Pension Reform Influences Automatic Enrollment Designs

August 9, 2006 ( - The Pension Protection Act, now passed by both the House and Senate and waiting for President Bush's signature, contains a number of potentially significant enhancements for defined contribution plans.

Among its 900+ pages, the bill seeks to encourage automatic enrollment and contribution acceleration designs, removes the current sunset provisions (tax law changes can never be viewed as “permanent”) of the individual retirement account (IRA) and pension provisions enacted under the Economic Growth Tax Relief and Recovery Act of 2001 (EGTRRA); and similarly extends permanently indexing to inflation the “Savers’ Credit,” which is currently set to expire after December 31, 2006.

Safe Harbor

As anticipated, the bill makes clear that its provisions supersede state wage withholding laws, particularly those in states that require an employee signature before withholding from their pay, that have been seen as an impediment to the adoption of these programs.   Plan sponsors are also offered a new safe harbor for 401(k) that relieves a sponsor of the need to do ADP/ACP testing and excludes the plan from Top Heavy consideration, if the plan is a qualified automatic contribution arrangement.

A “qualified percentage of compensation” must be deferred for eligible employees. This “qualified percentage of compensation” is no more than 10% of compensation and in the first year ending on the last day of the first plan year after the first contribution under the arrangement participants must be at least 3% of pay, the second year at least 4% of pay, the third year 5% of pay, and in years four and on, must be at least 6% of pay.

Employees must be notified of the planned automatic enrollment and investment selection with enough time between receipt of the notice and when the first elective contribution is made to make an affirmative election if he so chooses. This does not need to be applied to current employees with an election in effect.

The plan must also provide either a non-elective contribution of 3% of pay or a matching contribution equal to the participant contribution as a percent of pay or the matching contribution as a percent of the participant contribution.   Finally, and logically, if the participant makes an affirmative election, then they must be removed from the automatic arrangements. Although the state preemption is effective immediately upon enactment of the bill into law, the safe harbor does not go into effect until 2008

The PPA also discusses the default investments to be used in automatically enrolling plan participants into 401(k) plans, something for which the Department of Labor is reportedly drafting guidance. The PPA alludes to the DOL regulations, saying they will spell out “the appropriateness of designating default investments that include a mix of asset classes consistent with capital preservation or long-term capital appreciation, or a blend of both.” The PPA offers protection under 404(c) for plan sponsors who default participants into an investment option that satisfies the requirements of the DOL guidance, including the following notice requirements:

  • within a reasonable period of time before each plan year, a notice is provided explaining the employee’s right under the plan to designate how contributions and earnings will be invested and explaining how they will be invested in default of an affirmative election;
  • the employee has a reasonable period of time after receipt of the notice and before the beginning of the plan year to make an election.

Fund Replacements

Beginning in 2008, advisors and plan sponsors will also have protection under 404(c) when mapping participants during the removal or replacement of a plan fund or funds when the plan participant does not affirmatively direct a reallocation. The 404(c) protection continues if participants’ accounts are reallocated among one or more remaining or new investment options “the stated characteristics of [which], including characteristics relating to risk and rate of return, are, as of immediately after the change, reasonably similar to those of the existing investment options as of immediately before the change.”

However, as with the default fund requirements, there are notice requirements for the mapping of funds. Participants must be notified of the change and be provided information comparing existing and new investment options and must also be told that if they do not choose an affirmative option, they will be automatically moved into new funds. This notice must be given at least 30 days and no more than 60 days prior to the effective date of the fund change.