Back-to-Basics: Average Deferral Percentage Test
January 20, 2004

Congress has devised several nondiscrimination tests in order to prevent qualified retirement plans from overly favoring highly compensated employees (HCEs). Keep in mind that the first test that must always be done is the coverage test, which will be the subject of a different article. Once the coverage test is passed or, if not passed, once the necessary steps have been taken to pass coverage, then the average deferral percentage (ADP) test must be performed. Both the coverage test and the ADP test use mathematical techniques to compare the participation and contribution rates of the HCEs to the nonhighly compensated employees (NHCEs) to determine whether the plan is discriminating in favor of the HCEs. 

Who is a Highly Compensated Employee?
Generally, a highly compensated employee is an employee who is either a more than 5% owner of the business (also known as a 5% owner) in the year of testing or the prior year, or someone who makes more than $80,000 in compensation in the prior year, as adjusted annually for cost-of-living increases (COLA). For 2003, the COLA adjusted limit is $90,000. It is further possible to limit the number of HCEs by compensation to the top 20% paid group, which may be a particularly effective tactic in small plans maintained by professional groups such as law firms and physicians.

Keep in mind that the 5% owner rule also requires careful review of the ownership attribution rules for families and trusts. In effect, certain family members are deemed through their relationship to share in the ownership interests of the 5%owner. The family relationships taken into consideration when determining attribution of ownership include spouse, parent, child and grandchild. An adopted child is also taken into consideration. Not included are siblings, grandparents and in-laws. An example of how this works is if the husband and wife each work for the firm and the husband is 100% owner of the firm; by the family attribution rules, the wife would also own 100% of the business and would thus, be a highly compensated employee owner because she would also be a more than 5% owner.

Performing the ADP Test

To perform the ADP test, first determine every employee who is eligible to make an elective deferral. It does not matter if the employee actually made a deferral, only whether the employee was eligible to defer. Once this is determined, the list is divided into HCEs and NHCEs. Starting with the NHCEs, each employee’s Actual Deferral Ratio (ADR) is determined by dividing the employee’s compensation into the amount the employee deferred into the plan. Employees who are eligible but did not defer are included in this calculation. Once each employee’s ADR is determined, the ADRs are averaged to arrive at the NHCEs’ ADP. Below is an example to illustrate this process:
 

For the HCEs, the same process is used to arrive at the HCEs’ ADP. Once both the NHCE and the HCE ADP figures have been determined, they are compared against each other. The HCEs’ ADP may only exceed the NHCEs’ ADP by specific limits. The limits may be summarized as follows:

Using our example in which the NHCEs’ ADP is 2.53%, the HCEs’ ADP is limited to 2.53% plus 2% for a maximum of 4.53%. 

Timing of the test
Generally, the ADP test must be completed within 2½ months after the end of the plan year. The test must be made using the entire year’s compensation and deferrals, and thus, cannot be completed before year-end. Timely completion of the test will permit the employer to make any refunds required to pass the test without the need for the employer to pay an excise tax penalty. Thus, it is in the interest of the employer and its recordkeepers to complete the test within 2½ months of year-end. 

That is the Big Picture of How the ADP Test Is Done.
There are a variety of additional factors to be taken into consideration when deciding which testing methods may lead to the most favorable result. These issues will be addressed in the next article.

Bill Grossman, QPA

Back-to-Basics: Average Deferral Percentage Test - Part Two
January 20, 2004

In our first article on the Average Deferral Percentage (ADP) Test, we discussed coverage testing, the definition of a Highly Compensated Employee (HCE), the ADP test calculations, the maximum limit for the HCE contributions and the timeframe for the test. There are several additional factors that may influence the results of the ADP test. These factors include the plan’s definition of compensation, whether the current or prior year testing method is used and whether the 20% top-paid group option is used to limit the number of HCEs. 

Definition of Compensation
The definition of compensation impacts the calculation of the average deferral ratios (ADRs).  The following issues need to be addressed when determining testing strategies: 
 

1. Does the definition of compensation for testing purposes that is selected by the employer include pre-tax contributions?  Effectively, is the employer using “gross” or “net” compensation for testing?

This choice may dramatically affect the ADR calculation.  For example, in a plan using a testing compensation definition that excludes pre-tax contributions, a participant with compensation of $50,000 who defers $5,000 will have an ADR of 11.11% ($5,000 divided by $45,000). If pre-tax contributions were included in the test, the ADR for this individual would be 10% ($5,000 divided by $50,000).

Note, if an individual earned over $212,000 in 2003, the net and gross options work the same for that individual. If using the net amount, it is $212,000 less $12,000 for a total of $200,000. If using gross, the $212,000 is limited by the compensation cap to $200,000. 

If the employer has a significant portion of its highly compensated employees earning over the compensation limit, the test results are usually better if the “net” definition of compensation is used.

2. In the year a participant enters the plan, what is the definition of compensation for the year of entry? Is compensation taken into account for the entire year or is it limited to the time the employee actually participated in the plan?

This will depend on plan design.  In general, if the compensation calculation period is defined as “plan year while a participant,” compensation included will be limited to that received while the individual was actually participating. This too will have a dramatic effect on the ADR calculation. For example, in a calendar year plan, if compensation is defined as that received while a participant (instead of an alternate definition such as the entire plan year, the calendar year or the employer’s fiscal year) an employee who earned $60,000 during the entire plan year but only entered the plan on July 1 would be limited to a half year’s compensation in the ADR calculation. If this participant deferred $3,000, the ADR would be 10% ($3,000 divided by $30,000). Had the plan defined compensation as that received during the entire plan year, the ADR would have been 5% ($3,000 divided by $60,000).

Since very few HCEs enter in the first year, using compensation while a participant will generally improve the testing results.

Who is a Highly Compensated Employee?
Generally, a highly compensated employee is an individual who is either in the current year or the prior year, a more than 5% owner (either directly or by family attribution) of the business or an employee who received compensation of more than $80,000 as adjusted, in the prior year (i.e., $90,000 in 2002). The law provides an alternative that allows an employer to limit the number of HCEs as determined by compensation to the top 20% paid group.  This may be a particularly effective tactic in small plans maintained by professional groups such as law firms and physicians where more than 20% of employees may be highly compensated.

How does the 20% top-paid group work? An example will make it clear.

Assume that a company has 30 eligible employees whose compensation, listed in descending order, is as follows:

Without the top 20% option, all 10 employees making over $90,000 would be considered HCEs.  However, if the top 20% election were made, only the top 20% would be considered HCEs; and therefore, in this example, instead of 10 HCEs, only the top 20%, or the top 6 individuals, would be considered HCEs. This eliminates 4 of the HCEs from the HCE average and adds them to the NHCE average for testing purposes. As those with higher incomes generally defer more income, this may result in an increase of the average deferral percentage of the NHCE group while lowering the HCE group percentage. 

Current Year Method vs Prior Year Method Testing.
Plan design allows the choice of whether to use either the current year or the prior year testing method for ADP testing. The prior year testing method uses the prior year NHCE’s ADP as the basis for the current year maximum ADP for the HCEs . This makes its easier for some plans to pass the ADP test because the HCEs already know what their maximum ADP level is. For example, in a calendar year plan using the prior year method for the 2003 plan year, if the NHCE’s ADP for 2002 was 3%, then the HCE’s ADP for 2003 could not exceed 5%.

If the current year testing method is used, the HCE’s will not know the actual NHCE’s ADP until after the end of the plan year being tested. Although the current year method has less certainty, there are advantages to its use, because the prior year method has a tendency to artificially depress the maximum amount that individual HCEs may defer. This is because the prior method is based on group averages and ignores individual decisions to defer or to not defer.  In addition, the current year method provides more flexible options for the employer in the event the plan was to fail ADP testing.

Note that a plan may shift from the prior year method to the current year method at any time. However, once the change from the prior year method to the current year method occurs, the plan may not return to prior year method testing for five years.

Bill Grossman, QPA