The IRS' recent revenue ruling approving automatic enrollment for 401(k) plans has generated huge interest among plan sponsors.
9Before (the ruling), no one was really sure what the regulators thought. Now, we see every client interested," said Marc Cahn, senior vice president of compliance and consulting for Putnam Investments' defined contribution business in its Quincy, Mass.
"I think this will be the single biggest issue plan sponsors will have to tackle this year," Mr. Cahn said of automatic, or negative, enrollment.
Under the automatic enrollment arrangement, also called negative election, an employee's compensation is reduced by a specified amount that is contributed to the employer's 401(k) plan automatically, unless the employee affirmatively elects not to participate.
Under the revenue ruling released last month, as long as "an eligible employee has an effective opportunity to elect to receive cash or have that amount contributed by the employer to a profit-sharing plan," automatic contributions made by the employer from the employee's wages satisfy the requirements of the tax code governing 401(k) plans.
A negative election will not run afoul of the 401(k) tax regulations "merely because they (automatic payroll contributions to a 401(k) plan) are made pursuant to an arrangement under which, in any case in which an employee does not affirmatively elect to receive cash, the employee's compensation is reduced by a fixed percentage and that amount is contributed on the employee's behalf to the plan," the ruling states.
Interest in automatic enrollment has been especially high in companies in which a large percentage of the work force is being paid minimum wage or slightly above, said Bob Rudell, president of Scudder Kemper Retirement Services, Boston.
Still, said Mr. Rudell, "I do not think it will have a huge impact."
One attraction to employers: Automatic enrollment helps a plan pass discrimination testing because it leads to more participation by lower-paid employees.
Those 401(k) plan executives buoyed by news of the ruling have to wrestle with a few sticking points not addressed by the IRS.
One legal problem is that state wage-and-hour laws commonly prohibit an employer from taking part of an employee's wages without the employee's express written consent, said Stephen Saxon, a partner in The Groom Law Group in Washington. Negative elections run afoul of these laws, he added.
Although those state laws may be pre-empted by the federal Employee Retirement Income Security Act of 1974, Mr. Saxon said, "I'm not sure if anyone has gotten a formal opinion on 401(k) negative elections" from the Department of Labor under ERISA.
Including a statement in employment applications or in the initial enrollment materials authorizing the deduction "may work," he said.
Another issue: Employers with an automatic election process may lose 404(c) liability protections.
A footnote in the IRS revenue ruling says: "The Department of Labor has taken the position that a participant or beneficiary will not be considered to have exercised control when the participant or beneficiary is merely apprised of investments that will be made on his or her behalf in the absence of instructions to the contrary."
The way to regain 404(c) safe harbor is to encourage the participant to make his/her own choice shortly after joining the 401(k) through automatic enrollment, Mr. Saxon said.
THE DEFAULT OPTION
One huge hurdle is selecting the default option and the percentage of employees' salaries that will be contributed.
The 3% employee contribution in the plan at issue in the revenue ruling was directed to a balanced fund default option that included both diversified equity and fixed-income investments.
"That gives a lot of room for choosing a default," said Scudder Kemper's Mr. Rudell.
Not everyone agrees what the default option should be. Many firms that incorporated an automatic enrollment system before the IRS ruling selected a company stock or guaranteed fund option for employees who did not choose, according to Sholomo Benartzi, professor of accounting for the Anderson School at UCLA in Los Angeles.
The firms that have chosen a money market or stable value fund as the default option did so because those funds were lower risk, he explained.
Walt Lewis, is national director of institutional retirement sales at Stephens Inc., Charlotte, N.C., suggested a lifestyle fund that correlates with one of the better-known indexes. His firm distributes Nations Funds, NationsBanc Advisors Inc.'s mutual funds.
"My personal feeling is there would be a conservative asset allocation fund," Putnam's Mr. Cahn said.
But making the selection for employees is rampant with pitfalls, said Peter Vogt, assistant vice president and director of corporate markets for Hartford Life Inc. of Simsbury, Conn.
"If you make the default conservative and the market goes up, someone could say they have an opportunity loss," Mr. Vogt said.
Mr. Benartzi said that most providers are looking at the wrong asset allocation in a negative enrollment scenario. Both he and Mr. Cahn suggested the default option should vary depending on the participant's age.
So, the default option would be a lifestyle fund in which younger participants invest more aggressively than older employees, Mr. Benartzi said.
Mr. Rudell said a 3% contribution -- the contribution of the plan that sought the ruling -- might scare participants away, especially those who are lower paid. One solution could be to overweight the employer match so that there would be a 2% match for the first 1% of employee contribution, Mr. Rudell suggested.
"It's hard to turn down 200% return in the first 1%," he said. "This might avoid the employee's first irritated reaction if he sees the employer has put in twice as much."
One human relations executive who declined to be identified said the main issue for companies considering negative election is education.
"Employees do not always check their paychecks, especially with direct deposit. They would have money deducted and they would not know it," the executive said. "I think what it comes down to is disclosure."
Mr. Cahn agreed: "For people at the lowest end of the economic scale, if we only give them forms and there is no education effort at the same time, I'm not sure they will fully comprehend what's happening."
"People who feel comfortable with investments are probably already participating," Stephens' Mr. Lewis said.
Another challenge is how to satisfy the revenue ruling requirement that employees in a negative enrollment situation be given an "effective opportunity" to opt out of the 401(k) plan, Mr. Cahn said.