Impact of plan design

So just what is an Average Deferral Percentage (ADP) test and its sister test the Average Contribution Percentage (ACP) test?

Before the introduction of the ADP test employers could structure the plan to benefit the "highly-compensated employees" HCE's and pretty much exclude the lower paid people called the “non-highly compensated” employees(non-HCE). There was no incentive for employers to encourage lower paid workers to contribute to the plan. The ADP test was to designed to provide that incentive. Basically the test says if you can't get enough of your working base to contribute to the plan in a meaningful way then you - the HCE's- won't be abe to contribute to the plan either. If the non-HCE employees didn’t participate in significant numbers and at a significant rate of savings then the HCE group would be restricted in the amount they could contribute to their own retirement account.

ADP looks at the average contribution rates of HCE's and compares that average deferral rate to that of the non-HCE participants. Generally speaking there can be a 2% difference in those average deferral rates. A difference of more than 2% means the plan fails this test. The ACP test requires a similar look at matching contributions assuming the employer makes matching contributions. Failing either of these tests generally results in the return of contributions to the HCE group and either return of or forfeiture of a portion of the matching contributions.

Working with these tests provides an example of the value of an experienced third party administrator (TPA). An initial failure of one or both of these tests doesn't have to be the last word on whether HCE's receive money back. Unfortunately, many TPA firms stop after the first pass of these tests and return money. A knowlegdeable TPA knows there are additional rules to apply that may ultimately result in the plan passing. We are personally aware of an employer that had tens of thousands of dollars returned to their HCE group where if the administrator performing the tests has taken a few extra steps not a penny would have needed to be returned. This plan was with a large well known company and the employer likely assumed their adminstrators knew what they were doing. So how would this employer have known there was a problem with these admintrative services? Had this employer worked with an advisor with a broad range of knowledge, an advisor that knows to ask about things like this the return of contributions could likely have been avoided.

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