Wednesday, October 31, 2007

401k Annual Report

I periodically get emails from my company's HR department containing a summary report about our 401k program-- the value of the assets, administrative expenses, how much was contributed and paid out, etc. I usually ignore it. But this time, I didn't: I read it, and even did a little math to calculate how many employees might be participating and what the approximate rate of return was overall on the plan's investments. I didn't see anything that caused me alarm, and it was sort of interesting.
I was curious about it this time because I'd heard a rumor that our 401k plan could be in danger of failing the discrimination test-- in a nutshell, if highly compensated employees (HCEs) are contributing a much higher percentage of their salaries than non-highly compensated employees, it's considered discriminatory because the HCEs are getting more of a benefit than others. If a plan fails the test, HCEs might have some of their contributions refunded, and the allowed contribution amounts might be capped at a certain percentage of employees' salaries.

When you think about it, publishing seems like an industry where 401ks could easily run into this problem. The industry is largely based in New York, where the cost of living is extremely high. Yet average salaries are extremely low. So you're likely to have a lot of people who feel they can't afford to contribute until they start to get into the pay range of HCEs. For 2007, an HCE is defined as someone whose compensation is $100,000 or more this year, which doesn't go all that far in NYC. I think a company I used to work for may have had to limit 401k contributions for this reason-- I may be remembering wrong, as I wasn't as informed about these issues back then, but I think contributions were capped at a percentage, rather than the full dollar amount allowed annually for other plans.

At this point in my life, I'm about to cross the line into being an HCE myself-- whoopee, what a milestone! They should send you a lapel pin, or a Girl Scout-type badge or something... But since I am committed to maximizing my retirement savings by this method, I'd be annoyed if I could no longer contribute my full $15,500 or whatever the amount ends up being for future years. I hope our HR department is doing a good job talking entry-level employees into signing up for the 401k! And not just for my own selfish reasons...

In any case, I have no way of knowing where we stand on the HCE vs. non-HCE contributions just from reading the summary annual report, though the overall contributions vs. our number of employees suggests very few people max out their contributions. I guess that information might be in the full annual report, which I can request a copy of if I want to. I liked this paragraph at the end of the summary:

You also have the legally protected right to examine the annual report at the main office of the plan at XXX Publishing Company, New York, NY 100xx, and at the U.S. Department of Labor in Washington, D.C. or to obtain a copy from the U.S. Department of Labor upon payment of copying costs. Requests to the Department should be addressed to: Public Disclosure Room, N1513, Employee Benefits Security Administration, U.S. Department of Labor, 200 Constitution Avenue, N.W., Washington, D.C. 20210.
I wonder how many people show up at the Department of Labor asking to read their 401k annual report?!? It would be interesting to try it... I smell a My Open Wallet field trip in the making!


Peachy said...

1. I don't know anything about HCE.
2. I thought the limit of $15,500 was set by the gov't.
3. I'm assuming that you get a company match.

My first thought when you said some of their contributions refunded was the company's matching contributions to the 401k would be refunded (back to the company). Not the employee's own contributions. This would make more sense.

Just remember though, the compensation is $100,000. This could be the taxable income, not salary. So if you contribute the max to your 401k, and your salary is $100k, then your taxable is less. No go back and ready my disclaimers.

Congrats on the almost 6 figure income.

sarah said...

Your HCE status is determined by your prior year's earnings and only your earnings from one employer are considered. So, to be considered HCE in 2007, you would have had to have W2'd $100K at that particular company in 2006.

My company's plan limits contributions for HCEs to 10% and generally passes the discrimination testing by doing so.

Another company I worked for would "refund" contributions to HCEs at the end of the year after completing the discrimination testing.

Not sure which approach is better. Either way, some folks are bound to get caught.

OptionedUnarmed said...

The $15,500 limit is the maximum set by the government, but companies are permitted to set their own limits at a lower amount.

The way I think it works is that if the lower-compensated employees contribute an average of, for example, 6% of pay, then the average contribution of all higher-paid employees cannot exceed 8%. (The difference cannot be more than 2%.) Without this anti-discrimination law, it is unlikely that any company would ever encourage its regular middle-class and lower-income workers to participate in their 401k plan. Companies' only real incentive to encourage their employees to participate is so that their highly-paid executives can also participate.
If your plan fails the test, expect your company to roll out some kind of new 401k education program designed to get the lower-compensated folks to contribute more.

Anonymous said...

My 401k contributions are currently capped at $9000/yr because of HCE rules. A year ago I did get a portion refunded, about $400, due to the company failing to meet the criteria. I try to supplement my retirement savings by funding an IRA, but that gives me $13000 max for the year vs $15000+. But honestly, I'm not complaining! This is one financial "problem" I don't mind having.

Fiz said...

As OoptiondUnarmed said, the rule is the group of people who are highly compensated employees (HCEs) can't contribute a percent of income more than 2% above non-HCEs. The limits are across all members of the HCE or non-HCE group, so to get the contribution percentage for HCEs add up all the HCE contributions divide by the sum of gross HCE compensation. Do the same of all of non-HCEs.

It's impossible to know in advance how much each employee is going to contribute. So there are many ways to correct over compensation by HCEs some options are the plan can refund the excess contributions from HCEs or cap HCE contributions at a low percentage. Both of these options reduce the benefits of 401k participants.

The best option for plan participants is for the company to contribute extra money for the non-HCEs to bring their average % of contribution at least up to 2% lower than HCEs. This extra payment should be small, since the non-HCEs don't earn much. The extra payment should be an equal percetange of each non-HCE compensation.

So if the calculation sais that HCEs contributed 11 percent as a group and non-HCEs only did 8.5, then the company could chip in .5% of salary for each non-HCE ($250 for some one making 50k). Compare that to refunding the excess contribution ($500 for someone making 100k).

The money to cover this cost could come out of annual bonus or what would be paid into a profit sharing plan.

This option is best for plan participants because it increases retirement savings for non-HCEs and allows HCEs to contribute upto the IRS limits.

Unfortunately this option for the company to pay extra needs to be written into the plan documents when the 401k plan is setup or modified.

Amy said...

In my company, HCEs do have a cap, I believe at 15% of income, but since HCEs make $100K or more, that 15% is moot because it is so close to the federal $15.5K cap.

Anonymous said...

I'm glad you're discussing this, as it is a hot topic for me.

I just learned that my company failed its anti-discrimination test, so I'm going to be refunded any contributions above 4% of my salary, PLUS any gains for 2007.

Since I come close to maxing out my 401(k), this means I will be getting back 10-12k or more, and I'll have to pay taxes on all of it. (If you do the math, and assume 31 years to retirement and a mythical average rate of 8%, this means I'll lose something like $118,000 of my final 401k retirement equity.)

Unfortunately, I'm not really an HCE from a salary perspective. My company is a start-up and we were able to exercise some of our stock options last year. They were counted as salary for purposes of the test (which is probably why we failed---a lot of non-HCE employees got options, which bumped them into the HCE bracket).

So I get the worst of both worlds: My contribution is limited to 4% of my salary...and since my salary is lower than most true HCE's, I'll only be allowed to contribute $3320 this year, compared to $15,500.

If any of your readers have any advice for me, I'd love to hear it. This seems spectacularly unfair, and I'd be interested in knowing if there are any remedies.

Anonymous said...

Jim Cramer...THE SOURCE ON his take on 401k plans....Great tip!