Guest Article

(From the April 19, 2004 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Letter Clarifies IRS Position on Issues Relating to Automatic Enrollment 401(k) Plans

---

The IRS has issued a general information letter to further explain its position on certain issues relating to automatic enrollment 401(k) and 403(b) plans. Among other things the general information letter indicates automatic enrollment plans can provide for scheduled increases to participants' automatic compensation reduction amounts, and that these plans can tie such increases to pay raises and bonuses. Employers might want to incorporate these types of features into their automatic enrollment plans to further challenge employee inertia, and to avoid sending their employees the wrong message about whether a particular level of retirement savings is adequate.

The IRS issued the general information letter to Mark Iwry, former Benefits Tax Counsel for the Treasury Department. The letter is a statement by the IRS that "calls attention to a wellestablished interpretation or principle of tax law without applying it to a specific set of facts."

Background

Fifteen percent of employers participating in Deloitte's 2003 Annual 401(k) Benchmarking Survey have plans with automatic enrollment features, and another 10 percent are considering adding automatic enrollment features to their plans. Those that offer automatic enrollment report their primary reason for doing so is to increase plan participation (43 percent), improve nondiscrimination testing results (28 percent), or encourage retirement savings (26 percent). The vast majority (97 percent) report being satisfied with their automatic enrollment features. Previous IRS guidance on automatic enrollment 401(k) and 403(b) plans-- i.e., Rev. Rul. 2000-8, 2000-1 C.B. 617; Rev. Rul. 2000-35, 2000-2 C.B. 138; and Prop. Treas. Reg. Sec. 1.401(k)- 1(a)(3)(ii)-- answered the basic questions about whether these arrangements satisfied the rules for "qualified cash or deferred arrangements" under IRC section 401(k) and "salary reduction agreements" under IRC section 403(b). Basically, IRS has said automatic enrollment arrangements do satisfy these requirements so long as the employee has an effective opportunity to opt out of the plan, or to make a different election. Among other things, this means the employer must give employees advance notice of the plan's automatic enrollment procedures and their rights under those procedures when they first become eligible to enroll, as well as annual notice of their compensation reduction percentages and their rights to change those percentages.

However, this guidance also raised a variety of questions that the IRS, until now, had left unanswered. For example, for purposes of analysis the revenue rulings use specific examples of automatic enrollment plans with default compensation reduction contributions of 3 percent and 4 percent. This led some to wonder whether the IRS's conclusions might change if an employer set a higher (or lower) default. (According to the Deloitte survey, 89 percent of plans with automatic enrollment features use a default compensation percentage of 1 to 3 percent.)

The general information letter responds to this by stating the default compensation reduction contribution "is permitted to be any percentage of compensation that would be permitted in the case of an elective contribution or elective deferral made pursuant to an affirmative, explicit election (i.e., in which the default is no elective contribution or elective deferral)." Furthermore, the letter notes the default compensation reduction contribution can be greater than the amount of elective contributions or elective deferrals eligible for employer matching contributions under the plan.

Can Plans Provide for Automatic Increases to Default Contribution?

A more significant question raised by the previous guidance is whether automatic enrollment plans can provide for scheduled increases to the default compensation reduction contribution. One criticism of automatic enrollment has been that employees tend to stick with the default compensation reduction percentage. The Deloitte survey indicates 71 percent of automatic enrollees stay with the default percentage during re-enrollment, while another 5 percent either reduce the percentage or opt-out of the plan.

This stagnation may be attributable to the same inertia that prevented employees from taking the initiative to enroll in the first place, or to employees believing they can't afford to save any more. Another possible explanatio n is that employees-- including those that affirmatively elect to enroll in the plan-- accept the default compensation reduction percentage as their employer's idea of an adequate savings level.

In order to combat these problems, some have suggested automatic enrollment plans should go a step farther and provide for automatic increases to the default automatic compensation reduction percentage. These automatic increases could be tied to a specific schedule, or to pay raises and bonuses. But again, because previous IRS guidance did not talk about these types of arrangements, some employers have been reluctant to implement such innovations.

The general information letter approves these types of automatic increases so long as they are disclosed in the various notices to employees about the automatic enrollment procedures. Specifically, the notices should disclose how these increases would work, including the amount and timing of the increase and how it would apply to any pay raises or bonuses, if applicable.

Other Automatic Enrollment Issues

The general information letter does not address the ERISA fiduciary issues raised by automatic enrollment arrangements. Nor does it address questions about whether such arrangements violate certain states' wage garnishment laws. Those issues are under the jurisdiction of the Department of Labor and the relevant states, respectively.

However, previous IRS guidance noted the Department of Labor's position that plan fiduciaries may not rely on ERISA section 404(c) to protect them against claims by automatic enrollees relating to the choice of investments because the enrollees have not exercised control over those choices. As a result, most employers that use automatic enrollment choose very conservative investments for the ir default options. According to the Deloitte survey, almost two-thirds (66 percent) use short-term, low risk options such as money market and stable value funds, while 30 percent use balanced funds.

---

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Tom Brisendine 202.879.5365, Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Mike Haberman 202.879.4963, Stephen LaGarde 202.879.5608, J. D. Lutz 202.879.5366, Bart Massey 202.220.2104, Diane McGowan 202.220.2077, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5324, Tom Veal 312.946.2595, or Deborah Walker 202.879.4955. Copyright 2004, Deloitte.

---

BenefitsLink is an independent national employee benefits information provider, not formally affiliated with the firms and companies who kindly provide much of the content and advertisements published on this Web site, including the article shown above.