Benefit Plan Simplification Changes (Highly Compensated Employees, 401(k) Participation Requirements)

The new bill makes a number of changes in employee benefit plan law intended to simplify plan operations. The two most significant concern the definition of highly compensated employees and the participation requirements for 401(k) plans.

• Highly Compensated Employees: The current definition of a highly compensated employee is very complex. The new definition, effective for plan years starting after December 31, 1996, is simple: a 5% owner at any time during the preceding year or an employee whose compensation for the preceding year was $80,000 or more, to be indexed for inflation. This provision is effective on enactment.
• Section 401(k) Changes: The 401(k) changes are more sweeping. Current law requires that 401(k) plans meet rules specifying that the average percentage of pay deferred by highly compensated employees cannot be more than 1.25 times the average percentage of everyone else. This ratio can be as high as two, however, if the absolute difference among the two groups is less than 2% (that is, 4% to 2% would work, but 6% to 3% would not). Effective for plan years starting after December 31, 1998, the new bill provides alternatives to meet these tests through company matching contributions. To simplify somewhat, a company can qualify its plan even if the above tests are not met through one of the following two methods:
  • It matches employee elective deferrals at 100% up to at least 3% of pay and matches at 50% at least for contributions between 3% and 5%. The matching contribution rate cannot be higher for highly compensated employees than for other employees.
  • The employer makes a contribution to all eligible participants, whether they make an elective deferral or not, of at least 3% of pay.

  The importance of this provision for employee ownership purposes is simply that many companies may now decide to enhance their match to qualify their plans and let highly compensated employees contribute more than under current law. One way to do this would be to combine an ESOP with a 401(k) plan and use stock contributions for the match, or simply to contribute company stock as the match.