“Out of 500 eligible employees, only 93 are enrolled and not all are currently deferring. Everyone, including our HCEs, has the company match cut off at $1,850, so what can we do to avoid this in future? If employees choose not to enroll, it seems unreasonable of the government to count them in the testing rather than just those enrolled in the plan. At this rate, we will never pass the annual test. We are in the nursing home industry and have a nearly 50% turnover rate which I think is contributing to the testing failure”
Michael A. Webb, Vice President, Retirement, Cammack LaRhette Consulting, answers:
Excellent question! For those readers who may be unfamiliar with ACP, or Average Contribution Testing, it is a test that specifically applies to employer matching contributions that are contingent on a participant’s elective deferrals to the 403(b) plan. The contribution percentage of highly compensated employees (or HCEs, defined for 2011 as those who earned in excess of $110,000 in 2010) is averaged, and that percentage is compared to a similar average for all other eligible employees (with eligible-but-nonparticipating employees averaged in as a “zero”, which is why it can be a hard test to satisfy the test without good overall participation). If the HCE percentage exceeds the percentage for all other eligible employee (known as non-highly compensated employees, or NHCEs) by more than a certain amount, then the test fails. For more information, see 403(b) Plans: Things to Know about Average Contribution Percentage Testing.
You are quite correct that a low participation percentage among eligible employees can easily result in an ACP test failure, despite the measure you have taken to cap the matching contribution at $1,850, which would result in a lower contribution percentage for the most highly paid employees, which would positively impact test results. The government’s rationale in including in the averages eligible employees who choose NOT to make elective deferrals, unfair as it may seem to you, was clearly intended by Congress to make it harder for matching plans to discriminate in favor of highly paid employees. (Also, by the way, it is not necessary to cap the match for the NHCEs – that actually hurts your testing.)
However, one element of your question puzzles me. You state that you firm has a “nearly 50% turnover rate”. In my mind, that would actually help your testing results, since only employees who are eligible are subject to ACP testing. In order to be eligible, they must have satisfied the service requirement in order to receive the match (generally one year, up to two years if contributions are 100% vested). Even if you provide for immediate match eligibility, or a waiting period of less than one year, NHCE’s with less than one year of service may be excluded from ACP testing under what is called the “early participation rule”.
Thus, I would suggest that you double-check your test results to confirm that you are including only employees who are actually subject to the testing. (You may be tying matching to eligibility to participate for salary reduction contributions, which must begin earlier under the “universal availability” rule, but you don’t have to – for matching contributions, the plan can require that one or two-year wait.)
Assuming that your test failure is verified as described above, there are several options as to what you can do to avoid future ACP test failures, as follows:
1) Increase voluntary participation (not likely in your case, but it can’t hurt to consider whether employee education could be improved)
2) Change the matching contribution to a base, or nonmatching, contribution, that is provided to all eligible employees whether or not they choose to make an elective deferral
3) Automatically enroll all employees in the plan in manner that would exempt the plan from ACP testing (see the link above for details)
4) Convert to a ACP Safe Harbor contribution formula (see the link above for details), which would similarly exempt the plan from ACP testing.
A lot of 403(b) sponsors have gone with a safe harbor contribution, but it can come at the cost of more matching contributions as more employees participate. Best of luck with arriving at a more workable contribution formula in the future for your plan, and thanks for Asking the Experts!
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.
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