The Profit Sharing/401(k) Council of America recently reported in its 48
th Annual Survey of plan sponsors that 10.5% of respondents have automatic enrollment. PLANSPONSOR Magazine's 2004 Survey of Defined Contribution plans found an even higher percentage of plan sponsors, 19.2%, use automatic enrollment.
[1] Because academic studies have shown that auto-enrollment increases participation and helps plans meet the required nondiscrimination tests, many more plan sponsors are considering adopting this arrangement.
In addition to auto-enrollment, there are several "auto" components that plan fiduciaries and their advisors should examine to determine whether these additional features provide sufficient benefits to justify any added expenses and whether they are administratively feasible.
Automatic Enrollment
With automatic enrollment, employees are automatically enrolled in the 401(k) plan unless they specifically opt out. Plan sponsors and their advisors should consider the following questions when establishing an automatic enrollment procedure:
- Does your state law require employers to receive written notice from workers before wages are taken out of their paychecks?
- Currently, it is unclear whether state laws or the federal Employee Retirement Income Security Act take precedence.
- If the Roth 401(k) provision is added to your plan, do all new employees subject to auto-enrollment go into the Roth arrangement? If so, what should you do about employees who are already auto-enrolled – should their contributions be changed? How should you notify participants about the impact on their taxes?
- By the way, should we stop calling contributions made to a Roth 401(k) “deferrals,” since the participant will be paying taxes on those contributions?
Automatic Deduction
The auto-deduction feature determines the percentage or amount that will be witheld from participants' paychecks. Plan sponsors and their advisors should decide how to proceed on the following matters:
- What percentage should be the default?
- If the plan has a maximum matching %, should it be the deferral percentage that maximizes that match?
- If the matching formula is not limited, how do you determine what a participant can afford?
- Your plan allows participants over age 50 to make “catch-up” contributions.
- Do you figure this into the calculation of the default percentage?
Automatic Deferral Increases
Some plans ratchet up the deferral percentage for employees when they receive pay-raises. How do you plan to handle the following concerns?
- If you did not maximize the participant’s deferral, what should you do after the first year?
- If you are also increasing the participant’s contribution for health insurance and other benefits, have you checked to see whether you may have actually reduced the participant’s take-home pay?
Automatic Investment
The Labor Department is working on a regulation to give plans with auto-enrollment some protection from lawsuits, if the investment options chosen are “reasonable.” While it is unclear what this may mean, the risk and the expected return over a given time period are usually considered in a “reasonableness” test. Here are some questions that need to be considered:
- If the plan sponsor has put an education program into place that has as either its objective or metric for success that “educated” participants adjust their investment options, how “reasonable” was that default investment for that participant?
- When the fiduciaries are examining risk-adjusted past performance of the proposed default investment, what is the appropriate time period?
- If the median time period participants participate in the default provision is three years due to employee turnover or the “success” of the education program, should that be the time period used
- What is the process to measure risk-adjusted return? One methodology that is increasingly being used is “expected return.”
- As an example, If you were to put in $1 in an investment that had 999/1000 chance of returning $1 and 1/1000 chance of returning a negative $1,000, the expected return would be negative – not a desirable investment.[2]
- How is the employer matching contribution invested – in the same default investment?
- Unless it is dictated that the match goes into employer stock, participants may have reason to suspect that their default investment may not be considered appropriate.
- If the matching contributions are put into an investment that produces variable results, what will that do for forfeitures? Could a one-year negative return produce a liability that the employer may not be willing or able to take?
Automatic Rebalancing
An alternative to a fund with an allocation based upon retirement or risk is a mix of the existing plan investments. An advisor determines a target allocation that will give participants a good “risk-adjusted return.” Auto-rebalancing has the participants’ current allocation adjusted to restore the target allocation. How often should rebalancing be done – quarterly, annually, or only when the current allocation exceeds a range (e.g., the current stock percentage exceeds the target by 10%)?
Automatic Rollover
The account balances of terminated participants are transferred to an IRA and into a default investment. This year, a 401(k) plan must have procedures in place to automatically rollover the accounts valued between $5,000 and $1,000 (unless you do not have a mandatory cash-out provision in your plan). While there are final regulations from the Labor Department that provide a “safe-harbor,” the plan sponsor should consider how different the IRA default investment is from the 401(k) default investment.
There is a presumption that participants who do not make an investment selection lack the time, interest or confidence to do so. But if the time involved to make a decision is an hour – due to a questionnaire and fund reading material – and the expected difference in returns between a fixed interest account (e.g., stable value) and a market allocated investment (e.g., lifestyle fund) IN THE FIRST YEAR is nominal, then the participant may decide it is not worth their time to go through the process.