For Automatic Enrollment, Congress Got It Right

New regulations make is easier for companies to implement automatic enrollment

Many of the sweeping changes made by the Pension Protection Act of 2006 (PPA) to the U.S. private retirement system affect the requirements for 401(k) plans. Requirements such as quarterly participant statements explaining the importance of diversifying investments bear little relation to the current 401(k) environment, in which most plans already provide quarterly statements, daily valuation, online account access with statements on demand, and access to investment education. However, some PPA changes have real value for 401(k) plan sponsors and administrators. The best examples of these changes are the new rules on automatic enrollment. 

How the PPA Benefits Automatic Enrollment Programs
Because of the obvious benefit of increasing employee participation, automatic enrollment has been growing in popularity since the IRS first approved the concept in 1998. However, unresolved compliance and prudence issues caused many plan sponsors and administrators to hesitate to implement automatic enrollment. The PPA addresses many of these questions and makes it possible for employers to implement an “eligible automatic contribution arrangement” with some confidence that it complies with applicable law. 

The PPA defines an “eligible automatic contribution arrangement” as an arrangement under an employer plan that:

• permits a participant to elect between contributions to the plan and cash payments;
• treats a participant as having made an election to contribute at a uniform rate unless he or she makes a specific election not to participate or to contribute at a different rate;
• provides for a default investment which complies with ERISA and the Department of Labor rules in the absence of a participant election; and
• meets the notice requirements described below.

Before the beginning of each plan year, an eligible automatic contribution arrangement must provide participating employees with a written notice that is sufficiently accurate and comprehensive to inform them of their rights and obligations and is written in a manner calculated to be understood by the average employee. The notice must explain the employee’s right to elect not to make contributions or to change the amount of the contributions and explain how the contributions will be invested in the absence of an election by the employee. It must also give the employee a reasonable amount of time to make an election before the first contribution is made. Unfortunately, the PPA does not explain what “sufficiently accurate and comprehensive” and “reasonable amount of time” mean under these circumstances, although it is anticipated that these terms will be defined by regulations. 

For plans that meet these basic requirements, the PPA provides guidance and relief in a number of areas. One major concern for plan sponsors who implement automatic enrollment has been that implementing an automatic salary reduction for participant contributions to a 401(k) plan might inadvertently violate a state law requiring affirmative consent by the employee to any salary withholding. The PPA resolves this issue by specifically preempting these state laws for purposes of eligible automatic contribution arrangements. While most of the automatic enrollment provisions are effective beginning in 2008, the preemption provision is effective immediately. 

The PPA also adds a new discrimination testing safe harbor for eligible automatic contribution arrangements meeting requirements similar to the existing 401(k) safe harbor. Under the safe harbor, contributions under an eligible automatic contribution arrangement will be deemed to comply with the ADP/ACP and top-heavy nondiscrimination tests if the arrangement provides for:

• automatic enrollment of all eligible employees;
• minimum automatic employee contributions of 3 percent for the first year, which increase by 1 percent per year up to 6 percent for the fourth and later years of participation (excluding current employees who have an existing election regarding participation);
• a maximum automatic employee contribution of no more than 10 percent;
• a minimum employer matching contribution for each non-highly compensated employee equal to the employee’s contributions up to 1 percent of compensation plus 50 percent of the employee’s additional contributions up to 6 percent of compensation or a minimum employer non-elective contribution for each non-highly compensated employee equal to 3 percent of compensation;
• 100 percent vesting in employer contributions after two years of service; and
• employees must receive notice before each plan year regarding the default investment (compliant with ERISA and the Department of Labor rules) and their right to opt out of the arrangement, elect a different contribution rate or investment option, and be given a reasonable period of time to make any changes.

PPA Also Offers Safe Harbor
It should be noted that the PPA safe harbor is provided in addition to the original 401(k) safe harbor plan design that has been available since 1999. Plan sponsors now have a choice of meeting one of the safe harbors or operating outside both safe harbors and conducting annual nondiscrimination tests. In choosing between the two safe harbor options, the following factors should be considered:

• The potential maximum employer matching contribution required for an individual participant under the PPA safe harbor is lower than under the original safe harbor (3.5 percent compared to 4.0 percent of compensation), which in theory could result in lower total employer contributions. In practice, however, any savings resulting from the lower individual matching contributions is likely to be offset by the increased employee participation resulting from automatic employee contributions.
• Under the PPA safe harbor, employees must be 100 percent vested in employer contributions after two years of service. In contrast, the original safe harbor requires immediate 100 percent vesting in employer contributions. For an employer with high turnover among employees with less than two years of service, the relaxed vesting requirement may result in substantial forfeitures under the plan that can be used to offset future contributions.

Conclusion
In addition to the new safe harbor from discrimination testing, the PPA provides special relief for eligible automatic employee contribution arrangements that do not fall under the safe harbor by providing a mechanism for returning “erroneous” contributions to employees providing an extended period for the return of excess participant contributions. Under the PPA, a plan may permit an employee who unintentionally begins participating in the plan through automatic employee contributions to elect to withdraw the erroneous contributions within 90 days after the first contribution. The withdrawn contributions are not considered for purposes of nondiscrimination tests, are not subject to the 10 percent penalty on premature distributions or similar restrictions, and are taxable to the employee in the year distributed. 

Any employer matching contributions related to the erroneous contributions will generally be forfeited by the employee. In addition to their positive impact on the plan’s discrimination tests, permitting the withdrawals eliminates the expense of providing ongoing recordkeeping and investment services for an account with only nominal value. 

The PPA also extends the deadline for returning excess participant contributions and earnings without an excise tax to six months after the end of the plan year for eligible automatic employee contribution arrangements (compared to the 2BD month deadline for other 401(k) plans). 

In contrast to many provisions of the PPA, the automatic enrollment rules described above are generally clear, provide meaningful guidance and actually work in the real world. In this case, Congress got it right.