttressed by a NQDC plan or customized Management Security Plan is easy enough to analyze. What is difficult to do is shift one’s thinking. In reality, the quality of a company’s executive benefits plan is the true centerpiece of an effective risk management strategy. If you have any doubt, contemplate this next point: In its poll of some 1,000 U. S. employers1, AON Consulting clearly uncovered the depth of challenges we now face. Consider this trend point:
How much time do you have to revisit and revamp your retirement programs? Can you hold onto your senior people? Have young managers been tested sufficiently to take the reins? Can you attract the ‘next’ generation of best-of-breed talent? After all, the nation’s 80 million baby boomers are retiring at a rapid clip. At the same time, the world of work has radically changed. Seismic shifts in global economies and technologies have uprooted everything as we knew it. 1 2008 Benefits and Talent Survey, Aon Consulting
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This scene is played out often in American office buildings because Highly Compensated Employees (HCEs) may unintentionally over contribute to 401(k) plans. Then, the excess has to be refunded or reclassified as an after-tax contribution.
The ADP/ACP test is designed to prevent employers from managing a 401(k) plan that is discriminatory in favor of highly compensated employees. The HCE group is often comprised of owners, executives, or management employees. These individuals, by the nature of their roles, are generally in the best position to operate an unfair retirement plan, according to the government viewpoint on the matter. 
The ADP/ACP test reveals the unfairness of a plan, as described above, by examining the contribution percentages of each group—the highly and non-highly compensated employees. First, the test separates the company’s employees into one of the two groups based largely on a set compensation amount. If compensation is greater than a specified dollar amount, the employee is highly compensated. If it is less than the specified dollar amount, the employee is non-highly compensated. You then need to run a number of related tests, which adds to plan complexity. Human resource professionals lament full testing as an experience they prefer to avoid.
“Anticipated leadership and talent shortages threaten organizational sustainability. Nearly 60 percent of respondents report that they have a leadership talent shortage right now that will impede their organization’s performance. That is up from 16 percent just one year ago. Another 31 percent expect a leadership shortage will impede performance within the next four years.”