Should Your Company’s Retirement Plan Implement Auto-Enrollment?
Whether your company already offers a 401(k) plan or you are considering adding this benefit, automatic enrollment is one of many plan design considerations. Research has shown that auto-enroll offers many advantages to both the plan sponsor and the participant. Knowing your goals and the advantages and disadvantages of auto-enrollment may help you determine if the feature is right for your plan, and, if so, which type of automatic contribution arrangement is best-suited.
In general, there are three types of automatic contribution arrangements:
1. Automatic Contribution Arrangement (ACA) – If a participant does not complete an enrollment form, the employee’s compensation is automatically reduced by a fixed percentage (3% is standard) and the amount is contributed to the 401k plan. The default election no longer applies once the participant makes an affirmative election, whether it is 0%, another percentage or a fixed dollar amount. There is no provision under an ACA that allows that participant to have his funds distributed if he prefers not to have the amount taken from his compensation. It must stay in the plan until a distributable event occurs.
- If no deferral election, compensation is automatically reduced by a fixed percentage.
- Annual notice 30-90 days prior to beginning of plan year (in addition to providing to participant when he first becomes a participant).
- No process to distribute automatic deferrals.
- All nondiscrimination testing is required.
- Can be implemented at any time (via plan amendment).
2. Eligible Automatic Contribution Arrangement (EACA) – An EACA is similar to the ACA in that participants are treated as having elected to defer until they opt out of the plan (or make a separate contribution election). The plan must also have a qualified default investment alternative (QDIA). Participants must be given an annual notice explaining their rights under the arrangement. Unlike the ACA, the EACA may permit participants to withdrawal automatic deferrals (plus earnings) within a 90-day window. Lastly, if the plan were to fail ADP/ACP testing, the employer has 6 months after the end of the plan year to refund excess contributions without incurring the 10% excise tax.
- If no deferral election, compensation is automatically reduced by a fixed percentage.
- Annual notice 30-90 days prior to beginning of plan year (in addition to providing to participant when he first becomes a participant).
- Plan may permit participants to withdraw automatic deferrals within a 90-day window.
- All nondiscrimination testing is required; however, the deadline to avoid a 10% excise tax on excess deferrals is extended to 6 months after the end of the plan year.
- Can be implemented at the beginning of the plan year (via plan amendment).
3. Qualified Automatic Contribution Arrangement (QACA) – Under a QACA, the automatic deferral percentage must be increased each year. For example, the initial period would have a 3% deferral for a participant who did not make an election. Assuming no affirmative election, it must be increased to at least 4% in the 2nd year, 5% in the 3rd year, and at least 6% in the 4th and subsequent years. The percentage may not exceed 10%. Participants must be given an annual notice explaining their rights under the arrangement. If the QACA also meets the same requirements as an EACA, the plan may permit participants to withdrawal automatic deferrals (plus earnings) within a 90-day window.
A QACA also carries a required matching contribution of at least 100% of the first 1% deferred plus 50% of the next 5% deferred (for a maximum of 3.5% of compensation). The contribution must be 100% vested for a participant who has 2 years of service. This contribution exempts plans from the ADP/ACP tests, and, if the only contributions in the plan year are deferrals and matching contributions, plans are deemed to satisfy top heavy requirements.
- If no deferral election, compensation is automatically reduced by a fixed percentage, a minimum of 3% the first year. It must be increased to at least 4% for 2nd year, 5% for 3rd year, up to a minimum of 6% for the 4th year. The percentage cannot exceed 10%.
- Annual notice 30-90 days prior to beginning of plan year (in addition to providing to participant when he first becomes a participant).
- Plan may permit participants to withdraw automatic deferrals within a 90-day window.
- Plan has a required matching contribution – 100% of the first 1% deferred plus 50% of the next 5% deferred (total of 3.5% of compensation). The matching contribution must be 100% vested at two years of service.
- The contribution provides an exemption from ADP/ACP tests. Top heavy is also deemed to be satisfied if no additional employer contributions are made in the plan year.
- Can be implemented at the beginning of the plan year (via plan amendment).
There are some cons to automatic contribution arrangements. If the plan sponsor does not appropriately apply the fixed percentage to a participant’s compensation, an operational failure has occurred and the sponsor must provide a QNEC for the “missed deferral opportunity”, plus any matching contribution the participant should have received. This is a common issue with automatic contribution arrangements.
- Any of the ACAs will likely increase the company’s matching contribution obligation to the plan. A company should weigh this financial consideration against the reasons for wanting to implement an ACA.
- It is the plan sponsor’s responsibility to monitor the participants who should have an automatic deferral. This includes maintaining records under a QACA for participants who should receive a percentage increase each period. If not done properly, this also is an operational failure and the firm would likely need to make a corrective contribution.
- Some studies have shown that ACAs generally do not increase plan participation.
In addition, the plan sponsor would also need to decide whether they wanted the auto-enrollment to apply to only new participants, or all participants that don’t already have a salary reduction agreement, or all participants that are deferring less than the automatic deferral percentage. As well, if a sponsor would like the plan to include auto-escalation, it would need to choose the percent of compensation to escalate per year up to a maximum percentage of compensation. The timing of the escalation would happen on the same day for all participants, one chosen by the sponsor.
If you are a plan sponsor and find yourself needing or wanting to increase your employees’ participation in your company retirement plan, we encourage you to take the necessary steps to determine the best ways to do so. For more information on CapSouth’s retirement plan consulting services, please contact us toll free at (800) 929-1001.
Thank you to DWC ERISA Consultants for their assistance in writing this article.
