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Guest Article

Deloitte logo

(From the October 2, 2006 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

The Pension Protection Act of 2006: A Closer Look at ... Automatic Enrollment

(Note: This is the first in a series of periodic articles that will examine the "rest" of the PPA.)

The Pension Protection Act ("PPA") [P.L. 109-280] originated as a single-employer defined benefit pension funding reform bill, but its enduring legacy might be the numerous provisions relating to 401(k) and other defined contribution plans. Among other noteworthy provisions are those intended to remove legal obstacles to, and create new incentives for, automatic enrollment 401(k) and 403(b) plans. And unlike other provisions of the PPA, the positive effects of some of the automatic enrollment provisions will be felt sooner rather than later. Just last week the Department of Labor issued proposed regulations on the PPA's special fiduciary protections for default investment elections under automatic enrollment arrangements, which take effect beginning in 2007.

Although the provisions discussed below generally apply both to 401(k) and 403(b) plans, for simplicity this article will refer only to 401(k) plans.

What Is Automatic Enrollment?

In order to participate in a 401(k) plan, employees usually must choose between receiving cash compensation and making pre-tax contributions (called "elective deferrals") to their employer's 401(k) plan. Most employers treat an employee's failure to make any election as a decision to take immediate cash compensation by default. The underlying assumption is that employees who do nothing have made a conscious choice not to participate. While that may be true in some cases, other explanations are plausible. For example, some employees are intimidated by making even basic saving and investment decisions. Others simply do not take the time to make an election when given the opportunity to do so.

And even in cases where the underlying assumption is correct (i.e., that non-electing employees would rather take the money now than later), there may be good reason to second-guess those employees' decisions. For example, some employees choose not to participate in their employers' 401(k) plans because they think they cannot afford to save. But these employees may not be aware that elective deferrals are pre-tax contributions and thus do not reduce take-home pay on a dollar-for-dollar basis, or that they may be eligible for a special federal tax credit that further offsets the cost of saving.

Whatever the reason, employees who do not participate in their employers' 401(k) plans are hurting themselves by forgoing the related tax advantages -- including tax-free earnings growth, a.k.a., "compounding on steroids" -- and employer matching contributions (if available). But they also might be forcing plan sponsors to restrict contributions by and on behalf of highly compensated employees so that the employer's 401(k) plans can satisfy the actual deferral percentage (ADP) and actual contribution percentage (ACP) nondiscrimination tests, and do not become "top heavy." Thus, employers who are concerned about their employees' retirement savings have a strong incentive to maximize 401(k) plan participation.

Unfortunately, a significant number of employees do not take advantage of the opportunity to participate in their employers' 401(k) plans. The average 401(k) plan participation rate is 75 percent, according to the 2005/2006 Edition of Deloitte Consulting LLP's Annual 401(k) Benchmarking Survey. Approximately one-third of plans surveyed reported participation rates of 70 percent or less, but nearly one-quarter (24 percent) said their participation rates are at least 91 percent.

Employers that want to increase their 401(k) plan participation rates have at least two options for approaching the problem. One is to change employee behavior, a sometimes daunting task. Another is to make employee inertia work in favor of plan participation, rather than against it. This second approach is what automatic enrollment is all about. Basically, employees who fail to make an affirmative election to not participate in their employers' 401(k) plans are automatically enrolled unless, and until, they affirmatively opt-out of those plans.

Deloitte Consulting's Annual 401(k) Benchmarking Survey found 79 percent of plans with automatic enrollment features report an increase in participation, with an average participation rate increase of 18 percent. But still only 23 percent of plans have an automatic enrollment feature, although another 29 percent are considering adding one. Why is automatic enrollment not universally available? There is no straightforward answer to that question, but some plan sponsors have been deterred so far by certain legal obstacles to automatic enrollment both in federal and state laws.

The first of these obstacles is ERISA's fiduciary standards. When employers automatically enroll employees in their 401(k) plans, they must determine how large these automatic enrollees' elective deferrals will be and how those elective deferrals will be invested. These default deferrals and investment elections should be written into the plan document. Nonetheless, those who implement default investment elections are ERISA fiduciaries with respect to those actions, and the ERISA ? 404(c) special fiduciary protections do not apply (if at all) until the automatic enrollees take steps to exercise control over their accounts. Concern about potential fiduciary liability forces employers who have adopted automatic enrollment arrangements to walk a tight line between default investment elections that are neither too conservative nor too aggressive. And it may be keeping some employers out of the automatic enrollment game altogether.

What is the default investment election for automatic enrollment?
  • Principal Preservation (stable value, money market, etc.) 41%
  • Balanced Fund 15%
  • Lifestyle/Target Retirement Date Fund 38%
  • Other 6%
  • Total 100%
Source: Deloitte Consulting LLP's Annual 401(k) Benchmarking Survey 2005/2006 Edition

The second legal obstacle is laws in some states that limit the ability of employers to garnish their employees' wages. Even though automatically enrolling employees in a 401(k) plan so they can begin saving for retirement is conceptually different from involuntarily diverting part of their salary to pay a judgment or other debt, some states' wage garnishment laws do not necessarily recognize the distinction. This is a significant problem for employers with employees in multiple states, because the basic nondiscrimination requirements for 401(k) and other tax-qualified retirement plans generally preclude plan sponsors from implementing automatic enrollment only for employees in certain states.

How Does the PPA Help?

The PPA addresses the fiduciary issue by establishing a default investment election safe harbor, and addresses the wage garnishment issue by amending ERISA to specifically preempt any state law "that would directly or indirectly prohibit or restrict" any automatic enrollment arrangement. The fiduciary protection is effective for plan years beginning after December 31, 2006, and the preemption provision is effective as of August 17, 2006 -- the date the PPA was enacted.

With respect to the fiduciary relief, the PPA amends ERISA ? 404(c) to specify that automatic enrollees will be treated as exercising control over their investments if the default investment election is consistent with Department of Labor (DOL) regulations. This means fiduciaries will not be responsible for any losses associated with investing automatic enrollees' contributions in accordance with the DOL's guidance. In keeping with the PPA's mandate for the DOL to issue regulations within six month of the bill's enactment, the DOL has just issued proposed regulations. 71 FR 56806 (September 27, 2006).

Under the proposed regulations, the special relief would be available only if fiduciaries invested automatic enrollees' assets in "qualified default investment alternatives" (QDIAs). A QDIA would be defined as an investment alternative that --

  • does not directly invest employee elective deferrals in employer stock;
  • does not impose financial penalties or otherwise restrict participants' abilities to transfer their holdings to other investment alternatives available under the plan;
  • is a registered mutual fund or managed by an investment manager;
  • is diversified so as to minimize the risk of large losses; and
  • is either --
    • a life-cycle, target-retirement date or similar product or portfolio that adjusts asset allocations and risk levels over time to reflect participants' ages, target retirement dates, or life expectancies;
    • a balanced fund, or similar product or portfolio that sets asset allocations to meet a "target level of risk appropriate for participants of the plan as a whole"; or
    • a managed account that adjusts asset allocations and risk levels over time to reflect the participant's age, target retirement date, or life expectancy with a goal of reducing risk as the participant ages.

In addition to the QDIA requirement, the safe harbor protection is available only if the following conditions are met:

  1. Automatic enrollees must have had the opportunity to direct their investments, but did not do so;
  2. At least 30 days before the initial investment, and at least 30 days before each subsequent plan year, automatic enrollees must be furnished a summary plan description (SPD), summary of material modification (SMM), or other notice meeting specific content requirements;
  3. Any material provided to the plan relating to an automatic enrollee's investment in a QDIA must be provided to the automatic enrollee;
  4. An automatic enrollee must be given the opportunity to transfer assets from the QDIA to any other investment alternatives available under the plan without financial penalty and no less frequently than once within any three month period;
  5. The plan must offer a "broad range of investment alternatives," as defined in the ERISA ? 404(c) regulations at DOL Reg. ? 2550.404c-1(b)(3) (basically, the plan must offer at least three investment alternatives, each of which is diversified and has materially different risk and return characteristics).

Significantly, this special fiduciary relief relating to default investment elections for automatic enrollees is available regardless of whether the plan at issue satisfies all the requirements for protection pursuant to ERISA ? 404(c).

But There Is More ...

In addition to clearing these legal barriers to automatic enrollment, the PPA addresses a possible administrative barrier to such arrangements and establishes new incentives for 401(k) plan sponsors to implement automatic enrollment arrangements. The administrative barrier relates to plan sponsors' concerns about automatic enrollees opting out of the plan after a short period of time, leaving behind small accounts to be administered.

To address this concern, the PPA creates a special rule permitting plans to distribute "erroneous automatic contributions" within 90 days of an automatic enrollee's first elective contribution. These corrective distributions will be treated as compensation, rather than as plan distributions. As a result, otherwise applicable withdrawal restrictions and the 10 percent penalty tax on early withdrawals will not apply. Also, these "erroneous automatic contributions" will not count for nondiscrimination testing purposes.

Incentives to Offer Automatic Enrollment Features

Finally, the PPA creates new incentives for employers to add automatic enrollment features to their 401(k) plans. Specifically, plans with automatic enrollment features that meet certain requirements -- so-called "qualified automatic enrollment features" -- will be treated as satisfying the ADP and ACP nondiscrimination tests. Also, the top-heavy rules will not apply to plans consisting solely of contributions made pursuant to qualified automatic enrollment features.

An automatic enrollment feature will be "qualified" only if it satisfies certain requirements relating to (1) automatic deferrals, (2) employer contributions, and (3) notices to employees. Specifically, plans must set their default deferral percentages for automatic enrollees at no less than three percent in the first year, four percent in the second year, five percent in the third year, and six percent in the fourth year and beyond, up to a maximum of ten percent. The default deferral percentages must apply universally to all eligible employees, meaning everyone eligible to participate in the arrangement except for those who became eligible before the automatic enrollment feature became "qualified."

Employer Contributions

The employer contribution requirement is a bit more complicated. It can be satisfied in either of two ways. One way is for the employer to make a three percent non-elective contribution on behalf of each non-highly compensated employee who is eligible to participate in the automatic enrollment feature. The other way is for the employer to make matching contributions to non-highly compensated employees on a dollar-for-dollar basis up to one percent of compensation, and then on a 50 cent per dollar basis up to six percent of compensation. Also, the matching contribution rate for highly compensated employees cannot exceed the rate for non-highly compensated employees.

If the plan makes matching contributions to satisfy the employer contribution requirement it will need to meet additional standards to be deemed to pass the ACP test. Specifically --

  • matching contributions may not be provided with respect to elective deferrals exceeding six percent of compensation;
  • the rate of matching contributions may not increase as the rate of an employee's elective deferrals increase; and
  • the rate of matching contribution with respect to any rate of elective deferral by a highly compensated employee is no greater than the rate of matching contribution with respect to the same rate of elective deferral by a non-highly compensated employee.

Whether the employer chooses the non-elective or matching contribution options to satisfy the contribution requirement, the employer's contributions must become 100 percent vested after no more than two years of service. Also, these employer contributions will be subject to the same withdrawal restrictions as apply to employee elective deferrals.

Finally, in order to satisfy the notice requirement, employers must give each employee eligible to participate in the automatic enrollment feature a notice that explains --

  1. the employee's right to elect not to make elective deferrals, and to elect a different rate of elective deferral than the default deferral rate; and
  2. how the employee's elective deferrals will be invested if he or she fails to make an investment election.

After receiving the notice employees must have a "reasonable period of time" before the first elective deferral contribution to make an affirmative election with respect to contributions and investments.

These special incentives, including the corrective distribution rules, are effective for plan years beginning after December 31, 2007.

Deloitte logoThe information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations.

If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608 , Bart Massey 202.220.2104, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Carlisle Toppin 202.220.2067, Tom Veal 312.946.2595, Deborah Walker 202.879.4955.

Copyright 2006, Deloitte.

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