The 401(k) plan remains one of the best savings options available, especially for long-term retirement goals, but many employees still do not participate. Author Mark Swanson explains why an automatic contribution arrangement might be just the tool for making inroads with this group of holdouts.
"These are the times that try men's souls." Thomas Paine's phrase describing the 18th century also seems appropriate today in light of the turmoil of the financial markets. Events have put a renewed emphasis on savings and prudent financial decisions – such as taking advantage of automatic contribution arrangements (also known as automatic enrollment arrangements). Under such arrangements, employees are automatically enrolled in the company's 401(k) plan unless they affirmatively elect not to participate. Rather than being asked if they would like to participate, employees are asked if they don't want to participate.
Plans with automatic contributions first appeared in the 1980s, but widespread implementation was limited by legal and administrative issues, including:
- Fiduciary liability for investment of contributions without express participant direction;
- State laws requiring written direction from employees to withhold deferrals; and
- The costs of maintaining accounts with small balances when participants stopped contributing shortly after their first deferral. Provisions contained in the Pension Protection Act of 2006 (PPA) and subsequent regulations have paved the way to overcoming these and other issues.
The PPA provides liability relief to fiduciaries that use qualified default investment alternatives (QDIAs) for the investment of participant contributions that were automatically deducted from the employee's pay. It provides that federal law supersedes any state law that would directly or indirectly prohibit or restrict an automatic contribution arrangement by, for example, requiring written consent. And it permits, but does not require, a plan to include a 90-day revocation period that allows withdrawals of contributions made to the plan shortly after they were automatically deducted.
The PPA also introduced the concepts of eligible automatic contribution arrangements (EACAs) and qualified automatic contribution arrangements (QACAs), which provide additional benefits to plans that adopt automatic enrollment provisions. An overview of QDIAs, EACAs, and QACAs, along with their notice requirements, follows.
Section 404(c) of the Employee Retirement Income Security Act of 1974 (ERISA) limits the liability of plan fiduciaries where plan participants exercise control over the investment of their individual accounts. Under automatic contribution arrangements, fiduciary relief is available when a participant fails to make an investment election if the participant's account is allocated to a QDIA.
QDIA regulations describe a QDIA as an investment mechanism rather than as a specific investment. Each mechanism is intended to meet a participant's long-term savings objective. Examples of QDIAs include:
- Investments taking into account age or anticipated retirement date (such as, a life-cycle or target date retirement fund);
- An investment product with a mix of investments that takes into account the ages or anticipated retirement dates of the group of plan participants as a whole rather than each individual participant (a balanced fund); and
- A professional investment management service in which the plan's ERISA investment manager invests the participant's account among the plan's investment options to provide a mix of investments that takes into account the participant's age or anticipated retirement date (a managed account).
Under an EACA, a plan's automatic deferral percentage must be a uniform percentage of pay chosen by the employer and the plan must comply with the notice requirements (see below). An employer may, but is not required to, permit a 90-day revocation withdrawal period after the first automatic contribution. An EACA does not provide the benefit of testing relief afforded a QACA, but it offers greater flexibility in the provisions a plan may incorporate.
The main benefit of a QACA is testing relief. In exchange for relief from average contribution percentage and average deferral percentage testing, all of these requirements must be satisfied:
- The plan must set a minimum automatic deferral with an escalator – that is, after the initial period, the minimum percentage must increase by 1 percent per year until it reaches 6 percent (but may continue increasing each year until it reaches 10 percent of pay).
- The initial automatic deferral must be at least 3 percent and no more than 10 percent of pay. A plan is permitted to set the minimum higher than 3 percent.
- The plan must provide a nonelective contribution of at least 3 percent of pay or a matching contribution equal to 100 percent on the first 1 percent deferred plus 50 percent of deferrals between 1 percent and 6 percent.
- Vesting on the employer contributions cannot be more restrictive than 100 percent after two years of service.
- Generally, the QACA must be in effect for an entire 12-month plan year.
Plans using QDIAs must provide information to participants about the QDIA and the right to direct investments under the plan. Similarly, plans using EACAs and QACAs must provide a notice with information about the EACA or QACA and instructions for how and when an employee can opt out of automatic enrollment. In cases where the timing of the required QDIA and EACA/QACA notices coincides, the two notices may be combined.
Automatic Contribution Arrangement Considerations
The PPA certainly made automatic contribution arrangements more practical. Use of such an arrangement might allow a company to take advantage of relief from some compliance tests. If the plan includes a matching contribution by the company, however, the company must consider the extra costs that could come with greater employee participation. As a starting point, a company may simply want to ask, "Who are the employees who don't participate now, and do they just need the nudge afforded by automatic enrollment?"
Adopting provisions for automatic contributions and determining the best path for a company and its employees should not be a rushed process. Because some notices must be provided before the beginning of a plan year, it might not be possible to implement provisions before 2010 in the case of calendaryear plans. A company considering implementing automatic contributions should contact its 401(k) provider or benefits consultant sooner rather than later for an evaluation of the options.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.