Compliance Matters: Identifying Compensation Errors

A common operational defect occurs when employee benefit plans do not utilize the proper definition of “eligible compensation” when determining salary deferrals, matching contributions and employer discretionary contributions.

Wide-Ranging Definitions

The definition of “compensation” can be wide-ranging — covering everything from expense reimbursements and car allowances to bonuses, commissions and overtime pay. When the correct definition of compensation, as spelled out in the plan document, is not applied, the plan may experience inaccuracies in any or all of these key areas:

• Participant deferrals
• Employer matching contributions
• Discretionary employer contributions

As a result, an overstatement or understatement occurs in participant accounts — an operational error that must be corrected. In this case, the defect must be fixed and the participants’ account balances must be “made whole” as if the error never occurred.

How It Happens

Typically, compensation errors occur in one of two ways:

1. The original definition of compensation is not followed. Here, it could be as simple as plan administrators not reading the plan document to establish the proper compensation to be used. As a result, the payroll system is not properly set up initially and the error compounds through the system to record-keepers and third-party administrators.

2. The definition is changed and third-party administrators are not notified — or they fail to properly administer the change in compensation. Sometimes, the plan’s definition of compensation is amended but the proper service providers or personnel are not notified of the change. Or, the change is communicated, but the third party fails to make the update.

In either case, the correct plan definition of compensation is not used and deferrals and allocations are improperly calculated.

Fixing the Mistake

The good news is that the plan sponsor can correct these errors using the IRS Employee Plans Compliance Resolutions System (EPCRS). There are also Fix-it Guides available from the IRS for 401(k) plans and 403(b) plans.

When plans fail to follow the plan definition of compensation, they must correct for the improper amounts as follows:

Deferrals — If you’ve improperly determined elective deferrals and the participant deferred too much, give the participant a distribution of the excess amount plus earnings.

Allocations — If an improper allocation results in an under-contribution, make a corrective contribution, including earnings, for the affected participants. If there are improper profit-sharing allocations, forfeit and reallocate the allocations plus earnings to plan participants or put them in an unallocated account for later use.

Take Steps Now to Avoid Compensation Errors

Eligible compensation should be thoroughly defined by the plan document and cover the entire range of compensation, from W-2 wages and overtime to bonuses and fringe benefits.

To avoid errors with participant deferrals and employer contributions, perform annual reviews of the plan document. Then consider these additional best practices suggested by the IRS and Department of Labor:

• Provide proper training to the in-house personnel who determine compensation to ensure that they fully understand the plan documents definition of compensation.
• Consider simplifying your plan’s definition of compensation and use the same definition for multiple purposes.
• Know what your third-party administrators have agreed to provide by reading the service contract and, if applicable, the user control considerations contained in their SOC 1 report. Providers may be relying on you for information, such as compensation and deferral amounts they need to do their job correctly.
• Retain a copy of all service contracts and keep a summary of what’s being supplied to the plan by the third-party administrator, actuary or consultant. It’s a good idea to contact providers on an annual basis to ensure that you have the most current contract in hand. Keep the service contract and summary with the person responsible for maintaining all plan documents.
• If the plan document is amended, check the definitions against the old document, noting any differences. Have a centralized person or department responsible for maintaining all plan documents.
• Communicate any changes to the plan document to everyone involved in the plan’s operation. Plan sponsors should develop an internal communication mechanism to timely and accurately advise service providers of changes.

Using an incorrect definition of compensation in your retirement plan can lead to costly operational failures. For more information on how you can protect your plan’s qualified status, contact your BMF Advisor.