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Stephen Abramson

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401(k) Plans – Automatic Enrollment

Have any of your clients had to take refunds from their 401(k) plan to satisfy the non-discrimination testing (the ADP or ACP test)?  Are your clients restricted in the amount of the deferrals they can make to their 401(k) plan?  Are your clients satisfied with their employee’s participation rate in their 401(k) plan?  If the answer to any of these questions is no consider recommending the addition of an automatic enrollment provision, sometimes called negative election, to their plans.

Automatic enrollment was first introduced by McDonald’s several years ago and has gained significant popularity since then.  Plans that provide for automatic enrollment typically experience participation rates of between 80% and 90% as compared to traditional voluntary enrollment plans that experience rates of 50% to 60%.  In a survey conducted by Hewitt Associates participation rates in automatic enrollment plans were 91% compared to voluntary plans at 68%.  In addition the opt out rate for the automatic enrollment plans, i.e. those employees that were automatically enrolled but subsequently made an election to opt out, was between 1.5% and 10% of those automatically enrolled.  Although automatic enrollment does not guarantee satisfaction of the non discrimination testing it is more likely that the increase in participation rates will help toward that goal.

The Pension Protection Act of 2006 (PPA) in attempting to promote automatic enrollment introduced a new Safe Harbor 401(k) plan available beginning January 1, 2010.  This new plan design includes automatic enrollment for all eligible employees beginning at 3% and increasing by one percent each year up to a minimum of 6%.  Optionally the employer can continue the annual increase until an employee is deferring 10%.  Each employee’s deferral rate is based on their individual year of participation.  If, for example, employee A enters the plan in 2010 at 3% their deferral rate will go to 4% in 2011, 5% in 2012, etc.  Employee B who enters the plan in 2011 will be enrolled at 3% and increased to 4% in 2012, 5% in 2013 etc.  Although this seems like a lot of recordkeeping it should not be a problem for most Third Party Administrators.  The new plan design, similar to the existing Safe Harbor 401(k) plan requires either a non elective employer contribution for each eligible employee of 3% of compensation or a matching contribution equal to 100% of the first one percent the employee defers and 50% of the next five percent the employee defers, for a maximum match of 3.5% for any employee that defers 6% or more.  Unlike the existing Safe Harbor 401(k) plan the employer contributions are subject to a two year cliff vesting schedule, i.e. zero vesting in year one and 100% in year two.  In addition, similar to the existing Safe Harbor 401(k) plans, the automatic enrollment Safe Harbor is deemed to satisfy non discrimination testing (ADP and ACP testing) and top heavy requirements.

One of the concerns in any automatic enrollment plan is the management of investments of those employees that make the automatic deferral but do not make any investment election.  The Department of Labor has advised that the deferrals may be deposited in certain types of accounts without creating fiduciary responsibility on the part of the employer.  These accounts include balanced funds, lifecycle funds and managed accounts.  To insure compliance all eligible employees must be given appropriate notice of the automatic enrollment and a reasonable period of time to make an alternate election or to opt out entirely.  In addition, beginning in 2008, a new “do-over” rule allows employees that have been automatically enrolled to be cashed out within ninety days of their automatic enrollment, including gains attributable to their deferrals, without penalty.

                For those employers that choose not to deal with the perceived complexity of the Safe Harbor auto enroll plan or choose not to make an employer contribution an auto enroll feature can be added to a traditional 401(k) plan without any employer required contributions.

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Q & A From IRS – Simplified Employee Pensions (SEPs)

Which employees must participate in a SEP plan?

 

If the SEP has the most restrictive eligibility requirements as provided in form 5305-SEP contributions must be made for all employees who:

  • Reached age 21
  • Worked in at least three of the last five years, and
  • Received at least $550 in compensation for the year

 

The plan can also use less restrictive requirements, e.g. age 18 and $550 in earnings.

 

What is the 3 of 5 eligibility rule?

 

This rule means that employees must be included who have worked in 3 of the last 5 years.  As an alternative the plan may allow for immediate participation or e.g. two years out of the last five.  If the 3 of 5 rule is used all service must be counted regardless of the amount.  In the extreme one day of service in a year would validate that year as one of the three.

 

If the 3 of 5 rule is used is a contribution required for an employee who reached their third year in 20xx?

 

No, a contribution is not required for the employee until the year that contains their 4th anniversary of employment with the company.  In addition only plan years are counted, i.e. employment years prior to the adoption of the plan does not count.

 

If the only eligibility requirement of the plan is age 21 can the employee’s compensation be prorated from the date the employee turns 21?

 

No, the compensation used as the basis for the calculation of the contribution must be the entire plan year compensation.

 

Can the employee’s compensation be prorated based on when the employee first earns $550 in compensation?

 

No, once the employee earns $550  in compensation the entire plan year’s compensation must be considered.

 

Must the eligibility requirements be the same for all employees in the plan including owners?

 

Yes, the eligibility provisions must be the same for all employees including owners.

 

If I establish a plan with immediate eligibility can I require different eligibility requirements for future employees?

 

Yes, the plan can be established initially with immediate eligibility. At a later date the plan can be amended to more restrictive eligibility but those employees that entered the plan with the more liberal eligibility requirements must now also satisfy the more restrictive eligibility requirements.

 

Example: Immediate eligibility

Owner              DOH       2010

Employee #1    DOH       2010

Plan amended effective 2012 to 3 of 5 years

Owner and employee #1 has three years of service, would participate in 2013, the 4th anniversary of employment, therefore cannot continue participation in 2012

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Fiduciary Protection With A Qualified Default Investment Alternative (QDIA)?

Among the various alternatives to a traditional 401(k) plan the automatic enrollment plans are an effective response to low rank and file participation.  Either an auto enroll Safe Harbor or an auto enroll provision in a traditional plan will help increase participation and in the traditional 401(k) plan improve the results of the non discrimination testing.  One of the plan sponsor’s fiduciary concerns revolves around the choice of investments for those employees that do not alter the auto enroll election and therefore do not choose their investments.  Final regulations provide the following conditions that must be satisfied in order to obtain safe harbor relief from fiduciary liability for investment outcomes in this situation:

  • Assets must be invested in a “qualified default investment alternative” (QDIA) as defined in the regulation.
  • Participants and beneficiaries must have been given an opportunity to provide investment direction, but have not done so.
  • A notice generally must be furnished to participants and beneficiaries in advance of the first investment in the QDIA and annually thereafter. The rule describes the information that must be included in the notice.
  • Material, such as investment prospectuses, provided to the plan for the QDIA must be furnished to participants and beneficiaries.
  • Participants and beneficiaries must have the opportunity to direct investments out of a QDIA as frequently as from other plan investments, but at least quarterly.
  • The rule limits the fees that can be imposed on a participant who opts out of participation in the plan or who decides to direct their investments.
  • The plan must offer a “broad range of investment alternatives” as defined in the Department of Labor’s regulation under section 404(c) of ERISA.

 The final regulation does not absolve fiduciaries of the duty to prudently select and monitor QDIAs and does not identify specific investment products – rather, it describes mechanisms for investing participant contributions. The intent is to ensure that an investment qualifying as a QDIA is appropriate as a single investment capable of meeting a worker’s long-term retirement savings needs. The final regulation identifies two individually-based mechanisms and one group-based mechanism – it also provides for a short-term investment for administrative convenience.

 The final regulation provides for four types of QDIAs:

  • A product with a mix of investments that takes into account the individual’s age or retirement date (an example of such a product could be a life-cycle or targeted-retirement-date fund);
  • An investment service that allocates contributions among existing plan options to provide an asset mix that takes into account the individual’s age or retirement date (an example of such a service could be a professionally-managed account);
  • A product with a mix of investments that takes into account the characteristics of the group of employees as a whole, rather than each individual (an example of such a product could be a balanced fund); and
  • A capital preservation product for only the first 120 days of participation (an option for plan sponsors wishing to simplify administration if workers opt-out of participation before incurring an additional tax).

A QDIA must either be managed by an investment manager, plan trustee, plan sponsor or a committee comprised primarily of employees of the plan sponsor that is a named fiduciary, or be an investment company registered under the Investment Company Act of 1940.   Recognizing that some plan sponsors adopted stable value products as their default investment prior to passage of the Pension Protection Act and final regulations, the regulation grandfathers these arrangements by providing relief for contributions invested in stable value products prior to the effective date of the final rule.

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