Using Eligibility Rules To Control Plan Enrollment

When To Be Generous

ERISA doesn’t dictate how generous you must be regarding enrollment. So if you want to make all new hires eligible to participate and receive fully vested employer matches from day one, you won’t encounter any legal difficulties. There are, however, sound reasons you might not want to take that approach.

Generally, prospective employees expect competitive 401(k) benefits. This is especially true in a tight labor market. From a sponsor’s perspective, turnover is lower and plans aren’t 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 isn’t tight, some industries and businesses have higher turnover rates than others. If you routinely experience high turnover, allowing new hires to join the plan right away may lead to burdensome administrative efforts, possible errors and higher overall administrative costs. One potential effect could be having to distribute many small 401(k) balances to participants who left within a year, or maintain those legacy accounts until former participants request a rollover.

Limits on Limits

Many plan sponsors end up somewhere between immediate enrollment and highly restricted or delayed enrollment. ERISA restricts your ability to limit eligibility in multiple ways:

Age restriction. You are not required to enroll employees below the age of 21, but you cannot have an age requirement that exceeds 21. This may or may not have an impact, depending on your workforce demographics. Many plans either have no age requirement or use age 18 as the minimum age.

Delayed gratification. It is possible to delay entrance to the plan for up to 18 months if the plan is designed properly. This is accomplished 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 your plan is a calendar year plan. You hire Joe Smith on July 2, 2016, and he completes one year of service and the 1,000 hour requirement by July 2, 2017, he would enter the plan as of January 1, 2018.

Category-based standard. Plan sponsors do not have to have the same set of standards for exempt and nonexempt employees. For example, you could set more generous eligibility rules for exempt employees than nonexempt employees. One reason you may want to do this would be if the labor market is tight for the types of jobs your exempt employees hold, but not your nonexempt employees.

However, your ability to establish these job classification distinctions is limited by your 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.

It is also possible for there to be different eligibility rules for union (collectively bargained) and nonunion jobs, and those distinctions, like the delayed eligibility timing tactic, aren’t subject to the minimum coverage tests.

Make the Choice

There are pros and cons to restrictions on eligibility for 401(k) plans. Plan sponsors should be aware that if new employees don’t get on the 401(k) bandwagon early, they might be less inclined to participate later when they’re eligible. This could lead to discrimination test failures, namely those comparing deferral rates of NHCEs to HCEs. Still, for some employers, a restrictive eligibility strategy may prove useful.

Sidebar: Vesting and Matching Contributions

If you’re focusing on reducing the costs of your 401(k) plan related to matching contributions, flexibility with vesting rules can help. For example, you can allow new employees to enroll and begin making their own contributions promptly, but postpone the date at which they become entitled to take ownership of any matching contributions.

You have two formulas to choose from if you wish to postpone the date when employees are fully entitled to keep the matching contributions:

  1. Cliff vesting formula. Using this formula, employees aren’t vested in any matching contributions until they’ve completed three years of service. That is, they go from zero to 100% vested when they’ve been in the plan for three years.
  2. Graded vesting formula. Using this formula, a participant’s vesting status increases in 20% increments, after the participant’s 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.
Years of Service Cliff Vesting Graded Vesting
1 0% 0%
2 0% 20%
3 100% 40%
4 100% 60%
5 100% 80%
6 100% 100%

You can be more liberal with either of the vesting formulas, but not more restrictive. Also, keep in mind that, if you sponsor a safe harbor plan, participants are automatically 100% vested in employer contributions. In addition, if you sponsor a Qualified Automatic Contribution Arrangement, participants must be vested in employer matching contributions in two years.

Whenever considering plan design options, it’s important to work with experienced professionals who can advise you on the options available, as well as what may work best for your company given your objectives and employee demographics.

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