New Law Encourages Automatic Enrollment To Help Employers Boost Participation in 401(k) Plans
There is significant concern that many employees will be financially unprepared for retirement. Unfortunately, many employees (particularly, non-highly compensated employees) do not elect to participate in their employer's 401(k) plan. It is believed that 401(k) plan participation would significantly increase if employees were automatically enrolled in the plan unless they opted-out, instead of having to opt-in by making an election to contribute. Under automatic enrollment, when an employee does not make a 401(k) plan election, a specified percentage of the employee's wages are withheld from his/her paycheck and contributed on a pre-tax basis to his/her account under the plan.
Many employers have been slow to adopt automatic enrollment because of state laws that prohibit wage withholding without an employee's consent and the risk of fiduciary liability resulting from investment losses attributable to an employee's automatic contributions to the plan. The recently enacted Pension Protection Act of 2006 ("PPA") addresses these issues. The PPA also creates an "automatic enrollment safe harbor plan" and changes some of the distribution rules that apply to all automatic enrollment plans, including automatic enrollment plans which do not qualify for the safe-harbor. As a result, there is likely to be increased interest in automatic enrollment 401(k) plans. This article summarizes the changes made by the PPA regarding automatic enrollment plans.
Pre-Emption of State Laws Prohibiting Wage Withholding. The PPA provides that ERISA pre-empts the provisions of state laws, such as the Maryland Wage Payment and Collection Act, which prohibit withholding from wages without an employee's written authorization, from applying to automatic enrollment provisions of a 401(k) plan if the plan provides employees with advance written notice that (a) describes the automatic enrollment feature, (b) gives employees the right to change the amount of the contribution or opt out of the automatic enrollment feature, (c) describes the time periods for making elections, and (d) describes how the contributions are invested in the absence of specific investment directions. Notice must be given within a "reasonable period" before the beginning of each plan year.
Protection Against Fiduciary Liability for Contributions Made Pursuant to Automatic Enrollment. As background, an employer has been able to minimize its exposure to fiduciary liability based on investment decisions made by participants by allowing participants to select their investments in a manner which complies with Section 404(c) of ERISA. To comply with Section 404(c), participants must be able to exercise control over their plan investments. At a minimum, they must (a) be provided with prospectuses and other information necessary to enable them to make informed investment decisions, (b) be able to change investments at least quarterly, and (c) have at least three investment options with materially different risk and return characteristics.
Employers have been concerned that Section 404(c) protection may not be available for contributions that are invested by the employer in a "default" investment fund (i.e. the investment selected by the plan sponsor if the employee does not designate an investment). Effective for plan years beginning after December 31, 2006, the PPA provides Section 404(c) fiduciary protection for default investments as long as they are invested in a "qualified default investment alternative" ("QDIA") and certain notice requirements are met.
The U.S. Department of Labor ("DOL") has issued proposed regulations interpreting the QDIA requirement and establishing detailed conditions that must be met for an employer to qualify for protection against fiduciary liability. The new default investment rule applies to all participant directed 401(k) plans - not only automatic enrollment plans. For example, it applies to an employee who forgets to select an investment for contributions he elected to make.
Many employers currently use a money market fund as their default fund. Employers with money market default funds should change to a QDIA to minimize their fiduciary liability.
The new rule does not provide complete fiduciary immunity to the employer. Employers are still responsible for the prudent selection and monitoring of all of the investment options available under the plan, including the QDIA.
Automatic Enrollment Safe Harbor Plan. As an additional incentive to encourage automatic enrollment, the PPA creates a new "safe harbor automatic enrollment 401(k) plan". Effective for plan years beginning in 2008, an automatic enrollment plan that satisfies the safe-harbor requirements is deemed to meet the Internal Revenue Code's ADP and ACP nondiscrimination requirements for elective contributions and matching contributions, respectively. This can result in a substantial savings of time and effort for the employer's HR department and can increase the amounts that highly compensated employees are permitted to contribute to the plans.
To meet the safe harbor requirements, a plan must set a minimum automatic contribution which must be at least 3% of compensation in the first year of each employee's participation, 4% in the second year, 5% in the third year and 6% (but not more than 10%) in any subsequent year. Employees must be permitted to opt-out of the automatic feature or contribute a different percentage to the plan.
Also, employers must make either (a) a 3% non-elective contribution to all eligible non-highly compensated employees, whether or not they opt-out or change the amount of their contributions, or (b) provide a matching contribution to all non-highly compensated employees equal to at least 100% of the first 1% of compensation contributed and 50% of contributions between 1% and 6% of compensation. All such employer contributions must vest within 2 years.
Newly hired employees must be notified in advance of the automatic enrollment feature and be given a "reasonable" period before the first contribution to opt-out or to change the amount of their contribution. In addition, annual notice of the automatic enrollment feature must be given to all participants at least 30 days, but not more than 90 days, before the beginning of each plan year. The annual notice must describe the automatic enrollment feature and similarly advise employees of the procedures for changing the amount of their contributions or ceasing contributions completely. It must also describe how the contributions will be invested in the absence of an investment election.
Additional Provisions Applicable to Automatic Enrollment Plans. The PPA liberalizes the early withdrawal rule for both safe harbor and non-safe harbor 401(k) plans. Employees can withdraw automatic enrollment contributions within 90 days of the date of the first deferral. Withdrawals are not subject to the 10% tax on distributions made before a participant attains age 59½ .
401(k) plans that fail the ADP and /or ACP test must distribute the excess contributions to highly compensated employees within 2½ months after the end of the plan year in order to avoid a 10% excise tax on the excess contributions. The PPA extends the period to six months for a non-safe harbor automatic enrollment plans. As noted above, safe harbor plans are exempt from ADP and ACP testing.
The PPA assists employers that want to increase their employees' participation in their 401(k) plans.