As I wrote about last week the President signed into law the Pension Protection Act of 2006, or the PPA in August. The PPA covers many aspects of tax-advantaged savings products but the items getting most of the attention are those dealing with retirement accounts. One highlight is regarding the automatic enrollment provision that allows employers to have employees automatically begin to participate in their retirement plan and have to manually opt-out. This is generally the exact opposite of how plans are currently administered. While this is a great idea, how will it actually work and why would employers wish to set their plan up this way? The PPA has put together some provisions to encourage employers to adopt this provision:
Automatic Enrollment Safe Harbor. The PPA includes a special automatic enrollment safe harbor for nondiscrimination testing, or qualified automatic contribution arrangements. So in order to be considered a qualified automatic contribution arrangement, the plan must satisfy these requirements:
- Salary deferral contributions in the amount of 3% of compensation must be contributed to the 401(k) plan by all non-highly compensated employees who choose not to opt-out in the employees’ first plan year of participation. In each succeeding year the salary deferral contribution to at least 4%, 5%, and 6% of compensation respectively. The automated salary deferral percentage may not exceed 10% of compensation and notice must be issued to participants detailing their right to opt-out or elect an alternative deferral percentage.
- The employer must make a minimum 3% non-elective contribution to the plan on behalf of each non-highly compensated employee or match their salary deferrals at 100% of the first 1% of compensation, plus 50% of the next 5% of compensation.
- The non-elective and matching contributions must be 100% vested after two years of service.
If a 401(k) plan complies with the above requirements for qualified automatic contribution arrangements, the plan is deemed to satisfy the nondiscrimination rules for salary deferral contributions and for employer match contributions. This is important because in order to maintain the tax-qualified status a plan must meet the nondiscriminatory test so this ensures that employers who do choose to utilize automatic enrollment will have to meet the above minimum requirements which is good news for employees.
Some other key aspects of the provision are that ERISA will pre-empt any state laws that would serve as an obstacle for an automatic enrollment plan design (e.g. state payroll withholding laws that require employees to provide affirmative or written election for payroll deductions) as long as the requirements for participant notification and default investments are also satisfied. Beginning in 2008, participants who are automatically enrolled into their plan have 90 days to opt-out and request any contributions made for that plan year to be refunded. The proceeds will be taxed as ordinary income but the 10% IRS early withdrawal penalty will not apply.
This provision is a great step in helping individuals save for retirement but ultimately it comes down to employers to adopt this process. The good news is the provision sets clear requirements that are in the employee’s best interest. A minimum of 3% deferral to start with an automatic increase each year thereafter as well as employer match contributions. Given the apathy of most people when it comes to enrolling their employer’s retirement plan this should greatly improve the number of employees enrolled in their employer plans.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.
This will increase participation. But I'm skeptical that there will be a significant improvement in the average person's financial position at retirement.
Already, too many people cash out their 401K when changing jobs. Someone who needs to be automatically signed up in order to participate will probably not be so lazy when it comes to getting their money on leaving their jobs. Particularly if the plan requires termination of their account if less than $5K or some other amount.