Automatic enrollment in Secs. 401(k) and 403(b) plans.
Surveys indicate that participation and contribution rates are significantly higher in plans that use automatic enrollment; see, e.g., Holden and VanDerheis, "The Influence of Automatic Enrollment, Catch-Up, and IRA Contributions on 401(k)Accumulations at Retirement," EBRI Issue Brief No. 283 (July 2005). Further, the plan nondiscrimination rules are eliminated if the employer adopts automatic enrollment in a way that meets certain requirements. These factors will almost certainly entice many employers to implement the automatic-enrollment feature.
Use of Automatic Enrollment
In the past, there were at least two major barriers to the use of automatic enrollment. First, some states prohibit automatic deductions from an employee's pay. The PPA '06 addressed this, by providing that all state laws that prohibit automatic enrollment are preempted by Federal law, effective on the PPA '06's enactment. Second, employers have had significant concerns about the fiduciary responsibility and liability for the investment of contributions made to the plan through automatic enrollment. The Department of Labor (DOL) issued proposed regulations in September 2006 to address these concerns (DOL Prop. Reg. Section 2550. 404c-5), and is expected to issue final regulations in early 2007.
For plan years beginning after 2007, plans that offer automatic enrollment and meet certain requirements are exempt from the usual nondiscrimination tests that apply to employees' elective deferrals and employer matching contributions. These tests are referred to as the actual deferral percentage (ADP) test and the actual contribution percentage (ACP) test (as described in Sec. 401 (k) (3)(A)(ii) and (m) (2)(A), respectively), and are used to ensure that Secs. 401(k) and 403(b) plans do not discriminate in favor of highly compensated employees (HCEs).The ADP test applies to employees' elective deferral contributions; the ACP test applies to an employer's matching contributions. Sec. 401(k) plans are subject to both the ADP and ACP tests, while Sec. 403(b) plans are subject to the ACP test. The requirements to avoid these tests involve the following plan features:
* Employee automatic-enrollment contribution percentages.
* Employer contributions.
* Vesting schedule.
Automatic-enrollment contribution percentages: To avoid the tests, the PPA '06 requires that the automatic contributions, stated as a percent of an employee's compensation, fall within a specified range. The top of the range is always 10%; i.e., the automatic-contribution percent cannot exceed 10%. The bottom of the range varies, depending on how long the employee has been automatically enrolled in the plan. For the first year, the bottom of the range is 3%; the automatic-contribution percent cannot be less than 3%. The minimum contribution percent increases in 1% increments each year, until it reaches 6% in the fourth year. The minimum employee contribution percent remains at 6% for all years beyond the fourth year. The automatic-contribution percentages must be consistently applied to every eligible employee.
Employer contributions and vesting: In addition, to avoid the nondiscrimination tests, the employer must make either a matching contribution or a nonelective contribution on behalf of each non-HCE. If the employer chooses to make matching contributions, they must equal 100% of the first 1% of compensation contributed by the employee, plus 50% of the next 5% of compensation so contributed.
If the employer chooses to make nonelective contributions (i.e., not based on the employee's elective deferral contributions), they must equal at least 3% of the employee's compensation.
The employer contributions, whether matching or nonelective, must be 100% vested after the employee has completed two years of service.
If these requirements are met, the plan is deemed to satisfy the nondiscrimination test for the employee's elective deferral contributions (i.e., the ADP test). If the employer chooses to make matching contributions, the plan will also be deemed to satisfy the nondiscrimination test for the matching contributions (i.e., the ACP test), if the following additional requirements are met: 1. Matching contributions are not provided for elective deferrals in excess of 6% of compensation.
2. The rate of matching contributions does not increase as the rate of an employee's elective deferrals increases.
3. Matching contribution rates for HCEs do not exceed the rates for non-HCEs.
The PPA '06 instructed the DOL to issue regulations on default investments that apply when an employee fails to direct the investment of his or her plan contributions. When an employee is automatically enrolled, it is quite possible that he or she will not take any action to direct contribution investment. As noted above, the DOL issued proposed regulations in September 2006 that establish the type of funds that must be used.
Fund types: The default investment may be either a "life cycle" or "targeted retirement date" fund. These funds use a mix of equity and fixed-income investments based on the participant's age, target retirement date or life expectancy. Several mutual fund companies currently offer these funds. Alternatively, the plan can provide that an investment manager will create the type of investment mix described above for each participant, rather than using a fund made available through a mutual fund company. A final alternative under the proposed regulations allows a plan to use a default investment based on these same criteria, but using the demographics of all plan participants taken as whole (rather than for each participant individually).
Fiduciary liability: For an employer to avoid fiduciary liability on default investments, the following requirements must be met:
1. The default investments must be one of those described.
2. The plan participant must have had the opportunity to choose his or her investments, but did not do so.
3. A notice that meets certain requirements must be provided to the plan participant at least 30 days before the first time a default investment is made, and at least 30 days before the beginning of each subsequent plan year.
4. All investment materials (e.g., prospectuses, proxy voting material) received by the plan must be provided to the participants.
5. At least once each quarter, participants must have the opportunity to transfer out of the default investment into another investment, without financial penalty.
6. The plan must offer a broad range of investment alternatives.
Congress's intent was clear when it included the provision for automatic enrollment in the PPA '06: many employees were not properly saving for retirement, and Congress wanted to facilitate increased savings. Now that the state law and default investment issues have been addressed, it is expected that many employers will seriously consider an automatic-enrollment feature for their Secs. 401(k) and 403(b) plans.
FROM G. EDGAR ADKINS, JR., CPA, AND JEFF MARTIN, CPA, WASHINGTON, DC
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|Title Annotation:||EMPLOYEE BENEFITS & PENSIONS|
|Publication:||The Tax Adviser|
|Date:||Feb 1, 2007|
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