Before 401(k) plans burst onto the employee benefit scene in the 1980s and traditional pension plans had not yet gone nearly extinct, there were profit-sharing plans. The purpose of these plans, as the name suggests, was to spread some of your profits around the workforce.
But as 401(k) plans emerged, they were often incorporated into an existing profit-sharing plan structure, which shares the same “defined contribution” plan format. That opened the door wider for employees to add to their retirement savings, as they do today.
Over time, old-school pensions started to fall by the wayside. As they did, employers began to counterbalance the termination of those pensions by committing themselves to make fixed formula-based contributions to employees’ 401(k) accounts, as annual contributions or as part of a matching formula. The role of a company’s profit in determining contribution amounts has faded since then.
The most recent survey by the Plan Sponsor Council of America (PSCA) indicates that only about 5% of plan sponsors match amounts set aside by employees on a discretionary basis and make no other contributions. Four percent make discretionary non-matching contributions exclusively. More employers use a combination of fixed and discretionary contributions.
Linking to Profits
There’s much to be said for tying discretionary contributions to profits. For starters, say you’ve had a bad year and belt-tightening is in order. Suspending contributions to your 401(k) plan, whether your basic formula is matching or otherwise, could help you conserve cash. On the flip side, there’s the underlying concept of the profit-sharing plan that pre-dated the 401(k): That is, profit-sharing plans demonstrate to employees that their collective efforts to bring financial success to the enterprise will be rewarded.
Keep in mind that with or without profits, if your profit-sharing plan is incorporated into a 401(k), employees will still be able to set aside a portion of their earnings, regardless of what you do.
There are different ways to structure a 401(k) with a profit-sharing component. Begin with deciding how much of your profits to allocate to the profit-sharing plan overall. For example, if you want to make a point to your employees about the degree of your commitment to the profit-sharing concept, you could establish a formula linked to your profits that would determine the amount.
Alternatively, you could make that determination entirely discretionary. Suppose you have a profitable year, but you know that you will be making heavy capital expenditures next year, and you need to accumulate some cash for that purpose. In that scenario, keeping your options open makes sense.
Divvying Up the Profit Pool
The next plan design decision is how profits that are set aside for the plan are to be divvied up among plan participants. The simplest method is to give everyone an amount based on a fixed percentage of their compensation.
Let’s say your profits allow you to contribute $100,000 over the next 12 months. Your annual payroll for full-time employees covered by the profit-sharing 401(k) is $2 million. Five percent of $2 million is $100,000, so you’d make contributions to each plan participant equal to 5% of their pay. Or you could contribute at that pace with each pay period if you’re confident you can afford that amount.
As it happens, 5% of payroll corresponds to the average employer contribution for all 401(k)s, according to the PSCA survey.
There are two other ways to go, however. And these alternative contribution formulas are available to you even if you don’t have a profit-sharing component. They offer a way, subject to discrimination testing limits, to steer a higher allocation of employer contributions to older or higher-earning employees.
One is called cross-testing. It involves splitting your workforce into two or more groups. A typical dividing line is highly compensated employees (HCEs) and business owners in one group, and everyone else in another. Different contribution percentages for each group are limited by a formula based on the proportion of the average benefit relative to the same calculation for the lower paid group.
It would allow, for example, a company with two HCEs, ages 50 and 45, in one group each earning $245,000 to contribute $49,000 to the profit-sharing retirement accounts of both HCEs (that is, a total of $98,000). And the company could contribute less than $8,000 for four non-HCE and younger employees combined. In this illustration, if a uniform contribution rate was used instead, the combined contribution to the lower paid group would be close to $25,000.
The other method, called an age-weighted formula, is similar to cross-testing but doesn’t involve creating distinct employee groups.
Using the alternative contribution formulas involves more number-crunching administrative work to ensure that they clear discrimination testing hurdles. Plus, some workforce demographic patterns lend themselves better than others to steering larger contributions to the more senior group. Still, assuming no philosophical objections, it might be worth investigating.
You may, in the end, decide to stick to a simpler, uniform percentage of compensation approach. If so, linking employer retirement plan contributions to your profits still allows for options. One downside to keep in mind, however, is that the less certain employees are that the company will be assisting them with their retirement savings, the less value they might assign to your 401(k) plan. And that may undermine their commitment to you.