NONDISCRIMINATION SAFE HARBOR ALTERNATIVES FOR 403(b) AND 401(k) PLANS

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1 FOR ADMINISTRATOR USE ONLY. NOT FOR DISTRIBUTION TO EMPLOYEES. NONDISCRIMINATION SAFE HARBOR ALTERNATIVES FOR 403(b) AND 401(k) PLANS Retirement plans of private employers are subject to a variety of nondiscrimination requirements intended to ensure that the plans do not unduly favor highly compensated employees (HCEs). (For 2006 plan years, non-highly compensated employees (NHCEs) are defined as employees with compensation of less than $95,000 in the 2005 plan year.) For 403(b) matching plans, the 401(m) matching test [also known as the Average Contribution Percentage (ACP) Test] is generally the nondiscrimination test that poses a problem. This test generally compares the average employer matching and employee after-tax contributions made for HCEs with the average made for NHCEs. For 401(k) plans, both the ACP and Average Deferral Percentage (ADP) tests often pose difficulties. The ADP test generally compares the average employee elective deferral contributions made by HCEs (pretax and Roth, if permitted by the plan) with the average made by NHCEs. The ADP test does not apply to elective deferrals under a 403(b) plan. Since 1999, safe harbor alternatives to the ACP and ADP tests, created by the Small Business Job Protection Act of 1996 (SBJPA), have been available to 403(b) and 401(k) plans. Plans that meet the requirements of one of the SBJPA safe harbors are deemed to automatically meet the requirements of the ACP and ADP tests without actually having to conduct the tests. In plan years beginning after December 31, 2007, additional safe harbor alternatives to the ACP and ADP Tests created by the Pension Protection Act of 2006 (PPA) will also be available to 403(b) and 401(k) matching plans that adopt automatic enrollment features for their plans. SMALL BUSINESS JOB PROTECTION ACT OF 1996 ACP AND ADP SAFE HARBORS To qualify for one of the Small Business Job Protection Act of 1996 (SBJPA) design-based safe harbors, a plan subject to ACP and/or ADP testing must meet three basic requirements: Matching or nonelective employer contributions must conform to the requirements of one of the SBJPA safe harbor designs, Employees must be notified of their rights and obligations under the plan in a timely fashion, and A34390 (11/06)

2 SBJPA safe harbor provisions must be adopted by the first day of the plan year to which the provisions will apply. (Employers who wish to adopt the 3% nonelective safe harbor may do so as late as December of the plan year if certain additional requirements are satisfied.) If a plan meets these three basic requirements, but also allows employees to make after-tax contributions, those contributions will be subject to the ACP Test (even though pretax and employer matching contributions will not). In addition, the plan still needs to satisfy the 410(b) minimum coverage test. CONTRIBUTION REQUIREMENTS FOR THE SBJPA SAFE HARBORS. A plan can meet the SBJPA safe harbor contribution requirements through: a basic matching contribution formula, an enhanced matching contribution formula, or a nonelective employer contribution. There can be no requirement that participants work a specified number of hours in order to receive an allocation. Regardless of which of these designs is used, matching or nonelective employer contributions made to satisfy the safe harbor must be fully vested and nonforfeitable, and must not be distributed to employees younger than unless those employees separate from service, become disabled, or die. Employer contributions must be made on the basis of a uniform nondiscriminatory definition of compensation. (See below.) Allowing employees to designate some or all of their elective deferrals to the 401(k) or 403(b) plan as Roth after-tax contributions will not make a plan ineligible for the safe harbors. But plan sponsors are not required to permit Roth contributions to qualify for the safe harbors and plan sponsors cannot require participants to make their deferrals in the form of Roth contributions. BASIC MATCHING FORMULA. Under the SBJPA safe harbors basic formula, the plan must provide an employer match for any eligible NHCE equal to 100% of elective contributions of up to 3% of compensation and 50% of elective contributions between 3% and 5% of compensation. The rate of matching contributions for HCEs cannot be higher than the matching rate for NHCEs with the same rate of elective contributions. No other NONDISCRIMINATORY DEFINITION OF COMPENSATION To qualify for the SBJPA safe harbors, employer plan contributions must be made on the basis of a uniform nondiscriminatory definition of compensation. This requirement will be satisfied if the plan bases contributions on W-2 wages, regardless of whether those wages include pre-tax employee contributions to retirement, TDA, and Section 125 cafeteria plans. But any uniform definition of compensation can be used if it passes the Compensation-Ratio Test. To conduct the Compensation-Ratio Test, Calculate the ratio of plan formula compensation to total compensation (however defined) for each employee eligible for the plan; Calculate the average compensation ratio separately for HCEs and for NHCEs. The plan definition passes the Compensation-Ratio Test if the average for the HCEs does not exceed the average for the NHCEs by more than a de minimis amount. NONDISCRIMINATION SAFE HARBOR ALTERNATIVES FOR 403(b) AND 401(k) PLANS 2

3 SAMPLE MATCHING FORMULA PLANS Institution A has a contributory retirement plan to which employees can contribute up to 10% of compensation. The institution provides a 100% match on contributions up to 3% of compensation, and a 50% match on contributions between 3 and 5%. Employee 1 contributes 2% of compensation and receives a 2% employer match. Employee 2 contributes 4% of compensation and receives a 3.5% employer match (100% of the first 3% and 50% of the remaining 1%). Employee 3 contributes 10% and receives a 4% employer match (100% of the first 3%, and 50% of the next 2%). This plan satisfies the SBJPA s Basic Matching Formula requirement. If the plan provided a 200% match on contributions up to 3% of compensation, it would still satisfy the Enhanced Matching Formula requirement. Employee 1 would receive a 4% employer match on his 2% contribution; Employee 2 would receive a 6% employer match for her 4% contribution (200% of the first 3% and 0% of the remainder); and Employee 3 would receive a 6% employer match for his 10% contribution (200% of the first 3% and 0% of the remainder). matching contributions are allowed, but additional discretionary employer contributions are permitted. (See Discretionary Employer Contributions on Page 5.) ENHANCED MATCHING FORMULA. Under the SBJPA safe harbors enhanced formula, the plan contribution formula must provide employer matching contributions for NHCEs that are at least as generous as those NHCEs would have received under the Basic Matching Formula, at any rate of elective contribution under this formula. The rate of employer matching contributions cannot increase as the rate of elective contribution increases. No employer matching contributions can be provided for elective employee contributions in excess of 6% of compensation. HCE matching contributions cannot be higher than matching contributions for NHCEs with same rate of elective contribution. (See Sample Matching Formula Plans.) NONELECTIVE CONTRIBUTION REQUIREMENT. Under the SBJPA, as an alternative to using the Basic or Enhanced Matching Formula, a plan can provide nonelective (e.g., mandatory) employer contributions of at least 3% of compensation for each eligible NHCE. If nonelective contributions are made for NHCEs, the plan can match elective employee contributions up to 6% of compensation, provided the rate of match does not increase as the rate of elective deferral increases. No HCE can have a matching rate higher than any NHCE with the same elective contribution percentage. (See Sample Nonelective Contribution Plans on Page 4.) A plan can place certain restrictions on eligible employees rights to begin or cease participation or to change their contribution rate. At a minimum, however, eligible employees must be given a window period of at least 30 days prior to the beginning of each year to make or change elections. Employers can set a cap on elective contributions, but all employees must be allowed to contribute a high enough percentage of compensation to receive the maximum amount of employer matching contributions. If desired for purposes of administrative convenience, employers can require employee contributions to be whole percentages of pay (e.g., 2% as opposed to 2.1%) or whole dollar amounts. Employers can choose to match employee contributions on either an annual or a payroll-by-payroll basis. NONDISCRIMINATION SAFE HARBOR ALTERNATIVES FOR 403(b) AND 401(k) PLANS 3

4 SAMPLE NONELECTIVE CONTRIBUTION PLANS Institution B has a contributory retirement plan. All eligible NHCEs automatically receive a 3% employer contribution whether or not they elect to make any contributions of their own. The institution provides a 100% match on all HCE and NHCE elective contributions of up to 6% of compensation. Alternatively, this plan would satisfy the nonelective contribution requirement under the SBJPA safe harbors, if HCEs also received nonelective contributions, if the employer match was not 100% or if a higher matching rate applied to lower contribution rates, provided that: (1) the nonelective contributions were provided for all eligible NHCEs, (2) no matching contributions were provided for employee contributions exceeding 6% of compensation. NOTICE REQUIREMENTS INVESTMENT ADVICE. In addition to meeting contribution requirements, SBJPA safe harbor plans must meet notice requirements in order to qualify for exemption under the safe harbors. Generally, eligible employees must be notified annually of their rights and obligations under the plan at least 30 but not more than 90 days before the start of the plan year. Employees who become eligible for the plan during any given year must receive notice no more than 90 days before their date of eligibility. The notice must describe the contribution formula (including matching, nonelective, and discretionary employer contributions), and the conditions under which the contributions are made. The notice must also describe the type and amount of compensation that employees can contribute, and the timing and procedures for signing salary reduction agreements. Vesting and withdrawal provisions must also be described. A plan can use electronic media to satisfy the safe harbor notice requirement, provided the media chosen are reasonably accessible. The electronic notice must be no less understandable than the paper documents and employees must be informed that free printed copies of the notice are available on request. The safe harbor notice can cross-reference the Summary Plan Description (SPD) for certain information, but the notice itself must include explanations of: the plan contribution formula, its vesting provisions, the administrative requirements for making employee contributions, and the name, address, phone number, and, if applicable, the address of the individuals who can provide employees with plan information. NONDISCRIMINATION SAFE HARBOR ALTERNATIVES FOR 403(b) AND 401(k) PLANS 4

5 PLAN PROVISIONS. Generally, in order to take advantage of the SBJPA safe harbors for a given plan year, plan documents should be amended before the plan year begins, and the amendments should specify the safe harbor method the plan will use. The TIAA-CREF prototype 401(k) plan, which was amended and restated to include the SBJPA requirements, includes these safe harbors. Sample amendment language is available for the specimen 403(b) plans provided by TIAA-CREF. If the nonelective employer contribution method is used to satisfy safe harbor requirements, the amendment authorizing that method s use can be adopted as late as 30 days prior to the end of the plan year. Before the plan year begins, however, employees must be notified that such an amendment may be adopted; and they must also receive supplemental notice at least 30 days before the plan year ends that the amendment has been or will be adopted. Noncontributory plans amended during a given plan year may incorporate a safe harbor employer match on elective employee contributions for the first time. This provision enables the plans to take advantage of the safe harbors in that plan year and thereafter. Plans must be amended to reflect the employer match at least three months before the end of the plan year, and they must also meet the notice and contribution requirements. OTHER NONDISCRIMINATION REQUIREMENTS. Plans that meet the requirements of the SBJPA safe harbors are exempted from the ACP and ADP Tests but must still satisfy the Minimum Coverage Test as well as the nondiscriminatoryavailability-of-benefits-rights-and-features requirements of the General Nondiscrimination Test. As a rule, plans satisfy minimum coverage requirements if the percentage of NHCEs eligible for participation is at least seven-tenths of the percentage of eligible HCEs. Plans will satisfy the nondiscriminatory-availability-of-benefitsrights-and-features requirement of General Nondiscrimination if all eligible employees are eligible for the same benefits, rights, and features of the plan. HOW TO STOP TAKING ADVANTAGE OF SBJPA SAFE HARBORS. A plan that has adopted one of the SBJPA safe harbor methods may be amended to reduce or eliminate safe harbor employer matching or nonelective contributions after the amendment becomes effective. Employees must be notified of the change at least 30 days in advance, and must also be given a reasonable opportunity to cancel or modify their salary reduction agreements. Plan documents should be amended to provide that the ACP and/or ADP Test will be performed and satisfied for the entire plan year, using the current-year testing method. Furthermore, safe harbor requirements must be satisfied for the portion of the plan year preceding the amendment s effective date. DISCRETIONARY EMPLOYER CONTRIBUTIONS Employer matching contributions must be mandatory under the terms of the plan in order to satisfy the SBJPA safe harbor Basic or Enhanced Matching Formula requirements. Once these requirements have been met, however, the plan formula can provide for additional discretionary contributions. Employers can decide each year whether to make the additional discretionary contributions, and they are also free to determine how much they will contribute, but additional discretionary contributions cannot exceed 4% of any employee s compensation. NONDISCRIMINATION SAFE HARBOR ALTERNATIVES FOR 403(b) AND 401(k) PLANS 5

6 PENSION PROTECTION ACT OF 2006 AUTOMATIC ENROLLMENT SAFE HARBORS SBJPA safe harbor plans are considered particularly suited to smaller employers. But what about the specific needs of larger employers who are seeking to increase the number of employees who participate in their plans? Automatic enrollment (which is also referred to as negative election ) may be a good compromise. Under these arrangements, all eligible employees are automatically enrolled in the plan at a specified contribution rate and with contributions going into a default investment option selected by the plan sponsor. An employee can subsequently make an election to not participate, to contribute a different percentage of compensation to the plan and/or to transfer funds or change future contribution allocations from the default option to other investment options offered under the plan. Typically, automatic enrollment requires employees to have a predetermined percentage of their pay, usually 3%, deferred as soon as they become eligible for the plan, unless the employees affirmatively elect otherwise. Employers who are adding an automatic enrollment feature to an existing plan often apply the automatic enrollment policy only to new hires. Most automatic enrollment plans are used by employers who have experienced difficulty passing the ACP and/or ADP tests. Although automatic enrollment can often increase employee participation, it does not guarantee passing the ACP and ADP tests. But thanks to the Pension Protection Act of 2006 (PPA), starting in 2008, optional new safe harbors will ensure that qualifying automatic enrollment plans do satisfy the ACP and ADP test requirements. SAFE HARBOR INCENTIVE FOR QUALIFYING AUTOMATIC ENROLLMENT PLANS. Automatic enrollment plans that satisfy new safe harbor requirements established by the PPA are exempt from certain nondiscrimination requirements: Contributory 403(b) plans with automatic enrollment that satisfy PPA safe harbor requirements will be deemed to satisfy Average Contribution Percentage (ACP) Test requirements automatically without testing. 401(k) plans with automatic enrollment that satisfy the PPA safe harbor requirements will be deemed to satisfy Average Deferral Percentage (ADP), ACP, and Top-Heavy requirements without testing. These new safe harbors are in addition to the SBJPA Design-Based Safe Harbor alternatives to the ADP and ACP Tests described above. To qualify for the PPA safe harbors, automatic enrollment plans must provide an annual notice to employees providing information about the automatic enrollment provisions and about participants right to opt out of participation or to change their deferral percentage and/or investment allocations. And the plans will still need to satisfy the other nondiscrimination requirements as discussed under the SBJPA safe harbors on Page 5. DEFAULT EMPLOYEE CONTRIBUTION RATE. To qualify for the PPA safe harbors, the default automatic employee contribution rate, which will apply unless an employee opts out of participation or signs a voluntary salary reduction agreement with another contribution rate, must: be at least 3% in the first year of automatic participation, 4% in the second year, 5% in the third year and 6% in the fourth and subsequent years, but never exceed 10%. NONDISCRIMINATION SAFE HARBOR ALTERNATIVES FOR 403(b) AND 401(k) PLANS 6

7 REQUIRED EMPLOYER CONTRIBUTIONS. To qualify for a PPA safe harbor, an automatic enrollment plan must also meet one of the following requirements: Provide a nonelective employer contribution of at least 3% for all eligible NHCEs regardless of whether they have changed their contribution percentage or even if they have elected not to make any employee contributions at all. (If nonelective employer contributions are made for NHCEs, they can also be provided to HCEs.) Provide an employer match for all NHCEs equal to at least 100% for contributions of up to 1% of compensation and 50% for contributions between 1% and 6%. No match can be provided for employee contributions in excess of 6% of compensation and the employer matching percentage cannot be higher for any employee than for another employee with the same or a lower contribution percentage. (If matching contributions are provided for NHCEs, they can also be provided for HCEs.) Unlike the SBJPA safe harbors, the PPA safe harbors do not require immediate 100% vesting for all employer contributions But all employer contributions in a PPA enrollment safe harbor plan must be 100% vested within two years of automatic enrollment. C36941 A34390 (11/06)