401(k) Plan Contributions: Keep Calm but Know Your Options

The coronavirus (COVID-10) pandemic has had adverse effects on many industries. Both employers and employees are seeking ways to respond to financial stress resulting from the economic slowdown and financial market volatility.

If your company’s revenue has plummeted, you might be considering eliminating or scaling back your contributions to employees’ 401(k) accounts. Here’s what you should know before making any cuts.

Without a Safe Harbor Plan

Generally, employers can stop contributing to employees’ 401(k) plans, but they must jump through some procedural hoops. If you don’t have a “safe harbour” plan and your plan document allows for suspending contributions, you’ve got some latitude.

Recall that the “storm” that you’re sheltered from in a safe harbour 401(k) plan is the kind of storm where you fail IRS discrimination tests. The tests’ purpose is to prevent an excessive proportion of the 401(k) plan’s benefits from going to business owners and executives, relative to everyone else.

Without a safe harbour plan, while you can drop your contributions easily enough, you’re still subject to discrimination testing — as you always were. Just be sure to comply with whatever notification and other requirements your plan document calls for.

Safe Harbor Rules

If your 401(k) uses a safe harbour design, it could get more complicated. Remember, that to get a safe harbour status, you had three plan design options:

1. To match what employees put into their accounts (the “deferral” amount) dollar-for-dollar up to 3% of their income, plus a 50% match on any savings amounts between 3% and 5%.

2. To provide an “enhanced match” that simplifies the first matching formula. An example of an enhanced match is 100% on deferrals up to 4% of the employee’s pay.

3. To offer “nonelective” contributions to employees’ accounts equal to at least 3% of their earnings, no matter what, if anything, they put in on their own.

If your safe harbour plan document already states that you reserve the right to suspend your contributions for any reason, you can do so in the middle of your plan year. However, you’ll be subject to discrimination testing.

If your plan document doesn’t include a mid-year suspension provision, IRS regulations allow you to drop (or reduce) contributions only if your business is losing money. In addition, for a mid-year suspension in this scenario, you need to amend your plan document accordingly and formally notify employees of this at least 30 days prior to taking any action.

If the safe harbour matching formula you’re using was the matching variety, employees must be given a chance to change their deferral amount. You must provide them with this opportunity even if they wouldn’t be allowed to make changes under the terms of your plan in normal circumstances. Your plan also will be subject to discrimination testing.

Monitor Plan Investments

Whether or not you decide to suspend 401(k) matching and nonelective contributions as a belt-tightening measure, you should still focus on other aspects of the plan. For example, you need to closely monitor how your plan investment options are performing.

Compare your plan’s performance with the objectives and strategies articulated by the fund managers when you decided to incorporate them into your plan. If you discover that they haven’t kept up with these expectations, you’ll need to consult with your advisors and respond appropriately.

With most investments tanking in the current environment, it’s natural for employees to be rattled. The degree to which they really should be alarmed will vary according to their circumstances. Many may take drastic action to escape the volatility when they’d probably be better off by just sitting tight. See “View Current Trend through a Historical Lens,” at right.

Right for You?

Desperate times sometimes call for desperate measures. Responsible employers want to do everything possible to help relieve their employees’ financial stress during the COVID-19 pandemic. But they also need to keep the business afloat — so employees have a place to return to work after the dust settles.

Cutting back on 401(k) contributions can temporarily free up cash flow to help businesses stay alive. To evaluate whether this could be a smart move for your business, contact your CPA or HR professional.

Employers shouldn’t give investment advice. But they can steer employees toward helpful guidance from authoritative sources. Much of that guidance recommends putting current nerve-wracking events in a historical context.

For example, a recent primer by Fidelity Investments titled “Bear Market Basics” listed vital statistics for every stock market peak-to-trough decline of at least 20% since 1929. A 20% drop is the common definition of a bear market.

Using the Standard & Poor (S&P) 500 as a proxy for the stock market, 16 bear markets have occurred since 1926. The average period it’s taken for markets to return to the prior peak is 22 months. The longest was 37 months from 1946 to 1949. The two shortest drops lasted only three months in 1990 and 2018.

In addition, the magnitude of bear market declines has varied from 86% in 1929 to 20% during the mini-crashes in 1990 and 2018. The average bear market decline has been 39%.

Where the stock market is headed from here is unpredictable. But another set of statistics in the “bear market basics” report is noteworthy. It shows that the stock market usually has risen at a fast pace (averaging 47% in the first 12 months of the periods measured) after it hits bottom.

The lesson? Investors who bailed out of bear markets on the way down need to be very good at predicting when precisely things will turn around. Otherwise, it may take them a lot longer to reverse some of their bear market losses, than if they had stayed put.