DC Corner: ADP/ACP Testing & Plan Design Considerations
By Ruth Schau
Retirement Section News, September 2022
A few years ago, the SOA Retirement Section Council created a Defined Contribution (DC) Initiative. Since that time the initiative has grown and branched into sub teams as we focus our efforts for the future. This article, which continues the series published here as the “DC Corner” of Retirement Section News, provides helpful information about the DC Initiative, inviting you to increase your knowledge of and engagement with DC-related topics in the future.
DC Plan Design: Create Your Role
Actuaries can be well suited to provide consulting to both DB and DC plans. Multiple times the following statement has been made to me from investment consultants, “I didn’t know about nondiscrimination requirements.” Well, the simple answer is nondiscrimination test requirements exist and it may be a precarious and costly situation for your client if these aren’t reviewed as a core part of a plan design project. Plan design for DC plans seems easy but should not be looked at any less seriously than DB plan design. The key steps are the same—gather employer goals, budget for the plan, determine viable options, discuss with the client, and help them align design with goals.
Depending on your level of experience, you may need to review the rules and model data, or in some situations, you might be able to estimate results of the design without employee data and without modeling. Let’s review a few design options (and check out the “ADP/ACP Basics” for a refresher on the basic rules):[1]
Example A: Automatic enrollment at 3 percent set every year, no automatic increase.
When you consider this design, there are a few key items to note:
- Over time, the non-highly compensated employees (NHCEs) will converge to an ADP slightly less than the 3 percent automatic deferral rate as some employees will opt out or contribute less than 3 percent.
- Over time, the highly compensated employees (HCEs) will be limited to an ADP slightly lower than 5 percent.
- Is 5 percent a deferral level where the HCEs will be happy? Probably not.
- Is 3 percent a level where all employees are benefitting by creating a financially sound retirement? Probably not unless there is a DB plan or other significant nonelective employer contribution.
- For some plan designs, employees saving at 3 percent (or 5 percent) of pay may not be receiving the full employer-provided match.
Why would a plan sponsor want to employ this design? If an inexperienced consultant is recommending it, then they likely have another client with this design, and it seems to work for them. “Let’s just keep using the design I know.” Hopefully you’re thinking this may be a bad approach to plan design, and it is. Since I’m stating example A isn’t necessarily a strong plan design, let’s consider what might be better.
Example B: Automatic enrollment at 3 percent, plus automatic increase at 1 percent per year up to 8 percent to 10 percent.
Moving from example A to example B, we added automatic increases. A simple change like this can significantly improve nondiscrimination test outcomes and of course the financial outlook for future retirees.
- Over time, the NHCEs don’t converge at 3 percent, but at a higher deferral rate that depends upon the demographics. If there are more new hires, the rate will trend toward 3 percent, but for organizations with a broad mix of service levels, this plan might experience a 6 percent to 7 percent average NHCE deferral.
- HCEs will still have the +2 percent limit apply. However, if 6 percent is the average NHCE deferral rate, then 8 percent is the limit for the HCEs. Many of the HCEs will be able to defer what they would like without being limited and subjected to returned contributions at the end of the year due to the ADP test limitation. (Note that the lower paid employees classified as HCEs may not be able to defer to the IRS 402(g) limit of $20,500 for 2022 as this test depends upon the demographics of all the HCEs.)
Is this the right design? This question may still be hard to answer as there isn’t a perfect plan design that fits all organizations. A better question to ask is does this design benefit employees by helping them build a sound financial retirement? If the combined employee and employer deferrals and contributions equal 15 percent or more, this design may work for this organization. Is it the best? Let’s consider another option.
Example C: Automatic enrollment at 6 percent, automatic increase at 1 percent per year up to 10 percent.
In moving from example B to example C, we again changed one element of design. This plan design drives higher levels of deferral earlier in employment. Some employers say that their employees cannot afford this option with the higher initial deferral rate, but does an employer really know their employees that well? While some employees may need to reduce their savings below 6 percent in their first few years, it may not be true to assume this applies to all employees. It might be better to support those employees who can save at 6 percent and allow others to voluntarily reduce their deferral rates below 6 percent.
- Depending upon demographics, over time NHCE average deferrals may move toward the 6 percent to 8 percent range.
- Over time HCEs will be limited using the +2 percent rule at an average of 8 percent to 10 percent.
- If the total employer contribution is 6 percent or more combining match with nonelective contributions, employees will be building a financially solid retirement with combined employer and employee savings of 14 percent to 16 percent.
Summary
Did you find it interesting that an employer match wasn’t stated in the designs reviewed above? With automatic enrollment and automatic increases, the match doesn’t drive the outcome, the automatic features do. However, without automatic features, the match is critical in determining whether a plan can pass the nondiscrimination tests and also support employees by selecting defaults with financial outcomes at retirement in mind.
Before we wrap this up, I want to share a few design thoughts. Plan goals generally include high participation rates and high deferral rates. If the budget is met for a design option, but only if less than 60 percent to 90 percent of employees participate, then this is a plan design that bears further review. If the budget is restricted, consider a reduction in the match. Even if auto-enrollment and auto-increase aren’t adopted in this design project, it should typically be planned for the future. It may be less than optimal to have a design where auto-enrollment can’t be added without decreasing the employer match. So plan for the future appropriately and discuss limitations of this type of proposed design with your client.
As stated before, there isn’t a single, perfect plan design that should be used by all organizations. If you aren’t leading the design project and you hear about a new design, it is time to act. Question your clients if they indicate they are changing their design. You might ask:
- How did they select this design?
- Have they confirmed design alignment with goals? (Make sure they set goals)
- Does the design meet their budget? (And does it meet the budget if auto-enrollment and auto-increases are present?)
- Have they modeled and reviewed nondiscrimination test results?
If you want to consult on DC plan design, learn the nondiscrimination testing rules. There are other nondiscrimination test rules that apply, but we only covered the ADP/ACP rules in this article. Once you master this knowledge and gain experience, there will be frequent times you will be able to look at a design without any employee demographic information and know whether a plan is likely to have testing problems.
DC plan design projects can be fun and certainly can be mastered by actuaries. Own this work for your clients!
|
ADP/ACP Basics 401(k) plans must meet both average deferral percentage (ADP) and average contribution percentage (ACP) tests unless they provide a safe harbor plan design. 403(b) plans must meet the ACP test unless they provide a safe harbor plan design. So why do 403(b) plans get a pass on the ADP test? This is because there’s an additional rule, the Universal Availability rule, which requires all employees to be given the chance to defer to the plan. This rule doesn’t mean they're immediately eligible for an employer match or other employer contributions, only that they have the right to defer their earnings. Basic Rule: The ACP/ADP of highly compensated employees (HCEs) can’t be more than two times the ACP/ADP of NHCEs, or the ACP/ADP of HCEs can’t be more than 2 percentage points higher than the ACP/ADP of NHCEs. The lesser of these two test results are used.
|
Statements of fact and opinions expressed herein are those of the individual authors and are not necessarily those of the Society of Actuaries, the newsletter editors, or the respective authors’ employers.
Ruth Schau, FSA, FCA, EA, is sr. director pension solutions, International Division, for Pacific Life; and vice chair of the Society of Actuaries Aging and Retirement Steering Committee.