Approximately 47 million Americans actively participate in 401(k) retirement savings plans. Despite their popularity, however, 401(k) plan participation rates aren’t what they should be at some companies. Be it for lack of motivation, lack of understanding, or other reasons, some employees who are eligible to join a 401(k) plan simply don’t.

Low participation among a company’s nonhighly compensated employees can make it difficult for a plan to pass the tax law’s nondiscrimination tests, forcing the company to restrict deferrals by highly compensated employees. Increasing overall participation can make it possible for highly paid employees to take full advantage of the 401(k) plan, in addition to improving the retirement outlook for all employees. Automatic enrollment is one approach employers are using to boost participation.

How It Works

With automatic enrollment, preset elective deferrals to the 401(k) plan begin as soon as an employee becomes eligible to participate, unless the employee elects to receive cash or have another amount contributed. The set percentage is withheld from the employee’s pay and deposited in the plan.

• Acme’s 401(k) plan provides for an automatic enrollment contribution of 3% of eligible compensation. Jason begins working for Acme and is immediately eligible to participate in the plan. He does not opt out of making a plan contribution or choose to contribute a different amount. As a result, Acme begins to withhold 3% of Jason’s compensation, contributing the money to his plan account.

To implement automatic enrollment, the employer notifies each eligible employee of the arrangement and of the employee’s right to choose not to make contributions. Employees must be given sufficient time after receiving the notice to elect not to participate in the plan and have the option of changing their elections in the future.

Pension Protection Act Incentives

The 2006 pension law provides several incentives for employers to adopt automatic enrollment.

Prohibitions on withholding. Conflicts with state laws on wage withholding without employee consent have been eliminated.

Default investments. Employers will be protected from fiduciary liability for the investment of contributions made to the plan through automatic enrollment, provided the plan follows U.S. Department of Labor guidelines regarding default investments.

Nondiscrimination safe harbor. 401(k) plans have the option of following certain safe harbor rules that will allow them to avoid the tax law’s top-heavy rules and bypass actual deferral percentage (ADP) and actual contribution percentage (ACP) nondiscrimination testing. The safe harbor requires:

• First-year automatic contributions of no more than 10%, with a minimum contribution of 3% of pay, increasing by 1% annually up to 6% of pay in the fourth year;
• Mandatory employer contributions, either in the form of matching contributions on up to 3.5% of compensation or nonelective contributions of at least 3% of compensation;
• 100% vesting of these employer contributions after two years of service; and
• Compliance with certain notice requirements.

Worth Considering

If your company sponsors a 401(k) plan or is considering starting a plan, automatic enrollment is a feature you may want to consider. Please let us know if you’d like help with your analysis, contact us at 585-419-0670.