What Is the Definition of Compensation and Why Does It Matter?

We've all been in a "don't shoot the messenger" situation where you have to be the bearer of bad news even if you did nothing to cause the problem.

That’s precisely the situation that our client, Nancy, found herself in when she took over as director of Human Resources and Employee Benefits at a prominent local company. We sat across from her at her new stately desk as she explained how her predecessor failed to check a box in the payroll system that withheld employee elective 401(k) deferrals from bonuses and how that little unchecked box was going to potentially cost her new boss big bucks. Now, Nancy found herself in the unenviable position of explaining how this happened in the first place. 

In our experience, this is a very common error made by payroll managers and it is generally very costly to the company. To make matters worse, the large majority of 401(k) administrators do not catch these mistakes because their recordkeeping systems aren’t always in perfect sync with your payroll data and they may not even take responsibility for checking the data you give them. So how do you know whether you’re currently administering your plan’s definition of compensation properly?

The Governing Documents

The first step to uncovering the actual definition of compensation for your company’s qualified retirement plan is to review the plan documents—more specifically the summary plan description (SPD) as well as your company’s adoption agreement with a prototype plan, volume submitter plan, or individually drafted plan Document. 

For example, the plan document and SPD may say:

Eligible compensation for computing contributions under the Plan is the taxable compensation for a  Plan Year reportable by your Employer on your IRS Form W-2, excluding reimbursements or other expense allowances, fringe benefits, moving expenses, deferred compensation, any payments made to an Employee performing Qualified Military Service in lieu of wages the individual would have received from the Employer if the individual were performing service for the Employer, and welfare benefits and including salary reduction contributions you made to an Employer sponsored cafeteria, qualified transportation fringe, simplified employee pension, 401(k), 457(b) or 403(b) plan.

This is an example from a Fidelity SPD.

Sound simple enough?


Roles and Responsibilities  

Due to the complexities surrounding the administration of a 401(k) plan, the majority of plan sponsors hire third-party vendors to provide recordkeeping, third-party administration (TPA) services, trustee, and/or investment advice to their plan while trusting that the vendors will do their best to run the plan compliantly. Much to the plan sponsor’s surprise and dismay, it remains the responsibility of the plan sponsor to ensure that all data, processes and procedures are accurate. To explain, many plan sponsors assume that because they are sending payroll and participant data to a vendor who is serving as the plan's TPA and recordkeeper, that the vendor is verifying that the data is accurate and correctly follows the rules set forth for the plan in the plan document. The vendor often contends that it is the plan sponsor's responsibility to follow the rules and send precise data. Therefore, if neither the plan sponsor nor the vendor has thoroughly checked the data for accuracy, there is a good chance that something could go wrong.    

It Happened - Now What?  

If upon review of any of the provisions of your plan document, you find that you are out of compliance because the plan is not adhering to the strict definitions set forth in the plan document, there are steps you can take to correct and fix the problem. First, you should contact an ERISA attorney who can provide you with specific case law surrounding your issue. The next step may be to examine the self-correction methods made possible through the Internal Revenue Service (IRS) Voluntary Correction Program (VCP). The VCP suggested correction method for missed deferrals, in Nancy's case on bonus compensation, is to make a qualified nonelective contribution for the employee that compensates for the missed deferral opportunity. The formula for calculating the missed deferral opportunity is 50% of what should have been deferred plus employer match (if applicable) plus lost earnings (IRS 401(k) Plan Fix-It Guide, correction number 6). In most cases, the plan sponsor can rely on the vendor to calculate the correction amount if they are able to provide the vendor with the necessary participant data.   

The silver lining to Nancy’s story is that her company caught the issue before an official IRS or Department of Labor (DOL) audit occurred giving them the opportunity to self-correct. In 2013, the DOL collected $1.69 billion in fines, voluntary fiduciary corrections and informal complaint resolutions. With audits on the rise, it is anticipated this dollar amount will continue to climb. Even though it may seem daunting to become an expert on all of the provisions of your plan document, with the right assistance and investigation into the proper processes and procedures, you can keep you and your company running in the right direction.

Grinkmeyer byline headshots

Trent A. Grinkmeyer, AIF, CRPC; Valerie R. Leonard, AIF; and Jamie Kertis, QKA, AIF  

Trent Grinkmeyer, Valerie Leonard, and Jamie Kertis are Registered Representatives and Investment Adviser Representatives with/and offer securities and advisory services through Commonwealth Financial Network, Member FINRA/SIPC, a Registered Investment Adviser. Fixed insurance products and services offered through Grinkmeyer Leonard Financial or CES Insurance Agency. Grinkmeyer Leonard Financial, 1950 Stonegate Drive, Suite 275, Birmingham, AL 35242. (205) 970-9088.   

This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the authors do not necessarily reflect the stance of Asset International or its affiliates. The persons portrayed in this example are fictional. This material does not constitute a recommendation as to the suitability of any investment for any person or persons having circumstances similar to those portrayed, and a financial adviser should be consulted.