Considerations When Establishing a New 401(k) Plan or Migrating to a New 401(k) Provider

By: Shawn E. Lampron , Marshall Mort , Matthew Cantor

Establishing a new 401(k) plan or migrating to a new 401(k) provider is a complex process involving multiple stakeholders. Companies should expect up to four months between the commencement of the process until finalization and rollout of the new plan or completion of the transition.

In addition, this process invites government scrutiny, requires various filings, and (perhaps most importantly) creates ongoing administrative and fiduciary duties even after the plan has been successfully established.

This alert will (1) identify some key decision points in the 401(k) plan’s design and then (2) explain certain material ongoing obligations for those overseeing the 401(k) plan.

Plan Design Choices

1. Eligibility Criteria for 401(k) Participation:

Generally, 401(k) plans should limit eligibility to those persons who are common-law employees for tax reporting purposes. It is typically best practice to exclude the following individuals:

  • Leased employees; these are generally individuals hired on a substantially full-time basis from a third-party agency legally known as a leasing organization;
  • Persons who may later be reclassified as employees by a government agency or court; and
  • Foreign employees with no U.S. income or with limited U.S. income from short-term visas.

Note that recent law prohibits 401(k) plans from excluding long-term part-time employees (such as certain part-time and seasonal employees), but companies may decline to offer matching contributions to these individuals. Because the distinction between long-term and other part-time employees requires an ongoing monitoring burden, we recommend instead including all part-time employees under the plan.

In addition, it is crucial to exclude independent contractors; otherwise, the plan would be deemed to be a multiple employer plan and the 401(k) plan could be disqualified.

2. Definition of Plan Compensation:

The determination of which types of compensation are eligible for 401(k) employee contributions (and potentially an employer match) is a key decision point. Many standardized plan documents include total W-2 compensation in the plan’s definition of “compensation” by default. However, this may unintentionally cause certain benefits, such as car allowances and gains from exercise of non-statutory stock options, to be included in the definition of compensation.

If these benefits are then overlooked when determining plan contributions, this could result in missed 401(k) deferrals and matches. Corrective contributions from the company’s own assets may be required (including to make up for lost earning potential).

We recommend excluding the following from the 401(k) plan’s definition of compensation:

  • Income from stock acquisitions (e.g., option exercises or RSU settlements or payments resulting from cancellation of equity)
  • Sign-on, tenure, other ad hoc bonuses and gross-up payments
  • Fringe and/or health and welfare benefits that may be taxable or paid in cash
  • Post-termination pay such as bonuses, commissions and other trailing pay earned prior to termination of employment but paid following termination of employment
  • Advances on salary or bonuses subject to clawback (e.g., sign-on bonuses)
  • Unused vacation pay and other last-day severance payments

As each company’s compensation structure and elements can vary considerably, the company should coordinate any decisions regarding plan compensation by involving its HR, Benefits and Payroll Teams.

Please note that some 401(k) providers refuse to accommodate custom exclusions, which can make administering 401(k) contributions administratively burdensome. Amendments to eliminate certain benefits from the definition of compensation may only be made on a go-forward basis (not retroactively) and, in the case of safe harbor 401(k) plans, may only take effect once the next plan year begins.

3. Consider Limiting 401(k) Plan Loans:

While offering plan loans to active participants is a common practice, it can be a source of administrative complexity. Consider (i) restricting participants to one outstanding loan at a time, (ii) only allowing a new loan once the first plan loan has been repaid, and (iii) requiring all outstanding loans to be repaid upon termination of employment.

4. Avoid Installment and Annuity Payments; Automatically Roll Small Balances:

Consider simplifying plan administration by offering only lump sum cash payments to participants and beneficiaries rather than installments or annuity payments. When former employees do not otherwise elect a rollover or distribution, consider electing to automatically roll over small account balances (e.g., $5,000 or less) to an IRA.

5. Seek and Appoint Trained Professionals as Trustees and Investment Advisors:

a. Trustees: Companies will often engage a third-party financial institution as the trustee of the 401(k) plan in what is commonly known as a “directed” trustee relationship. The directed trustee retains fiduciary responsibility for holding the assets but acts at the direction of a plan fiduciary. Oftentimes, however, with respect to small plans, the 401(k) recordkeeping arrangement will require an officer of the company to retain full responsibility as an ERISA named trustee, and a separate arrangement will be set up with a financial institution acting as a custodian to merely hold the assets with the individual named as trustee retaining ERISA fiduciary responsibility. This type of arrangement should be avoided if possible as it can lead to the board and or other officers retaining co-fiduciary responsibility with the named trustee.

b. Investment Advisors: To shield the board and the named plan fiduciaries from liability, it is critical to appoint an investment advisor as either an ERISA “3(21) advisor” or an ERISA “3(38) investment manager” with oversight responsibility with respect to the 401(k) plan. A “3(38) investment manager” is preferable to a 3(21) advisor since a 3(38) investment manager has heightened authority regarding investments without requiring prior approval of the board, 401(k) plan committee or other plan fiduciaries. As a result, the delegation of investment responsibility to a 3(38) investment manager more effectively shields the board and other plan fiduciaries from co-fiduciary liability. An investment policy statement between the company and the advisors is often helpful to delineate responsibilities and provide directional guidance to the advisors.

Those who oversee 401(k) plan functions and administrative choices are held to a high standard of conduct and should understand their responsibilities. The following are material ongoing obligations to keep in mind.

Ongoing Operational Burdens and Risks

1. Timing of Contributions:

The 401(k) plan contributions (including loan repayments) are due promptly upon payment of the underlying wages. Failure to do so is considered an indirect loan to the company and a prohibited transaction under the IRS and DOL requirements and can result in significant penalties. Failure to timely remit 401(k) contributions is one of the most common compliance failures flagged for 401(k) plans. Specific timing rules include:

  • For 401(k) plans with 100 or more participants, contributions are generally due within three business days and must be applied consistently. However, if the company is able to remit these amounts within one to two business days, then the earlier deposit date applies.
  • For smaller 401(k) plans, there is a safe harbor deposit deadline requiring contributions within seven business days.
  • A willful failure to accurately report the late remittance can be punishable by up to $100,000 or imprisonment up to 10 years.

2. Engaging an Independent Auditor:

Generally, a 401(k) plan that covers 100 or more participants on the first day of the plan year is required to engage an independent qualified public accountant specializing in 401(k) plan audits to examine and opine on the plan’s financial statements as part of the annual IRS Form 5500 reporting process. The headcount is determined by including all employees actively participating in the 401(k) plan, employees who are eligible to participate but do not elect to contribute, and terminated employees with account balances under the plan on the first day of the plan year.

Plans with fewer than 100 employees may be subject to special rules that require an audit.

For plan years beginning on or after January 1, 2023, the 100-participant threshold for exemption from the large plan audit requirement with respect to defined contribution plans (such as 401(k) plans) will be based upon the number of participants with account balances rather than merely eligible participants.

Failure to properly prepare and timely file an audit annually when required can result in significant penalties.

3. Routine Nondiscrimination Testing of Benefit Amounts:

401(k) plans that provide salary deferrals and employer contributions must pass nondiscrimination testing depending upon the plan’s design. There are three main nondiscrimination requirements:

  • The Top-Heavy Test: This test ensures that no more than 60% of the plan’s assets are credited to key employees. Notably, smaller plans are more likely to fail this test, often resulting in a costly minimum employer contribution of 3% of compensation to the plan accounts of non-key employees for the relevant year.
  • The ADP Test: This tests whether the salary deferrals of highly compensated employees are disproportionate to those made by non-highly compensated employees.
  • The ACP Test: This test is like the ADP test but tests employer-matching contributions rather than salary deferrals.

Many companies bypass the above three tests by selecting a “safe harbor plan.” Safe harbor plans require either (i) a minimum annual employer matching contribution or (ii) an employer contribution on behalf of all 401(k) participants, even those who do not make contributions (called a nonelective contribution, or “NEC”). This design is common with our start-up clients that may otherwise not be large enough to pass the nondiscrimination tests. The employer matching contribution is generally 4% on salary deferrals (e.g., 100% of the first 3% and 50% of the next 2% of salary deferrals) or 3% of compensation as an NEC. The employer contributions are fully vested when made, meaning that employees who leave the company can take these contributions with them immediately upon termination.

4. Coverage Testing:

All 401(k) plans (including safe harbor plans) must also pass minimum coverage testing annually, taking into account all employees that are part of the same group of related entities who do not participate in the plan being tested (known as testing on a “controlled group” basis). At its simplest, this test requires that the portion of the eligible non-highly compensated employees who participate in the plan must be no less than 70% of the portion of the eligible highly compensated employees who participate in the plan. Passing this ratio percentage test demonstrates that the plan does not disproportionately cover highly compensated employees. Failure to satisfy this test can result in costly employer contributions (in the amount required to pass the minimum coverage testing) or potentially plan disqualification.

5. Shielding the Compensation Committee From Liability:

Avoid delegating responsibilities for the 401(k) plan to the company’s compensation committee or individuals participating in the compensation committee. Instead, fiduciary functions should be delegated to individuals with the time, knowledge and experience to handle day-to-day administration and operation of 401(k) plans—typically a 401(k) plan committee.

  • Ensure that the compensation committee charter, the board resolutions and the 401(k) plan documentation do not name the compensation committee as the plan administrator or charge it with responsibility for either performing fiduciary functions and/or delegating fiduciary responsibility to individuals and/or a committee appointed by the compensation committee. Empowering the compensation committee with fiduciary oversight responsibilities with respect to a 401(k) plan can potentially result in the entire board and its members being held personally liable as ERISA co-fiduciaries in the event of a 401(k) plan litigation.
  • The entire board should retain sole responsibility to appoint and remove 401(k) plan committee members. This responsibility should not sit with the compensation committee. The board’s fiduciary responsibilities should be limited to this function and high-level monitoring of the actions taken by the 401(k) plan committee in fulfillment of the 401(k) plan committee’s duties. The board’s non-fiduciary responsibilities should be limited to making decisions from a business perspective, such as concerning plan design and the budget allocated to the plan.
  • Ensure that the various plan documents that address the delegation of fiduciary responsibility are clear and consistent. Inconsistent documentation can result in co-fiduciary liability of the board and/or its members for the actions or inactions of other plan fiduciaries.
  • The 401(k) committee should generally meet no less frequently than three (3) times a year to review the operation of the 401(k) plan and other fiduciary issues; however, a review of the plan’s investment lineup should occur at least four (4) times a year or more frequently depending on market volatility.
  • The 401(k) plan committee should consist of at least three (3) members. To avoid conflicts of interest between 401(k) plan participants and the company, the company’s in-house lawyer should be an observer at the committee meeting but generally not serve as a voting member. Ensure that the 401(k) committee members are indemnified for their actions taken in good faith and, if appropriate, ensure the company has fiduciary insurance policies to cover them. The plan’s required fidelity bond protects the plan from fraud or embezzlement but not the plan’s fiduciaries from actions or litigation alleging a fiduciary breach.

Pay attention to the amendment process of the 401(k) plan. Failing to follow the plan’s terms can potentially result in an ineffective amendment. It is generally recommended for the full board to retain amendment authority with respect to substantive changes and changes that result in material increased costs to the plan. As a best practice, the amendment authority of a 401(k) plan committee should be limited to approving ministerial changes.

6. Note Regarding Alternative Retirement Plans:

Please note regarding multiple employer 401(k) plans, such as a PEO sponsored plan or other pooled employer plan arrangement, and SIMPLE IRA or Simplified Employee Pension (“SEP” arrangements): These plans are subject to different IRC and ERISA rules from traditional single employer 401(k) plans. In particular, a SIMPLE IRA or a SEP cannot be maintained in the same controlled group of related entities as a traditional 401(k) plan. Maintaining these arrangements simultaneously can result in disqualification of the traditional 401(k) plan and the SIMPLE IRA or SEP.

401(k) plans are complex to establish and administer. If a company is not ready to take the steps to adopt a 401(k) plan, many states have voluntary or state-mandated retirement plans that the company may enroll their employees in for the interim until the company has the time and resources to adopt their own 401(k) plan or other retirement vehicle. These state plans require limited employer involvement and generally only accept employee after-tax Roth contributions and do not require nor allow employer contributions. California, for example, requires employers with one employee to adopt the CalSavers Plan if they have not adopted their own 401(k) plan or alternate retirement vehicle as approved under California law. Note: If the company decides not to adopt a 401(k), they should check the requirements in the states where they have employees to determine whether the company must enroll their employees in the state program; failure to enroll in mandatory state plans can result in penalties.

While 401(k) plans do involve administrative complexity and an investment of time on the part of management, they provide employees with a great opportunity to save and are a valuable benefit for attracting and retaining talent. 401(k) plans are widely used. Being aware of the fiduciary responsibilities and risks and the various plan design considerations can lead to a smoother transition for the company and greater employee satisfaction.

Fenwick can advise on the implementation or amendment of 401(k) plans, provide ongoing advice and recommendations regarding best practices, review service agreements with third-party providers and, if necessary, assist with corrections of operational errors.

For additional information, please contact Fenwick counsel Jane Piehler or partners Shawn E. Lampron, Marshall Mort and Matt Cantor.

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