Beyond COVID-19’s devastating impact on public health is its second order effects on the U.S. and world economy. Businesses of all sizes need to trim costs. An obvious place to start is with contributions to 401(k) and other tax-qualified retirement plans. An employer’s ability to reduce, suspend, or defer these types of contributions is determined by plan type and terms and applicable law and guidance. Generally, it should be possible to make prospective changes to reduce an employer’s contribution obligations. Doing so retroactively is more challenging. This post reviews the options for cost cutting available to employers under their defined contribution 401(k) and profit sharing plans.
Typically, a “401(k) profit sharing plan” calls for employee elective deferrals, an employer match of some sort, and employer discretionary contributions. The reference to 401(k) in the preceding sentence generally refers to a “cash-or-deferred” feature, which can be made a part of a profit-sharing plan. Plans that offer only employee elective deferrals, or employee deferrals and an employer match are often referred to as “401(k) plans.” While plans that also provide for discretionary or non-discretionary employer contributions are often referred to as “401(k) profit sharing plans.”
Tax qualified retirement plans are subject to a robust set of eligibility and coverage requirements with respect to which non-discrimination testing is required. Testing is based on either a handful of design-based safe harbors or a “general” test. The purpose of these testing rules is to ensure that the generous tax benefits that accompany these arrangements are not conferred only on “highly-compensated employees,” but are rather shared, at least in part, by rank-and-file employees, a/k/a “non-highly compensated employees.” While these testing rules do not require exact parity, they do ensure that the non-highly compensated employees are treated fairly.
401(k) plans, i.e., plans that enable and allow employee elective salary deferrals, add an additional lever of testing—actual deferral percentage (“ADP”) testing—which is designed to ensure that deferrals made by non-highly compensated employees do not lag too far behind their highly compensation counterparts. A similar test—actual contribution percentage (“ACP”) testing—applies to matching contributions. Employers can avoid the need to perform the ADP and ACP tests by adopting a safe harbor plan. Under a safe harbor plan, employers must either make an across-the-board employer contribution of at least 3% of compensation or make matching contributions based on an IRS-approved formula (e.g., 100% of the first 3% of compensation, plus 50% of the next 2% of compensation). A safe harbor also requires advance written notification to plan participants.
The Rules for Midyear Reduction, Suspension, or Deferral of Employer and Matching Contributions
As with any question related to an employer’s tax qualified retirement plans, one begins by asking, “what kind of plan is this,” and “what does the plan document say?” Here are some of the possibilities:
- Discretionary employer contributions under a profit-sharing plan
As the name suggests, discretionary contributions are made at the employer’s discretion. Employer discretionary contributions are usually announced by the employer (e.g., a board vote and an announcement by management). Both employer discretionary contributions and non-discretionary contributions (discussed below) are routinely made after the close of the plan year. Where the employer contribution is within the employer’s discretion, no action is needed from the employer by way of a plan amendment or otherwise. The employer can simply choose to not make a contribution or make a contribution in an amount less than it might have otherwise planned or intended.
It is not always this simple, however. In a 1997 technical advice memorandum (TAM 9735001), the IRS considered and opined on a participant’s right to receive a contribution under a defined contribution plan’s discretionary allocation formula once the participant has satisfied the plan’s allocation conditions. The condition in this case was a “last-day-of-the-year” requirement (i.e., an employee must be employed on the last day of the year in order to be eligible to receive a contribution). The plan in question had a pre-determined allocation formula for 1992, which the plan sponsor sought to change in early 1993. The IRS said that once a participant accrued the right to receive an allocation (i.e. on 12/31/1992, the last day of the year), the contribution cannot be revoked. Thus, even though the contribution was discretionary, it was no longer possible to invoke that discretion to change it.
Many practitioners read TAM 9735001 to say that if a plan has a “last-day-of-the-year” requirement the employer contribution can be modified at any time before the end of the plan year. While this position seems widely agreed on, it might be aggressive. The IRS has jurisdiction over the tax code, and it can prescribe rules governing the tax qualification. The TAM interpreted the Internal Revenue Code’s anti-cutback rule under which a plan amendment cannot decrease the accrued benefit of any plan participant. The Internal Revenue Code does not confer benefit rights. Nevertheless, since both the Internal Revenue Code and ERISA contain the anti-cutback rule, there is at least a rational basis for this position.
- Non-discretionary employer contributions under a profit-sharing plan
Non-discretionary employer contributions are hard-wired into a plan. For example, a plan document might specify a fixed annual contribution. Here, it should be a simple matter to cancel or suspend non-discretionary contributions going forward, without issue, through a prospective plan amendment.
- Non-safe harbor 401(k) employer matching contributions
Matching contributions are employer contributions which may be either non-discretionary or discretionary. But unlike employer contributions that are routinely made following the close of the plan year, matching contributions are often made payroll-by-payroll. Where this is the case, a retroactive amendment is not possible; but the match could be reduced or eliminated going forward. Plans that make matching contributions following the close of a plan year usually impose one or more conditions such as a last-day-of the-year requirement or a 1,000 hours-of-service requirement. Where this is the case, the considerations discussed above in connection with employer contributions apply here as well.
Non-discretionary matching contributions must be contributed to the plan and allocated to participant accounts to the extent earned. As with employer contributions, an employer should be able to amend a plan prospectively to reduce or eliminate a non-discretionary matching contribution with respect to contributions not yet earned. Whether a matching contribution is deemed earned when the employee makes an elective contribution that is tied to the match is matter of plan design (e.g., where the match is made each payroll period). But even in instances where the match is earned each payroll period, a plan may be amended prospectively to reduce or suspend matching contributions. Of course, where a matching contribution is discretionary, the employer can stop the contribution at any time.
One might ask whether, if the employer announces a specified level of matching contribution at the commencement of a plan year under a plan with a discretionary matching formula, the employer must provide that level of match. We think not, provided of course that the plan document and summary plan description are clear that the match is discretionary. ERISA requires that plans be “established and maintained pursuant to a written instrument.” Courts have generally read this requirement to mean that the plan document controls.
- Safe harbor 401(k) plan
The issue of the suspension of contributions, whether employer, matching or enhanced match, first came to the attention of plan sponsors and regulators in the wake of the economic downturn of 2008-2009. The safe harbor rules do not generally allow for changes during the plan year. The IRS has since issued final regulations under which safe harbor 401(k) plan contributions can be reduced or suspended. The rules govern both safe harbor matching contributions and safe harbor non-elective contributions.
The final regulations provide for the reduction or suspension of safe harbor matching contributions following a 30-day waiting period and conditioned on providing employees with a supplemental notice of the reduction or suspension of contributions. Affected participants must be provided advance opportunity to change their elective contributions. The plan must also be amended to make elective and matching contributions subject to ACP and ADP testing for the year, applying the current year testing method. Contributions may be reduced or suspended midyear if the employer is “operating at an economic loss” (which should be easily satisfied in light of the COVID-19 pandemic), or if the employer reserves the right to suspend or reduce contributions during the year in its safe harbor notice.
- Plan termination
Employers can terminate their 401(k) plans and thereby realize a savings. Of course, contributions would be required for employees who have already satisfied the requirements to receive them as of the termination date. The final regulations governing midyear changes to safe harbor 401(k) plans allow and provide rules governing midyear terminations of safe harbor plans. Also, under the successor plan rule, an employer that terminates a 401(k) plan and distributes assets to participants is generally barred from starting a new 401(k) plan within 12 months after the original plan is terminated. For this purpose, a plan is not considered terminated until all of the plan’s assets have been distributed.
- Partial plan termination
Any time there is a reduction in force, there is the prospect of a “partial termination” of a plan. Where a partial termination occurs, terminating participants become fully vested in their account balance based on employer and matching contributions. What constitutes a partial termination is based on the facts and circumstances, but a partial termination is generally deemed to occur if more than 20% of the plan participants are involuntary terminated.
The COVID-19 pandemic presents employers and employees with many daunting challenges. The need to cut costs will cause them to reconsider, among other things, their benefit plans, programs and arrangements—of which retirement plans are a piece. If an employer decides to modify or terminate one of more of its tax-qualified retirement plans, ERISA prescribes certain notice and other formal requirements, which employers should take care to follow.