One of the most common compliance challenges facing traditional 401(k) plans is failing the Actual Deferral Percentage (ADP) test. When this occurs, highly compensated employees (HCEs) may be required to receive refunds of excess contributions, which can be frustrating for both executives and the plan sponsor.
While refunds are the most common correction method, they are not always the most effective long-term solution. Fortunately, there are several plan design strategies that can significantly reduce the likelihood of future ADP testing failures. Understanding these options can help plan sponsors create a plan that balances compliance, participation, and expenses.
Understanding the ADP Test
The ADP test, required under Internal Revenue Code §401(k), compares the average deferral rate of highly compensated employees (HCEs) with the average deferral rate of non-highly compensated employees (NHCEs). In simple terms, the test ensures that the plan does not disproportionately benefit higher-paid employees. If NHCE participation or contribution rates are low, the amount that HCEs can defer may be limited.
Plan Design Options to Improve ADP Testing Results
Increase Participation Through Automatic Enrollment
One of the most effective ways to improve ADP testing results is to increase participation among non-highly compensated employees. Automatic enrollment often significantly improves participation rates and can dramatically increase the NHCE average deferral percentage. Higher NHCE participation generally increases the ADP test limit available to HCEs.
Common approaches include:
| Automatic Enrollment Design | Typical Default Rate |
| Basic auto-enrollment | 3%-6% |
| Automatic escalation | 1% annual increases |
| Target contribution level | 10%-15% over time |
Implement a Safe Harbor Plan Design
One of the most reliable ways to eliminate ADP testing entirely is to adopt a safe harbor 401(k) plan. Safe harbor plans allow HCEs to defer up to the annual IRS limit without regard to the ADP test if the employer provides a required contribution. Note that Safe Harbor plans must also satisfy notice and vesting requirements.
Common safe harbor formulas include:
| Safe Harbor Contribution Type | Amount |
| Basic match | 100% on first 3%, 50% on next 2% |
| Safe Harbor Contribution Type | Amount |
| Enhanced match | At least as generous as basic formula |
| Non-elective contribution | 3% of pay to all eligible employees |
Add a Qualified Automatic Contribution Arrangement (QACA)
A Qualified Automatic Contribution Arrangement (QACA) combines automatic enrollment with safe harbor contributions.
Benefits include:
- ADP and ACP testing relief
- Ability to apply two-year vesting on safe harbor contributions
- Automatic escalation provisions that increase savings rates over time
QACA plans can be particularly effective for employers seeking to encourage higher participation while maintaining cost control. Note that QACA plans must also satisfy notice requirements.
Add Employer Non-Elective Contributions
If a plan fails ADP testing, the employer can make Qualified Non-Elective Contributions (QNECs) to NHCEs to increase their average deferral percentage.
These contributions must:
- Be 100% vested
- Be subject to the same distribution restrictions as elective deferrals
- Be allocated only to non-highly compensated employees
QNECs can be used either retroactively to fix a failed test or proactively to support compliance going forward. This is typically not a very cost effective option, however, and is rarely recommended.
Use Targeted Matching Contributions
Employers may also redesign their matching formula to encourage greater participation among NHCEs.
Examples include:
| Strategy | Goal |
| Stretch match | Encourage higher savings rates |
| Lower threshold match | Encourage participation among lower earners |
| Tiered match structure | Reward higher contributions |
Consider a Safe Harbor Mid-Year Conversion
Recent regulatory guidance allows some plans to adopt safe harbor non-elective contributions mid-year, which can provide ADP relief even after the plan year has begun.
However, certain conditions apply, including:
- Increased contribution levels (typically 4% rather than 3%)
- Specific timing requirements
This option can be helpful when testing projections indicate a likely failure.
Strategic Considerations for Plan Sponsors
When evaluating ADP mitigation strategies, plan sponsors should consider several factors:
- Workforce demographics
- Employee participation patterns
- Employer contribution budget
- Executive deferral goals
- Administrative complexity
Often, the most effective solution is a combination of plan design changes rather than a single adjustment.
The Role of the Plan’s Advisor
A knowledgeable retirement plan advisor can help plan sponsors:
- Model ADP outcomes based on employee data
- Evaluate cost implications of different plan designs
- Implement strategies that improve participation and compliance
- Align plan design with the employer’s broader benefits strategy
- Thoughtfully and strategically communicate changes to the employees
Proactive plan design can help transform ADP testing from an annual compliance challenge into an opportunity to improve overall plan effectiveness.
Conclusion
ADP testing failures are common, but they are often a signal that the plan’s design may not be fully aligned with the workforce’s savings behavior. By thoughtfully adjusting plan design features such as automatic enrollment, employer contributions, or safe harbor structures – all supplemented by a robust employee education and guidance program – plan sponsors can improve compliance outcomes while helping build a better perception of the plan by employees.
Connect with our team at Twelve Points today to learn more.
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