The risks and rewards of sec. 401(k) plan negative elections.

Sec. 401 (k) plan sponsors can automatically enroll employees on eligibility. Why should an employer do this? To increase the plan contributions that can be made by highly compensated employees. But, as this article shows, there are a number of related issues to consider, including Employee Retirement Income Security Act of 1974 and state law concerns.

One of the most interesting recent developments in Sec. 401(k) plan design has been the introduction of the so-called "negative election" or automatic enrollment of plan participants. In contrast to the traditional method of requiring an employee to elect to participate in an employer-sponsored Sec. 401(k) plan, several public companies have redesigned their plans to automatically enroll eligible employees. The employees are deemed to have elected to defer a specified percentage of compensation (often 1% to 3%), unless they affirmatively elect not to participate or elect a different deferral percentage. In some cases, the employer directs how automatic contributions will be invested; in other cases, the employer designates a conservative investment choice (e.g., money market fund) for the initial investment and the employee can change the investment selection later.

McDonald's was one of the first large, publicly traded companies to use negative elections. Other companies, including J.C. Penney, Hewlett-Packard, Motorola, Venator Group, Inc. (formerly Woolworth Corporation) and the Federal Home Loan Mortgage Corporation (Freddie Mac) have also taken this approach.(1) The Clinton Administration recently endorsed this technique to increase employee participation in retirement savings plans and the national savings rate in general.(2) Until recently, however, neither the IRS nor the Department of Labor (DOL) had issued formal guidance on negative elections. Employers and their advisers were concerned that, because participants in a negative election Sec. 401(k) plan do not affirmatively elect between receiving cash and having contributions made to the plan on their behalf, negative elections might cause plan contributions to fail as elective deferrals under Regs. Sec. 1.401(k)-1(g)(3); this would cause the plan to fail as a qualified cash or deferred arrangement.

The Service recently addressed these concerns in Rev. Rul. 98-30,(3) concluding that when employees have the opportunity to elect out of the automatic deferral provisions, contributions made under a negative election will not fail to be considered elective deferrals. With the issuance of this ruling, more U.S. employers will likely wish to consider using negative elections to increase employee participation in their Sec. 401(k) plans.

Benefits of Negative Elections

Helping Employees Save for Retirement

Negative elections encourage employees to save for retirement via the employer's Sec. 401(k) plan. Employees who would not voluntarily elect to defer a portion of their pay into retirement savings often receive psychological encouragement to continue (and even increase) their rate of retirement savings when their account balance is growing. For example, Freddie Mac has found that approximately 30% of its automatically enrolled employees have increased their deferral rates. While approximately 65% have kept their deferrals at the automatic 3% level prescribed by the plan, only 4% have opted out of participation. The plan's participation rate has increased from 81% to 83% and is expected to continue to increase over time with employee turnover.(4)

An employer that wishes to further increase the incentive for employee participation might also consider two other plan design issues. First, an employer might reduce the eligibility period from one year to three to six months; some employers have eliminated the eligibility period entirely. While reducing or eliminating the eligibility period may result in some additional administrative costs if the employer has high employee turnover, it will generally increase plan participation.

In addition, an employer might consider adding a matching contribution feature or making an existing match more generous. For example, an employer that makes a 3% automatic contribution might include a matching contribution of 50% of the first 6% of deferred compensation; the effect would be an additional 4.5% of compensation being added to the employee's account under the plan. The additional employer contribution is likely to have a significant effect on employee participation; when combined with a negative election program, it will likely increase the rate of employee retirement savings significantly.

Helping a Plan Pass the ADP Test

Perhaps more importantly, negative elections make it easier for a plan to meet the Code's qualification requirements, including the actual deferral percentage (ADP) test and the average contribution percentage (ACP) test. The Sec. 401(k)(3)(A)(ii)ADP test compares the average percentage of compensation deferred by eligible highly compensated employees (HCEs) with the average percentage deferred by eligible nonhighly compensated employees (non-HCEs). The Sec. 401 (m) ACP test compares the average percentage of compensation added to non-HCEs' accounts as matching and voluntary after-tax employee contributions with the average percentage of compensation added to HCEs' accounts as such contributions. Both tests prevent a plan from discriminating in favor of HCEs.

For purposes of the ADP and ACP tests, an HCE is defined by Secs. 414(q)(2) and 416(i)(1 (B)(i) as any employee who (at any time during the year or preceding year) was a 5% owner (i.e., owned more than 5% of the outstanding stock, capital or profits interest of the employer or was related to a 5% owner) or who (for the preceding year) had compensation from the employer in excess of $80,000 (as indexed for inflation); the employer may elect to include all employees whose compensation exceeded $80,000 for the preceding year, or only those among the top 20% of employees in compensation for the preceding year. All employees who are not HCEs are non-HCEs.

Regs. Sec. 1.401(k)-1(g)(1)(i) defines the ADP for a group of employees as the average of the actual deferral ratios of each of the employees in the group. Under Regs. Sec. 1.401(k)-1 (g)(1)(ii)(A), an employee's actual deferral ratio is determined by dividing his elective contributions for the plan year by his compensation for the plan year. A plan may satisfy the ADP test by meeting one of two tests set forth in Sec. 401(k)(3)(A)(ii) A plan meets the test for a given plan year if: 1. The ADP for the HCE group for the plan year is not more than 1.25 times the ADP for the non-HCE group for the preceding plan year. 2. The excess of the ADP for the HCE group for the plan year over that of the non-HCE group for the preceding plan year is not more than 2%, and the ADP for the HCE group for the plan year is not more than two times the ADP for the non-HCE group for the preceding plan year. Most plans use this test.

If a plan does not pass the ADP test for a given plan year, under Regs. Sec. 1.401(k)-1(f), (1) the plan must make corrective distributions to the HCEs to bring their ADP ratio into compliance with the tests, (2) the plan sponsor may elect to recharacterize some of the excess contributions as after-tax employee contributions (resulting in additional taxable income to HCEs), (3) the plan sponsor may make additional contributions to the plan that are allocated to non-HCE accounts as qualified non-elective contributions and/or qualified matching contributions or (4) some combination of these techniques may be used.(5) Each of these correction methods has costs and requires varying degrees of administrative effort on the plan sponsor's part.

Prior to 1996, non-HCE data from the current plan year was used to calculate the ADP ratio. As a result, the plan sponsor and the HCEs did not know until the end of the plan year whether the plan would pass the ADP test for that year. Section 1433(c)(1) of the Small Business Job Protection Act of 1996 (SBJPA) amended Sec. 401(k) to provide that the calculation of the ADP ratio for non-HCEs be based on information from the preceding plan year. However, an employer may elect to continue to use the pre-SBJPA method of calculating these ratios using current-year data, according to Sec. 401 (k)(3)(A), flush language; there may be times when this method is preferable. For example, if the non-HCE ADP is increasing (as would be expected for a plan that implements negative elections), using the prior-year's data will result in a delay in implementing the benefits of that increase.

In contrast, using the current-year's data to calculate the non-HCE ADP ratio will allow the plan to take advantage of these increases immediately. However, using the current-year's data will result in somewhat higher administrative costs and will not provide the same degree of certainty as to the amount HCEs can contribute in a given year. In addition, a plan that elects to use current-year data in calculating these ratios cannot elect to change to the new method and use prior-year data until it has used the current-year method for each of the five plan years preceding the year of the change (or the number of years the plan has been in existence, if less than five years).(6) A plan sponsor needs to consider this time limit in deciding whether to elect to use current-year data.

Using negative elections tends to increase participation (and, therefore, the actual deferral ratios) of the non-HCEs; increasing their actual deferral ratios will increase the ADP of the non-HCE group, making it easier for the plan to pass the ADP test. (See Example 1, below.)

Example 1: XYZ Corp., a small company, has four employees: A and B, each with annual compensation of $100,000, and S and T, each with annual compensation of $10,000. A and B are HCEs; each elects to defer $7,500 into XYZ's Sec. 401(k) plan for the current plan year. S and T are non-HCEs; S elected to defer $1,000 and T elected not to defer any of her compensation in the prior plan year. XYZ's plan provides for a matching contribution of 50% of the first 6% of compensation deferred; XYZ did not make an election to use the non-HCE data for the current plan year in calculating the ADP ratio. Under these facts, the ADP for each group of XYZ employees is computed as follows:

                            HCEs                Non-HCEs

                       A            B          S         T

Compensation        $100,000     $100,000    $10,000   $10,000
Deferral              $7,500       $7,500     $1,000        $0
Actual deferral         7.5%         7.5%       10%        0%
 ratio
Average actual              7.5%                   5%
 deferral ratio

The ADP for the HCE group cannot exceed 7% (5% + .2%); thus, the plan does not meet the ADP test. Under the first ADP test (1.25 x the non-HCE ADP), the ADP for the HCE group would be even more limited; it cannot exceed 6.25%.

However, if XYZ implemented a negative election plan design and automatically enrolled all participants with an automatic contribution level of 3% of compensation, T's actual deferral ratio would increase to 3% (assuming she did not opt out of p), and the ADP for the non-HCE group would increase to 6.5% (assuming S continued to defer $1,000). Because 7.5% (the ADP for the HCE group) does not exceed 8.5% (6.5% + 2%), the plan would satisfy the ADP test for that plan year.

Allowing HCEs to Increase Contributions

Viewed another way, the non-HCE ADP serves as an upper limit on the amount the HCE group may defer for a given year. In Example 1, before implementing negative elections, the HCEs would have been limited to an ADP of 7% of their compensation (5% + 2%); an ADP for the HCE group in excess of 7% would violate the ADP test. After implementing negative elections, however, the HCEs could defer up to 8.5% of compensation (6.5% + 2%), a 21% increase in the deferral limit. As the number of otherwise non-participating non-HCEs increases, the results become even more dramatic.

As Examples 1 and 2 illustrate, negative elections can have a significant effect on non-HCE ADP, which in turn will help the plan pass the Sec. 401 (k)(3) ADP test and dramatically increase the percentage of compensation HCEs may defer.

Example 2: The facts are the same as in Example 1, except there are two additional non-HCEs, X and Y, who did not elect to defer compensation in the prior plan year.

                            HCEs

                       A            B

Compensation        $100,000      $100,000
Deferral              $7,500        $7,500
Actual deferral         7.5%          7.5%
 ratio
Average actual              7.5%
 deferral ratio

                                      Non-HCEs

                       S            T          X         Y

Compensation         $10,000      $10,000   $10,000   $10,000
Deferral              $1,000           $0        $0        $0
Actual deferral          10%           0%        0%        0%
 ratio
Average actual                            2.5%
 deferral ratio

Because the non-HCE ADP is 2.5%, the HCE ADP cannot exceed 4.5% (2.5% + 2%) without violating the ADP test. However, if 3% negative elections were implemented, the non-HCE ADP would increase to 4.75%; the allowable HCE ADP would increase to 6.75% (4.75% + 2%), representing a 50% increase in the amounts HCEs can defer into the plan.

Likewise, implementing negative elections may allow a plan to satisfy the ACP test and give the sponsoring employer greater flexibility in the structure of its matching contributions. However, the Sec. 401(m) regulations are very complex; a discussion of the various methods of ACP compliance testing is beyond the scope of this article.

Risks of Negative Elections

While negative elections clearly have benefits for both employers and employees, and some of the uncertainty regarding the tax effects of their use has been resolved by Rev. Rul. 98-30, employers considering implementing negative elections should be aware that they are not entirely without risk. In particular, an employer who implements negative Sec. 401(k) elections should consider two potential risks: (1) fiduciary liability and (2) the violation of state wage payment laws.

Fiduciary Liability

In a traditional Sec. 401(k) plan, under which an employee must affirmatively elect to begin participating, the plan may be designed to comply with the provisions of Section 404(c) of the Employee Retirement Income Security Act of 1974 (ERISA). To qualify under ERISA Section 404(0, the plan must (1) be an individual account plan,(7) (2) provide an opportunity for a participant or beneficiary to exercise control over some or all of the assets in his individual account and (3) provide the participant or beneficiary with an opportunity to choose from a broad range of investment alternatives(8) the manner in which his account assets are invested. If these requirements are met, the plan sponsor is protected from fiduciary liability under ERISA Section 404(c) for any loss that is the direct or necessary result of the participant's exercise of control over his account.

However, if a plan uses negative elections and automatically enrolls employees, either the employer will determine the appropriate investments for the participant's account, or a default investment choice (e.g., a money market fund) will be used. If the employer determines the appropriate investment for the participant's account, the plan will not qualify under ERISA Section 404(c), because the participant is not exercising control over investment of his account assets. If a default investment choice is used, the employer will not enjoy the benefits of ERISA Section 404(c), because the plan participant is not affirmatively electing how his account assets are invested. A participant is not considered to have given an affirmative instruction regarding the investment of his account merely because he has been informed that certain investments will be made on his behalf absent his affirmative election.(9) In either case, the plan will not qualify for ERISA Section 404(c) protection, because participants cannot exercise initial control over the investment of their accounts.

Because ERISA Section 404(c) does not apply, the employer has a fiduciary duty under ERISA Section 404(a) (1) (A) and 03) to act prudently and in the best interests of the employee as to the investment of the amounts automatically withheld from an employee's compensation. Thus, the employer must assume some degree of fiduciary risk to achieve the benefits of negative elections. If, for example, the employer invests the employee deferrals in a conservative fixed-income or money market fund, an employee may raise a breach of fiduciary duty claim on the grounds that the investment choice was too conservative, particularly when other equity-oriented investments generate significantly greater returns.

On the other hand, if the employer selects more aggressive investments and market conditions decline, resulting in a loss to the employee's account, the employee may claim a breach of fiduciary duty on the grounds that the investment choice was too aggressive. The employer is thus put in the position of having to defend a potential breach of fiduciary duty claim if it guesses wrong. Further, even if the investment decision is ultimately found to be prudent, the employer will have spent considerable time, effort and money defending the claim.(10)

While a plan that implements negative elections will not initially qualify for ERISA Section 404(c) protection, an employer can minimize its exposure somewhat by making participant direction available as soon as the first dollar of the employee's pay is transferred into the plan. Employers should also provide employees with a Sec. 401(k) plan information package that includes all the information required under ERISA Section 404(c) regulations.(11) If an employer follows these suggestions, while the plan will not initially qualify for ERISA Section 404(c) protection, the employer's fiduciary liability will be minimized by limiting the period during which employees are unable to direct their account investments.

State Wage Payment Laws

Many jurisdictions have statutes or regulations requiring specific written authorization from an employee before any amount may be withheld from his paycheck as a payroll deduction.(12) Often, these laws impose penalties on an employer that fails to pay wages to an employee, including costs, attorney's fees and liquidated damages.(13) Some states impose criminal liability on the employer and its officers and agents responsible for an intentional failure to pay wages.(14) These state laws would tend to prohibit the use of negative elections; by definition, a negative election involves the withholding of a portion of an employee's compensation without his prior written authorization.

The DOL has indicated that New York's and Puerto Rico's statutes are preempted by ERISA Section 514(a)(15); that provision preempts all state laws as they relate to employee benefit plans covered by ERISA. The DOL ruled that the New York and Puerto Rico statutes "relate to" benefits provided under employee benefit plans in that they limit, prohibit or regulate the funding of such plans, including wage deductions to such plans. Presumably, the DOL's position would be the same as to other states' wage payment laws.

However, while the DOL has clearly expressed the view that state laws like those of New York and Puerto Rico, which require specific written authorization before any amount may be withheld from an employee's paycheck as a payroll deduction to fund employee benefits, are preempted by ERISA, the preemption issue is not clearly settled. In 1994, a district court found that West Virginia's general wage payment statute did not "relate to" an employee benefit plan and, thus, was not preempted by ERISA.(16) In addition, a number of state labor departments have informally expressed concerns that the opinions expressed by the DOL on this issue may be incorrect.(17) If a disgruntled employee or a state labor department chooses to contest this issue, an employer that uses negative elections may find itself defending the DOL'S preemption argument in court. The risk of litigation in this area is particularly high when a state's wage payment law is (like the West Virginia statute) a statute of general application not specifically directed at employee benefit plans. Given the potential imposition of liquidated damages, costs, attorney's fees and, perhaps, a criminal penalty under these state statutes, the risks in this area must be taken seriously. As with the fiduciary liability issue, even if an employer ultimately prevails on the preemption defense, it will be required to expend both time and money defending such litigation.

Conclusion

U.S. employers are certain to hear more about negative elections in Sec. 401(k) plans, particularly given the Clinton Administration's strong advocacy of their use to boost non-HCE participation. Large corporations that have implemented this technique have thus far found it very effective in achieving their desired goals. Negative elections clearly can help to increase employee participation in small and medium-sized companies as well; their use may be appropriate in some circumstances. However, before making the decision to change to a negative election structure, employers should carefully consider the potential costs and liabilities they may face from fiduciary duty claims related to the investment of the amounts automatically withheld and state wage payment laws.

EXECUTIVE SUMMARY

* According to Rev. Rul. 98-30, when an employee has the opportunity to elect out of automatic deferrals, contributions made under a negative election will not fail to be considered elective deferrals.

* Negative elections increase employee participation and can help a plan pass the ADP test.

* Employers can increase voluntary participation by reducing the waiting period for employee eligibility.

For more information about this article, contact Prof. Arsenault at [phone] or [e-mail].

(1) Andrews, "The Real Story of the 401 (k) Revolution," 7 Smart Money 114 (August 1998).

(2) President Clinton, remarks at the National Summit on Retirement Savings, Washington, DC (6/4/98), as reported in 25 BNA Pension & Benefits Reporter 1321 (6/8/98).

(3) Rev. Rul. 98-30, IRB 1998-24, 8.

(4) Thompson, "The Positive Side of Negative Elections," 42 HR Magazine 112 (November 1997).

(5) The plan terms govern the combination of options available to a plan sponsor.

(6) Notice 98-1, IRB 1998-3, 42.

(7) Under ERISA Section 3(34), an "individual account plan" is a pension plan that provides for an individual account for each participant, and in which benefits are based solely on the amount contributed to the account, adjusted for income, expenses, gains, losses and any forfeitures allocated to the account. Individual account plans include Sec. 401(k) plans, money purchase pension plans and profit-sharing plans.

(8) Under DOL Kegs. Section 2550.404c-1 (b)(3)(i)(A)-(C), a plan offers a "broad range of investment alternatives" only if the investment choices provide the participant or beneficiary with a reasonable opportunity to (1) materially affect the potential return on amounts in his account over which he is permitted to exercise control and the degree of risk to which such amounts are subject; (2) choose from at least three specific investment alternatives; and 0) diversify the investment of his account so as to minimize the risk of large losses, taking into account the nature of the plan and the size of participants' accounts.

(9) See DOL Regs. Section 2550.404c-1(c); preamble, 57 Fed. Reg. 46,923 (10/13/92).

(10) This potential liability is why many Sec. 401(k) plans are designed to qualify under ERISA Section 404(c).

(11) See DOL Regs. Section 2550.404c-1(b)(2). According to DOL Regs. Section 2550.404c-1(b)(2)(i)(B)(1), this information includes a description of the investment alternatives available under the plan, identification of any designated investment managers, the circumstances under which participants may give investment instructions, any transaction fees applicable, the identity and contact information for a plan fiduciary responsible for providing required information, information regarding the procedures in place for the confidentiality of a participant's investment decisions and certain other information relating to distribution of a prospectus and information regarding tender and voting fights for an investment. The regulation also requires certain other information to be made available to participants on request.

(12) See, e.g., Ariz. Rev. Stat. Section 23-352; Conn. Gen. Stat. Section 31-71e; Haw. Rev. Stat. Section 338-6; N.Y. Lab. Section 193; N.C. Gen. Stat. Section 95-25.8(2); P.R. Laws., tit. 17, Section 5(g) (prior to its amendment effective 6/30/95; see note 15); Tex. Lab. Code Section 61.018.

(13) See, e.g., Ariz. Rev. Stat. Section 23-355 (treble the amount of unpaid wages); N.C. Gen. Stat. Section 95-25.22(a)(1) (liquidated damages equal to amount due plus costs and attorney's fees); Tex. Lab. Code Section 61.053 (administrative penalty equal to lesser of amount of wages due or $1,000 if employer acted in bad faith).

(14) See, e.g., Conn. Gen. Stat. Section 31-71g (imposing fine up to $5,000 and/or imprisonment up to five years for failure to pay wages due, if certain conditions are met); N.Y. Lab. Section 198-a (fine up to $20,000 and imprisonment up to one year for knowingly permitting corporation to fail to pay wages); Tex. Lab. Code Section 61.019 (third-degree felony for failing to pay wages due employee after demand if hired employee intending not to pay wages).

(15) DOL Opinion Letter 94-27A (7/14/94) (addressing the New York statute); DOL Opinion Letter 96-01A (2/8/96) (addressing the Puerto Rico statute). In response to continued concerns among practitioners regarding this issue after the issuance of the DOL's opinion letter, the Puerto Rico statute was amended effective June 30, 1995 to add Section 5(1), which allows an employer to make deductions from an employee's salary for contributions to a plan subject to ERISA.

(16) Foxy. General Motors Corp., 863 F Supp 302 (D.W.Va. 1994).

(17) See Martin and Morse, "`Negative Elections:' The Solution for Increased 401(k) Participation?" 2 Pension &Benefits Week 3 (7/1/96), p. 4.

Stephen J. Arsenault, J.D., LL.M. Visiting Assistant Professor Department of Accounting and Legal Studies School of Business and Economics College of Charleston Charleston, SC