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Automatic Enrollment: Now More Than Ever

“Automatic enrollment” refers to a procedure whereby an employee who is eligible to participate in a 401(k) plan will be deemed to have elected to contribute to the plan at a specified rate unless the employee makes a contrary election – including an election not to contribute. Employers began implementing automatic enrollment features as long ago as the 1990s, so we now have substantial experience from which to judge their merits. By most accounts, those merits are substantial. 

Automatic enrollment takes advantage of the “inertia” commonly associated with retirement planning. That is, employees are inclined to take no action to change their current situation. If they are automatically enrolled in a 401(k) plan, they will likely remain contributors. By contrast, if they are not automatically enrolled, many will never take even the most minimal action needed to begin contributing. 

As explained below, the Pension Protection Act of 2006 (the “PPA”) eliminated most of the reasons often expressed by employers for not implementing an automatic enrollment feature. The last group of these PPA changes became effective as of January 1, 2008. This is therefore an excellent time to consider adding such a feature to a 401(k) plan. [1]

Advantages of Automatic Enrollment 

When asked, employers who have implemented an automatic enrollment feature typically give one or both of two reasons for doing so. First, by automatically enrolling employees in a 401(k) plan – even at a relatively modest contribution level – employers can help their employees save for their own retirement. This is not only good for the employees, but should also facilitate the employer’s movement of younger employees into more senior positions as older employees accumulate sufficient assets with which to retire. 

Second, those employers who wish to allow their highly compensated employees (“HCEs”) to increase their level of 401(k) savings may implement an automatic enrollment feature as a way of increasing the participation of non-HCEs. Increasing such non-HCE participation allows HCEs to make larger contributions without causing the plan to violate the income-based nondiscrimination rules applicable to 401(k) contributions (as expressed through the “actual deferral percentage” or “ADP” test). This may also help the plan satisfy the “actual contribution percentage” (or “ACP”) test applicable to matching contributions.

Historical Barriers to Automatic Enrollment 

Given these advantages of automatic enrollment, one might wonder why it did not become common even sooner. Three reasons are commonly given for the delay in adopting automatic enrollment. Employers adopting an automatic enrollment feature prior to enactment of the PPA had to deal with the following three concerns:

State Wage Payment Laws. Most states maintain “wage payment laws” that, among other things, prohibit an employer from deducting amounts from an employee’s paycheck without the employee’s written consent. An automatic enrollment feature might seem to violate such a law. Although the Department of Labor (“DOL”) has long taken the position that “preempts” the application of such wage payment laws to 401(k) plans, some states nonetheless threatened employers with legal action if they implemented such a feature.

Lack of ERISA Section 404(c) Protection. As more and more plans allow for participant direction of investments, the protection afforded fiduciaries under Section 404(c) of ERISA has become increasingly important. This provision shields a plan’s fiduciaries from liability for losses attributable to a participant’s exercise of control over investments within his or her account. Until recently, however, such “Section 404(c) protection” was available only with respect to amounts as to which a participant had made an affirmative investment election. “Default” investment elections remained subject to ERISA’s general fiduciary rules. Most participants who are automatically enrolled in a 401(k) plan fail to provide any affirmative investment direction. Accordingly, one of the consequences of automatic enrollment had been to deny fiduciaries the protection otherwise afforded under ERISA Section 404(c).

Stranded Small Account Balances. As a way of discouraging employees from spending their 401(k) account balances prior to retirement,the Internal Revenue Code (the “Code”) places sharp limitations on an employee’s ability to obtain an in-service distribution of such amounts. Typically, such amounts may not be obtained before age 59½ (unless the employee experiences a specified financial hardship). Inevitably, some employees who were automatically enrolled in a 401(k) plan did not wish to be enrolled, but had simply failed to take the action needed to opt out of that enrollment. By the time they contacted their employer to cease making further contributions, a small amount of money had already been deposited into their account. Due to the Code’s restrictions on in-service distributions, however, there was no way to distribute these small amounts until an employee had satisfied one of the conditions for an in-service withdrawal (or had actually terminated employment). Not only did this make the affected employees unhappy,but plan sponsors were required to pay recordkeepers to maintain small account balances that, in some cases, were smaller than the annual recordkeeping fee.

PPA Solutions (and Other Benefits) 

The PPA attacked these historical barriers to automatic enrollment on a comprehensive basis. It also provided certain additional benefits to employers choosing to implement an automatic enrollment feature. As a result, any employer willing to comply with the various conditions laid down by the PPA (as summarized later in this article) need not be deterred by any of the concerns described above. 

For instance, the PPA amended ERISA’s preemption provision so that this federal statute now expressly supersedes any state law that would “directly or indirectly prohibit or restrict the inclusion in any plan of an automatic contribution arrangement.” ERISA §514(e)(1). This explicit statutory reference to automatic contribution arrangements [2] should effectively settle any debate as to whether state wage payment laws preclude the implementation of an automatic enrollment feature. 

In the area of ERISA Section 404(c) protection, the PPA added a Paragraph 5 to Section 404(c) as a way of granting protection to fiduciaries of plans that specify an appropriate type of default investment. The PPA also directed the DOL to amend its Section 404(c) regulations to describe these appropriate default investments. PPA §624(a). The DOL recently finalized those regulations, which refer to such default investments as “qualified default investment alternatives” (or “QDIAs”). DOL Reg. §2550.404c-5. Although these QDIA regulations apply even outside of the automatic enrollment context, they will be particularly helpful to fiduciaries of plans under which participants are automatically enrolled. 

The PPA dealt with the problem of stranded small accounts by providing a 90-day window during which a participant who is automatically enrolled in a 401(k) plan may take action to reverse that enrollment – even on a retroactive basis. As further explained below, such a participant would be entitled to a refund of the amounts deducted from his or her paycheck and contributed to the plan, as adjusted for any investment gains or losses on those amounts. This refund provision should minimize the number of small account balances employers are required to pay recordkeepers to maintain. 

For plans that struggle to satisfy the ADP test each year, the PPA also added two provisions that are applicable solely to plans utilizing an automatic enrollment feature. These are (i) an extension (to six months) of the usual 2½-month deadline for making refunds to HCEs of discriminatory 401(k) contributions, and (ii) two new “safe-harbor” contribution formulas by which a 401(k) plan may be deemed to satisfy both the ADP and ACP tests. These additional benefits of implementing an automatic enrollment feature are also summarized below.

Current Trends in Automatic Enrollment

Thanks to the PPA, automatic enrollment is rapidly growing in popularity. According to a recent survey by Wells Fargo Bank, the number of 401(k) plans relying on automatic enrollment rose from 26% in 2006 to 44% in 2007. If employers that intend to implement an automatic enrollment feature within 18 months are included, the figure stands at 66%. 

Similar results have been found in other recent surveys. According to a survey by the Profit Sharing/401(k) Council of America, over 41% of large plans had already adopted automatic enrollment by 2006. Fidelity Investments found a 19% increase in the number of employers using automatic enrollment between 2005 and 2006. That survey found 29% of employers using automatic enrollment as of that later year. 

Another recent survey confirms that automatic enrollment is popular with employees, as well. A coalition of groups operating under the name “Retirement Made Simpler” surveyed participants in 401(k) plans that relied on automatic enrollment. Of the surveyed participants, 98% are glad their employers offer the plans, and 95% agree that the program has made retirement saving easy. Perhaps most significantly, however, 85% of survey respondents said that automatic enrollment had made them start saving for retirement earlier than they had planned. 

Whatever the actual percentages, it seems clear that automatic enrollment will soon be viewed as the standard approach to enrolling employees. Given the proliferation of automatic enrollment alternatives under the PPA, the more relevant question may be the type of automatic enrollment feature an employer should implement. The remainder of this article will outline the various types of automatic enrollment features currently available, along with some of the advantages of each.

ERISA PREEMPTION OF STATE LAWS 

As enacted, the PPA seemed to condition ERISA’s preemption of state laws on an automatic enrollment feature complying with the DOL regulations governing default investments (the “QDIA regulations” described immediately below). Somewhat surprisingly, however, those DOL regulations extended the benefits of this ERISA preemption to any automatic contribution arrangement maintained under a plan that is subject to ERISA. DOL Reg. §2550.404c-5(f)(2). This PPA provision became effective for plan years beginning after December 31, 2006. PPA §624. Accordingly, there should be no concern that a state would attempt to forbid a 401(k) plan from automatically enrolling eligible employees.

ERISA SECTION 404(C) PROTECTION 

Responding to the PPA mandate, the DOL proposed regulations describing qualified default investment alternatives in September of 2006. Those regulations were finalized on October 24, 2007 – with an effective date of December 24, 2007. The final QDIA regulations preserve the basic structure of the proposed regulations. Accordingly, these regulations describe three distinct types of QDIAs: 

  • argeted retirement date funds;
  • Balanced funds; and 
  • Managed accounts.

Despite requests from the insurance industry that it do so, the DOL declined to add stable value funds or other “capital preservation” options to this list of QDIAs. On the other hand, the final regulations do include a “grandfather” rule for certain stable value funds, as well as the ability to characterize a capital preservation option as a QDIA for a short period of time. 

Grandfather Rule. Under the grandfather rule, amounts previously invested in a stable value fund through a default investment procedure may obtain the protection of ERISA Section 404(c)(5) if (i) those amounts were invested prior to December 24, 2007, and (ii) participants having assets invested in that fund are notified of their ability to transfer those assets to any other alternative offered under the plan, on an immediate and penalty-free basis. 

The final QDIA regulations also recognize that recordkeepers may not be able to distinguish between assets that were defaulted into a stable value fund and those that were invested there at a participant’s direction. They therefore allow an employer to transfer any or all stable value assets to a new default investment option (one meeting the definition of a QDIA) without losing ERISA Section 404(c) protection. Again, affected participants must be given advance notice of this transfer, as well as the ability to make a contrary investment election if they so desire.

Short-Term QDIA. Recognizing that many employers who implement an automatic enrollment feature will also choose to take advantage of the 90-day refund option referenced above (and more fully described below), the final QDIA regulations also permit a plan to designate a capital preservation option (such as a stable value or money market fund) as a QDIA for the first 120 days after a participant’s first payroll deduction. Investing an automatically enrolled participant’s contributions in such a short-term QDIA would likely guarantee that, should the participant opt to reverse his or her automatic enrollment, the amount to be refunded would include the full amount deducted from the participant’s paychecks, along with a small investment gain. Utilizing one of the other three types of QDIAs could result in an investment loss, thereby depriving affected participants of a full refund.

STRANDED SMALL ACCOUNTS 

The advantages of ERISA preemption and expanded Section 404(c) protection are available to any automatic contribution arrangement – without regard to any additional requirements specified in the Code. However, any automatic contribution arrangement that satisfies the Code requirements for either an “eligible automatic contribution arrangement” (an “EACA”) or a “qualified automatic contribution arrangement” (a “QACA”) may take advantage of additional PPA provisions. 

For instance, any participant who is automatically enrolled in an EACA may be allowed to reverse that enrollment within 90 days and receive a refund of the amounts deducted from his or her paychecks. Code §414(w). An “EACA” is generally defined as any automatic contribution arrangement under which the default investment alternative is a QDIA and eligible employees receive timely advance notice of the automatic enrollment feature. Code §414(w)(3). Although the notice rules are generally described later in this article, it is worth noting here that plans under which employees enjoy this 90-day refund option need not provide as much advance notice of the automatic enrollment as must other plans. 

Under Code Section 414(w)(2), this 90-day refund procedure must conform to the following requirements: 

  • A participant must elect a refund within 90 days of the first date on which amounts were deducted from his or her paycheck.
  • The plan must refund all of the participant’s automatic contributions, adjusted for any investment gains or losses.
  • The plan may not refund any contributions made for pay periods beginning after the refund request is received.

The third of these three requirements will make it prudent for plans to adopt a presumption that any participant who requests a refund of automatically contributed amounts is also electing to make no further contributions to the plan. The preamble to regulations recently proposed by the IRS clearly authorizes such a presumption. 

The contrary presumption is not permissible. That is, a participant who elects to cease making contributions during the first 90 days may not be deemed to have requested a refund, as well. Rather, such a participant must submit an explicit refund request. Moreover, the preamble makes clear that a refund may not be conditioned on a participant’s agreeing to make no further contributions to the plan. Such a condition would violate the “contingent benefit rule” applicable to 401(k) contributions. Accordingly, a participant could conceivably request a refund and then immediately elect to begin contributing.

Under the proposed IRS regulations, any matching contributions attributable to refunded 401(k) contributions must be forfeited. Prop. IRS Reg. §1.414(w)-1(d)(2). These forfeited amounts must remain in the plan, to be used in the same way as other forfeitures, and may not be returned to the employer as “mistaken” contributions. 

To be an EACA, this automatic enrollment feature must be applied to all eligible employees who have not previously made a contribution election under the plan (including an affirmative election not to contribute). Prop. IRS Reg. §1.414(w)-1(e)(2),(4). This would include employees who became eligible to contribute to the plan prior to the implementation of the automatic enrollment feature, as well as newly hired employees who satisfy the plan’s eligibility waiting period.

However, the preamble to the proposed regulations makes clear that this refund option need not be made available to all participants in the EACA. Thus, a permissible approach would be to make this option available only to participants who are already employed by the plan sponsor at the time an automatic enrollment feature is added. Any such participant who fails to recognize the significance of a notice informing him or her of a future automatic enrollment could then request a refund within 90 days of the first payroll deduction – but this refund option would not be an ongoing feature of the Plan. Apparently, some recordkeepers (Fidelity Investments among them) are reluctant to administer this refund feature. An employer may thus wish to consider this limited transitional use of the 90-day refund option. 

Finally, the proposed IRS regulations clarify the proper tax reporting and treatment of amounts refunded under this procedure. Such amounts are to be treated as additional compensation, rather than a distribution from the plan. Accordingly, they are subject to income tax during the year of the distribution (rather than the year of the payroll deduction), and they are not subject to the 10% penalty tax on “premature” retirement distributions. Nonetheless, these refunds should be reported on a Form 1099-R, rather than an employee’s Form W-2. Prop. IRS Reg. §1.414(w)-1(d)(1).

SIX-MONTH ADP REFUND OPTION 

One of the “bonuses” associated with implementing an automatic enrollment feature that satisfies the definition of an EACA is the ability to make corrective refunds more than 2½ months following the close of the plan year in which an ADP or ACP violation occurs. Such a timely refund is necessary to avoid a 10% excise tax on the amount of any excess 401(k), after-tax, or matching contributions. The PPA amended Code Section 4979(f)(1) to extend this 2½-month period to six months in the case of an EACA. See also Prop. IRS Reg. §54.4979-1(c)(1). 

Given the difficulties often encountered in obtaining the final ADP/ACP testing results in time to meet the 2½-month corrective refund deadline, this PPA provision would be of great help to plans that typically fail the ADP or ACP test. Of course, simply adding an automatic enrollment feature should improve the results of the ADP and ACP testing, and perhaps avoid such a failure, altogether.

NEW ADP/ACP SAFE HARBORS 

Even before the PPA was enacted, the Code provided two alternative “safe-harbor” contribution formulas by which the sponsor of a 401(k) plan could avoid the trouble associated with ADP and ACP testing. See Code §401(k)(12). If employer contributions are made under either of these formulas, a plan will be deemed to satisfy these two tests. HCEs may then contribute up to the full annual dollar amount permitted under Code Section 402(g) ($15,500 for 2008) and may receive the full matching contribution provided under the plan’s formula. 

These pre-PPA safe-harbor formulas remain available to 401(k) plan sponsors who do not choose to adopt one of the new safe harbors described below. Under a “non-elective” safe harbor, an employer must make a 3%-of-pay contribution on behalf of all eligible employees. Code §401(k)(12)(C). A “matching” safe harbor results in a total matching contribution equal to 4% of pay for any eligible employee who elects to defer at least 5% of his or her own pay. Code §401(k)(12)(B). Both of these pre-PPA safe harbors require an annual advance notice, and both require that the employer contributions be immediately vested. Code §401(k)(12)(D), (E)(i). 

The PPA added two new safe-harbor formulas – available only to plans utilizing automatic enrollment. See Code §401(k)(13). Such a plan must provide not only for the safe-harbor employer contributions, but also a minimum (and increasing) level of automatic 401(k) contributions by any eligible participant who does not make a contrary election. Such an automatic enrollment feature constitutes a “qualified automatic contribution arrangement” (or “QACA”). Advance notice requirements (as described below) also apply to a QACA. 

Although there is substantial overlap between the requirements for an EACA (as described above) and those that apply to a QACA, they are distinct terms. A plan could offer an EACA (for instance, by complying with the DOL’s QDIA regulations) without providing the safe-harbor contributions required under a QACA. Or a plan could meet all of the QACA requirements without satisfying certain of the EACA rules. Typically, however, any plan that meets the QACA requirements will also want to satisfy the EACA rules – if only to qualify for the relief from stranded small accounts and the longer ADP/ACP refund period.

Minimum Automatic Contributions 

Under a QACA, eligible employees who do not make a contrary contribution election (or opt out entirely) must be automatically enrolled in the plan at a contribution rate that is no lower than 3% of pay. Code §401(k)(13)(C)(iii)(I). That contribution rate must increase to at least 4% by the first day of the second plan year beginning after that automatic enrollment occurs. Code §401(k)(13)(C)(iii)(II). The preamble to the proposed IRS regulations confirms that this could result in a period of two full plan years at the 3% rate – for instance, if an employee is automatically enrolled as of the first day of a plan year. 

Thereafter, a participant’s automatic contribution rate must be increased by an additional 1% per year until it reaches at least 6% of pay. Code §401(k)(13)(C)(iii)(III), (IV). The rate can continue to go higher, but it must be capped at 10% of pay. Code §401(k)(13)(C)(iii). According to the regulations’ preamble, the automatic enrollment percentage may also start at a rate above 3%. If so, that higher rate may remain permissible for a longer period of time, but it would eventually have to increase until it reached the 6% level on the schedule outlined above. 

As under an EACA, this automatic enrollment feature must be applied to all eligible employees who have not previously made a contribution election under the plan (including an affirmative election not to contribute). Prop. IRS Reg. §1.401(k)-3(j)(1)(iii). This would include employees who became eligible to contribute to the plan prior to the implementation of the automatic enrollment feature. 

In general, this minimum employee contribution formula must apply equally to all eligible employees. This does not mean, however, that all employees who are automatically enrolled in a plan will be contributing at the same percentage rate. Employees who are automatically enrolled during different years may be contributing at different percentages. See Prop. IRS Reg. §1.401(k)-3(j)(2)(iii)(A). For instance, in the fifth year of a QACA, new employees might be contributing at the 3% rate, while others are contributing at 4%, 5%, or 6%. These differing automatic contribution percentages will place some administrative burden on a plan’s recordkeeper. They will also require some participant education on this point. 

Another complication associated with a QACA is the pre-existing regulatory requirement that all employee contributions be suspended for a period of six months after a participant obtains a withdrawal under the “safe-harbor” hardship withdrawal rules. See IRS Reg. §1.401(k)-1(d)(3)(iv)(E)(2). Although such a suspension is permissible under a QACA, any automatic contributions in effect at the time of the hardship withdrawal must then automatically resume at the end of that six-month suspension period. Prop. IRS Reg. §1.401(k)-3(j)(2)(iii)(D). Any plan that relies on the safe-harbor hardship withdrawal rules will have to deal with this issue.

Safe-Harbor Employer Contribution Formulas 

The QACA safe-harbor employer contribution formulas are similar to the pre-PPA formulas. In fact, one of them is identical. This is a 3% non-elective contribution on behalf of all eligible participants. Code §401(k)(13)(D)(i)(II). 

The other QACA safe-harbor formula is a somewhat different matching formula. Under this safe harbor, an employer must match 100% of the first 1% of pay each eligible participant elects to contribute (or is deemed to have elected to contribute), plus 50% of the next 5% of pay that is contributed. Code §401(k)(13)(D)(i)(I). This would amount to a total matching contribution equal to 3½% of a participant’s pay, or slightly less than the 4% match that might be required under the pre-PPA matching contribution safe harbor. 

A significant advantage of these QACA safe harbors over the pre-PPA safe harbors is the ability to apply a vesting schedule to the employer contributions. A plan may require up to two years of service to vest in these QACA safe-harbor contributions. Code §401(k)(13)(D)(iii)(I). Any such contributions made on behalf of a participant who fails to complete two full years of service could be forfeited and used to offset any employer contributions on behalf of other participants. This should make the QACA safe harbors less expensive than the pre-PPA safe harbors (which require that all employer contributions be fully vested when made).

NOTICE REQUIREMENTS 

Under all of the automatic contribution arrangements described above, eligible participants must receive advance notice of their rights and obligations. Generally speaking, this notice must be provided during “a reasonable period before each plan year.” ERISA §§404(c)(5), 514(e)(3); Code §§401(k)(13)(E)(i); 414(w)(4)(A). Under the recently proposed IRS regulations, this notification obligation will be deemed to be met if an appropriate notice is provided between 30 and 90 days before the beginning of each plan year. Prop. IRS Reg. §1.401(k)-3(a)(2) (cross-referencing the pre-PPA safe-harbor notice rules found at IRS Reg. §1.401(k)-3(d)(3)(ii)). 

The recent IRS regulations also include a special notification rule for employees who are hired during the course of a plan year and are immediately eligible to participate in a plan. Such an employee must receive an appropriate notice at least a reasonable period of time before the first payroll deduction is made. Prop. IRS Reg. §401(k)-3(k)(4)(iii). 

The DOL’s QDIA regulations also contain rules governing the timing of participant notices. In addition to an annual notice, these regulations require that a participant receive a QDIA notice at least 30 days before the first default investment is made on his or her behalf. DOL Reg. §2550.404c-5(c)(3)(i)(A). 

This 30-day QDIA advance notice requirement does not apply, however, to any employee who has the right to reverse an automatic enrollment within 90 days after the first payroll deduction (i.e., under an EACA). In this case, the notice need only be provided on or before the date the employee becomes eligible to participate in the plan. DOL Reg. §2550.404c-5(c)(3)(i)(B). Thus, by offering this 90-day refund option, an employer may automatically enroll an employee before he or she receives any paycheck from which there is no 401(k) deduction – making it less likely that the employee will choose to discontinue his or contributions once those deductions begin. 

On November 15, 2007, the IRS issued a “Sample Automatic Enrollment and Default Investment Notice.” This Sample Notice is designed to satisfy the notification requirements applicable to both an EACA and a QACA, as well as the DOL’s standards for providing notice of a QDIA under ERISA Section 404(c)(5). Although this Sample Notice must be tailored to fit each plan’s specific circumstances, it should provide a good basis for drafting an appropriate notice to participants.

ADOPTING AN AUTOMATIC ENROLLMENT FEATURE 

A 401(k) plan may be amended to provide for automatic enrollment at any time. That is, an automatic contribution arrangement may be implemented without waiting until the first day of a plan year. 

On the other hand, any qualified automatic contribution arrangement must be implemented as of the first day of a plan year, and it must remain in effect for at least 12 months. This is because a QACA must comply with the same rules that apply to pre-PPA safe-harbor plans. Prop. IRS Reg. §1.401(k)-3(a)(2) (cross-referencing IRS Reg. §1.401(k)-3(e)(1)). Presumably, this full-plan-year requirement is designed to avoid the complications that would result from having a plan subject to ADP and ACP testing for only a portion of a plan year. 

Whether an eligible automatic contribution arrangement may be added to an existing 401(k) plan after the first day of a plan year is not entirely clear. Unlike QACAs, EACAs are not subject to any explicit 12-month requirement. However, the fact that all participants in a 401(k) plan must be included in an EACA (including existing employees who have never made a contrary election), and that all EACA participants must receive a notice in advance of each plan year, could be read to prohibit the implementation of an EACA during the course of a plan year. Additional IRS guidance on this point would be appreciated.

If an automatic enrollment feature is implemented during the first half of a plan year, the plan’s experience during the second half of that year may well demonstrate that automatic enrollment, alone, is sufficient to allow the plan to satisfy the ADP and ACP tests. If so, the plan’s sponsor might well conclude that there is no need to make the safe-harbor employer contributions required under a QACA, or to satisfy the EACA rules in order to gain the ability to make ADP/ACP refunds up to six months after the close of a plan year.


[1]Virtually all the points made in this article would apply equally to a Section 403(b) plan – particularly if that plan is subject to ERISA.
[2] The ERISA and Code provisions added or amended by the PPA refer to automatic enrollment features as “automatic contribution arrangements.” This terminology is probably more accurate than “automatic enrollment,” because employees have long been “automatically enrolled” in non-elective arrangements such as pension or profit sharing plans. The remainder of this article will use these two terms interchangeably.