Like yoga practitioners, plan sponsors have more flexibility than they may realize when it comes to setting eligibility rules for 401(k) plan participants. Even though the Employee Retirement Income Security Act (ERISA) sets many plan eligibility rules, plan sponsors have leeway to meet the demands of the employment market. Here are some thoughts for plan sponsors to consider when determining plan enrollment.
A “Pose” of Generosity
ERISA does not dictate how generous employers can be regarding enrollment. If an employer wants to make all new hires eligible to participate and receive fully vested employer matches from day one, then it will not encounter any legal difficulties. There are, however, sound reasons that a company might not want to take that approach.
Generally, in a tight labor market, prospective employees expect competitive 401(k) benefits. For sponsors, turnover is lower, and plans are not urgently trying to minimize 401(k) expenses. In this scenario, plan sponsors may want to be more liberal with eligibility requirements.
Even if the employment market is not tight, some businesses have higher turnover rates than others. If an organization routinely experiences high turnover, then allowing new hires to immediately join the plan may lead to needless administrative effort, possible errors, and higher administrative costs. The plan sponsor could wind up having to either distribute many small 401(k) balances to participants who left within a year or maintain those legacy accounts until former participants request a rollover.
Peacefully Vesting and Matching Contributions
Flexibility with vesting rules can help plan sponsors who are focusing on limiting the hard costs of their 401(k) plans related to matching contributions. For example, sponsors can allow new employees to enroll and begin making their own contributions promptly but postpone the date on which they become entitled to take ownership of matching contributions.
Employers have two formulas to choose from if they wish to postpone the date when employees are fully entitled to keep the matching contributions:
- Cliff vesting formula. With this formula, employees are not vested in any matching contributions until they have completed three years of service. That is, they go from zero to 100% vested when they have been in the plan for three years.
- Graded vesting formula. When using this formula, a participant’s vesting status increases in 20% increments after his or her second year in the plan. Thus, the participant is 40% vested after three years, 60% after four years, 80% after five years, and 100% after six years in the plan.
Employers can be more liberal, but not more restrictive, with either of the vesting formulas. Furthermore, if an organization sponsors a safe harbor plan, then participants are automatically 100% vested in employer contributions. In addition, if an employer sponsors a Qualified Automatic Contribution Arrangement, then participants must be vested in employer matching contributions in two years.
Achieving Balance Between Instant and Controlled Enrollment
Many plan sponsors find a happy medium somewhere between immediate enrollment and highly restricted or delayed enrollment. ERISA restricts an employer’s ability to limit eligibility in multiple ways:
- Age restriction. Although a plan sponsor does not have to enroll employees below the age of 21, it cannot have an age requirement over such age. This limit may or may not have an impact, depending on workforce demographics. Many plans either have no age requirement or use age 18 as the minimum age.
- Delayed gratification. A plan sponsor can mandate employees to wait up to 18 months to enter the plan. They establish this rule by requiring employees to work at least 1,000 hours over the course of a 12-month period to gain eligibility. The plan then provides that, once eligibility is met, entry into the plan is the next semiannual entry date. For example, suppose an employer’s plan is a calendar-year plan. A company hires Jane on July 2, 2016, and she completes one year of service and the 1,000-hour requirement by July 2, 2017. She would enter the plan as of January 1, 2018.
- Category-based standard. Plan sponsors can assign different standards for exempt versus nonexempt employees. For example, an employer could set more generous eligibility rules for exempt employees than for nonexempt employees. The company might want to do so if the labor market is tight for the types of jobs that only its exempt employees hold.
However, the ability to establish these job classification distinctions is limited by the plan sponsor’s need to satisfy IRS coverage tests. These tests are designed to prevent discrimination against lower-paid workers. For example, the percentage of participating nonhighly compensated employees (NHCEs) cannot be less than 70% of the participation rate of highly compensated employees (HCEs). In addition, the average benefits received by NHCEs must equal at least 70% of benefits received by HCEs. The average benefits test also features a more subjective nondiscriminatory classification component.
Learn why performing annual benefit plan non-discrimination testing is critical for IRS and DOL compliance.
An employer can also create different eligibility rules for union and nonunion jobs. Those distinctions, like the delayed eligibility-timing tactic, are not subject to the minimum coverage tests.
Choose CRI as Your Plan Eligibility Rules “Yogi”
Restricting 401(k) plan participation eligibility is not for everyone. It is important to note that if new employees do not join the 401(k) plan early, then they might be less inclined to participate later when they are eligible. This could lead to problems with other discrimination tests, namely those comparing deferral rates of NHCEs to HCEs. Still, for some employers, a restrictive eligibility strategy may prove useful.
Whenever considering plan design options, it is important to work with experienced consultants who can advise you on the options available, as well as what may work best for your company given your objectives and employee demographics. Contact CRI for greater guidance on how to “stretch” the limits of your employee benefit plans to best serve your workforce.