Considerations for Adopting a Safe-Harbor Plan Design

The deadline for adopting a new safe-harbor 401(k) plan is October 1, and while it’s not likely to be met for employers that have not already moved to adopt one, information about the plan design will help employers plan for future years.

A plan without a safe-harbor is subject to average deferral percentage (ADP) and average contribution percentage (ACP) testing requirements, notes Jason Gross, Ubiquity Retirement + Savings’ director of National Sales and Development, based in Chicago.

In many cases, the average deferral percentage for non-highly compensated participants limits the amounts highly-compensated participants can contribute to a 401(k). “This can be problematic, especially with a small business,” Gross says.                 

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To remedy this, the Internal Revenue Service (IRS) allows for a safe-harbor plan design which requires committed employer contributions in exchange for eliminating nondiscrimination testing requirements. Steve Friedman, shareholder at Littler Mendelson and co-chair of the Employee Benefits Practice, based in New York City, adds that a requirement is that contributions employers make are fully vested the date they go into the plan.

Gross explains that, under the safe-harbor plan rules, plan sponsors could make a non-elective contribution equal to at least 3% of all compensation for all non-highly compensated employees eligible to participate, regardless of whether they made any elective deferrals. Alternatively, an employer could agree to provide a 100% match on employees’ effective contributions up to 3% of compensation, and a 50%-minimum match on employee elective contributions up to the next 2% of compensation. Gross says the latter is the most popular option.

Plan sponsors may also use an enhanced match formula of 100% of the first 4% of pay that is contributed to the plan (this is the minimum required under this option), and 100% of the first 6% of pay is the maximum allowed to still get a pass on the ACP test.

If plan sponsors get into a financial bind with the cost of offering these plans, the IRS has issued rules for relief.

Adopting a Safe-Harbor Plan

The deadline to adopt a new safe-harbor plan is October 1; the IRS requires the first plan year to be at least three months.

According to Gross, most plan sponsors adopting a new safe-harbor plan use a prototype document. They have to fill out certain features they want in the adoption agreement, and it has to be signed prior to October 1. Then a written notice must be delivered to participants before October 1. Deposits of contributions need to be made in October to get that three months of coverage.

According to Friedman, any employer can take advantage of the safe-harbor plan design, not just small employers. And, if a plan sponsor has an existing plan it wants to switch to a safe-harbor design, amendments would be required for matching and non-elective contribution sections and other sections as well. Plan sponsors may wish to restate their plans entirely. Gross adds that switches to safe-harbor plan designs need to happen as of the first day of the plan year, with a 30-day prior notice to plan participants.

The October 1 deadline is not likely to be met for employers that have not already moved to adopt a new safe-harbor plan, but Gross says plan sponsors can consider it for future years. “Small business owners are overwhelmed with their business and often something like this is on their to-do list but continues to be pushed down by other priorities,” he says. “It is important to get the word out about these plans so employers can start planning in advance.”

Benefits of Offering Safe-Harbor 401(k)s

Ubiquity’s focus is on small plans—traditionally fewer than 100 employees, and Gross says many plans it puts in place are brand new plans. He adds that many small businesses come with a tax problem after taking years to build their businesses, and a 401(k) is a primary form of retirement savings and tax relief. “There is a low-level of managing tax savings without a safe-harbor plan,” he says. “This is a key piece of our discussion with them.”

A study last year of the 2,767 small business 401(k) plans for which Employee Fiduciary provides Employee Retirement Income Security Act (ERISA) compliance services found 68% of plans use a safe-harbor 401(k) plan design to avoid annual ADP/ACP and top-heavy nondiscrimination testing. But, this is also an advantage to large plans.

According to Friedman, safe-harbor plan designs are important to a lot of employers because employers often have bad news to deliver to highly paid plan participants—namely that they cannot defer enough. The highly compensated often have their contributions curtailed and often matching contributions are forfeited due to failing nondiscrimination testing. “Safe-harbor plans allow highly paid people to make contributions they might not otherwise be able to make and to receive employer match,” he says.

“It seems as though they are becoming more popular as time goes on,” Friedman concludes. “Employers are looking to both retain employees and minimize problems with plan testing. Safe-harbor plans are very attractive to employees.”

What 403(b) Plan Sponsors Can Learn From Recent Lawsuits

Steps can be taken to prevent a lawsuit, establish defenses if a lawsuit arises and buy fiduciary protection.

Fiduciaries of 403(b) plans will have to pay extremely close attention to recordkeeping fees and investment options to avoid getting caught in a whirlwind of 403(b) lawsuits.  

The ongoing 403(b) plan litigation surrounding a handful of major universities has many plan sponsors wondering whether their institutions might be the next target. However, several steps can be taken to prevent a lawsuit—and to establish defenses in the event one arises.   

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David Kaleda, a principal in the fiduciary responsibility practice at Groom Law Group in Washington, D.C., tells PLANSPONSOR that now is a critical time for plan sponsors to review fiduciary governance structures and to make sure they know exactly who is a fiduciary to the plan.  

“It’s important you make sure you have good processes and procedures in place to minimize fiduciary risk, especially when it comes to investment selection and what’s paid to service providers,” says Kaleda. 

In fact, high-cost investments and excessive revenue sharing fees seem to lie at the heart of allegations drawn against these plans.  

Common accusations include offering expensive investment options when similar, low-fee options are available; offering higher cost share classes when lower priced shares for the same funds are available; allowing payment of excessive revenue sharing by offering investments proprietary to the recordkeeper or its affiliates; and allowing payment of overall excessive recordkeeper fees.  

For example, plaintiffs accuse Yale University and New York University of charging participants excessive fees because both plans use multiple recordkeepers. It’s important to note that nothing in the Employee Retirement Income Security Act (ERISA) requires a plan to have a sole recordkeeper.  

Still, it’s important for plan sponsors to know how revenue sharing works, who is getting paid, what they are getting paid, and weather those fees are reasonable and in the participants’ best interests.  

“Revenue sharing does not have to be inherently bad,” explains Kaleda. “Where fiduciaries have a problem is not understanding how much they are paying and what they are getting.” 

In the case of NYU, its Faculty Plan retains Vanguard and TIAA-CREF as recordkeepers, and it offers proprietary funds from both firms as investment options. Inclusion of one investment option required NYU to also maintain TIAA-CREF as a recordkeeper and offer another specific investment option. Plaintiffs argued that this breached fiduciary duty and “loyalty,” because it prevented fiduciaries from independently assessing the prudence of each investment.  

A federal judge dismissed most claims against NYU, and ruled this contractual arrangement on its own was not sufficient to support a breach of loyalty claim.  

The judge said that to make that case, plaintiffs would have to “allege plausible facts supporting an inference that the defendant acted for the purpose of providing benefits to itself or someone else.” In other words, plaintiffs could not prove that NYU retained these recordkeepers for the benefit of either party without first considering the participants’ best interests—a task that should be paramount to every fiduciary.  

The judge also dismissed claims that NYU breached fiduciary duty by offering higher-cost retail share classes of certain funds when lower-cost institutional share classes were available. Once again, nothing in ERISA requires plans to offer the cheapest share classes. But, everything involving fees charged to participants must be reviewed with the utmost scrutiny, for reasonableness.  

In NYU’s case, the judge noted that retail shares can offer participants certain advantages over institutional shares, such as a higher degree of liquidity. In this sense, the judge ruled it was not clear participants would gain from lower expense ratios at the expense of lower liquidity, so inclusion of institutional shares “does not always demonstrate an unwise choice.” 

“It’s not an automatic loss that you have retail share classes instead of institutional,” says Kaleda. “Where you have a problem is if you can’t justify why you had one or the other, particularly if it is more expensive.” 

Plaintiffs also argued the plan offered too many investment options—more than 100—which confused participants and diminished the plan’s bargaining power in securing cheaper investments. The judge noted that nothing in ERISA requires plans to limit investments, even if it enhances their ability to offer cheaper investments.  

Claims plaintiffs successfully argued, and how 

As fiduciaries under ERISA, plan sponsors must consistently “monitor and remove imprudent investments.” And whether fees are excessive or not is relative to the quality of services provided. 

For example, plaintiffs argued that NYU imprudently maintained investments in the CREF Stock Account and TIAA Real Estate Account. They demonstrated these funds had consistent 10-year track records of underperformance compared to similar, lower-cost funds. The judge ruled plaintiffs plausibly supported this claim. She also found their claims of excessive recordkeeping fees to be sufficient, because evidence demonstrated that experts in the recordkeeper industry found their administrative fees to far exceed those of similarly-sized and organized plans. 

Kaleda adds that annuities in particular have often come under fire in these lawsuits.  

“Plaintiffs in these cases seem to be biased against insurance as an investment option,” says Kaleda. “All we talk about these days is lifetime income protection, so there could be reasons to have annuity options. But the way these complaints are written suggests that you shouldn’t have these.” 

John Morahan, senior vice president of Risk Strategies Company in Chicago, tells PLANSPONSOR this may have to do with the complexity behind annuities. “I think that many of the employees don’t really understand these products,” he says. “And I don’t think they are explained properly, so that leaves fiduciaries at risk of breaching fiduciary duty to employees.” 

Considering projections of low returns for the long-term and reports of growing longevity risk, proper education around these products could benefit participants as well as fiduciaries. 

Nonetheless, even taking the most careful steps as a fiduciary won’t guarantee you’ll be spared from litigation. Here is where fiduciary liability insurance can pay off.  

Setting up the right defenses  

Fiduciary liability insurance is designed to protect insured parties against claims alleging the breach of their fiduciary duties to the plan or allegations that they committed errors in plan administration. And while having this type of insurance is common among large plans, protections and lack thereof can vary significantly from policy to policy. 

Morahan says plan sponsors should pay close attention to the wording around claims made against non-indemnifiable individuals. These would be fiduciaries who aren’t protected with potential reimbursement for losses by existing insurance policies governing the university.   

“Generally, there are limitations on a university’s ability to indemnify individuals found liable in shareholders’ derivative suits,” explains Morahan. “This means that insurance is the last line of defense. And if there is a $25,000 insurance deductible, individuals considered fiduciaries will need to pay this out of their assets.”  

However, plans with zero-dollar deductibles for non-indemnifiable claims are available.  

“As the litigation against these large universities works its way down to mid-size and smaller universities, these colleges may not have the money to buy the right kind of limits,” says Morahan. “It’s important that the fiduciaries facing non-indemnifiable claims have a zero dollar deductible so they won’t have to pay plan losses out of their own pockets.”  

Another area Morahan suggests scrutinizing is the language surrounding personal conduct exclusions. Some policies won’t help cover legal defenses against a specific claim such as one alleging dishonesty or fraud.  

“The language for these exclusions must be carefully reviewed and negotiated,” suggests Morahan. “The objective is to make sure the insurer defends the insured until there is a final non-appealable adjudication. Many insurers use language that allows them to exit the defense of litigation early.” 

Universities should also make sure they understand how the policy defines key terms like “insured,” who is protected under the policy; “wrongful act,” what will it protect and what won’t it protect; and “loss,” what has to happen for the plan to invoke coverage. In addition, it is key to make sure the right coverage limits are set. 

“Make sure the coverage amount is adequate,” suggests Kaleda. “Talk to an insurance broker and make sure it covers the right people.” 

This task will undoubtedly become more complicated as the Department of Labor’s fiduciary rule undergoes implementation, even as provisions are being challenged and the rule faces backlash from President Donald Trump. 

“A lot more providers that interact with your plan can become fiduciaries because of the rule,” says Kaleda. “So many interactions with a 403(b) plan are now investment advice. You might have people in your benefits department that inherently become fiduciaries if they’re not careful. Make sure that liability insurance policy is broad enough that it will cover incidents where people you didn’t think were fiduciaries became one.” 

“Plan sponsors need to pay better attention to who is managing their retirement options and making sure they are putting best practices in place,” Morahan concludes. “Pay attention to the fees embedded in these plans, know who is being paid what. And if you’re paying one provider differently than another, know why.” 

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