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Commentary

Automatic 401k Enrollment

Automatic enrollment plans make saving for retirement easy for hard-to-reach employees.

When it comes to signing up for the company 401(k) retirement savings plan, roughly one out of every four eligible employees fails to enroll. That means some 12 million workers remain unmoved by company education efforts, such as seminars and brochures, and enticements, such as matching contributions or loan programs.

But there is a way lo boost 401(k) participation if all else has failed. With "automatic enrollment" or "negative election" plans, new hires are signed up in the company 401(k) plan unless they decline in writing or complete sign-up forms with different instructions. Failure to act one way or the other triggers automatic enrollment - using default elections.

But automatic enrollment is attracting more attention from benefits managers. Among the council's 1,200 members, 119 of the 275 who responded to a December 1996 survey said they would like more information about the practice.

Here's how automatic enrollment works. New hires are given an enrollment package before they become eligible to participate in the company 401(k) plan. The package contains a plan description, election forms, and a notice that failure to fill out and return the forms by a specified date will result in automatic enrollment. The default amount of pay deferred and investment choices vary from company to company.

As is standard practice for all 401(k) plans, employees may cancel their participation at any time or change the way their funds are invested.

Freddie Mac, the Federal Home Loan Mortgage Corp. in McLean, Va., started its automatic enrollment plan in January. The plan defers 3 percent of pay into a money market fund for those automatically enrolled. Freddie Mac will match that amount after one year. Employees may increase or decrease the deferred amount, opt out, or change the investment allocation.

The agency launched automatic enrollment for two reasons, says benefits manager Margaret Collenberg. "We thought that employees should save, and we should do what it takes to encourage them." The plan also helps with recruiting. "For competitive reasons, we wanted to be able to tell job candidates that in their first year they would have a tax-free savings account," says Collenberg.

Since the program began, about 30 percent of those automatically enrolled have increased their deferral amount. Roughly 65 percent have left the deferral at 3 percent. And only 4 percent have opted out.

Last December, before the plan changes were launched, Freddie Mac's 401(k) participation rate was 81 percent. Since then, the rate has edged up to 83 percent and is expected to climb over time with employee turnover, says Collenberg.

JC Penney, which launched its automatic enrollment plan in April, deducts 2 percent from employees' paychecks and contributes a matching 2 percent, says spokesman Duncan Muir. The funds are invested in a guaranteed-interest account.

Workers already on the payroll cannot be targeted for automatic enrollment, says Larry Grudzien, an attorney with William M. Mercer in Chicago. "By not signing anything in the past, they have elected. So employers can't impose a new automatic enrollment on existing employees," he says. 401k Tip---
The tax deferral of 401k has a huge compounding effect: $150 per month put into a typical taxable savings account paying 8% annual interest will grow to $42,034 by the end of 20 years (assuming a combined federal and state personal income tax rate of 34%). In a 401(k), however, the same deposits earning the same rate of return during the same 20 years will yield $88,353. Even if that amount is taxed at the 34% rate when the money is withdrawn from the plan, which is unlikely if the participant is retired, the 401(k) participant will walk away with more than $16,000 compared to the equivalent non-401(k) investment return. One small employer that has benefited greatly from a company-wide 401(k) is Target Laboratories (www.targetlab.com). The employees are very happy to be able to save for their retirement in tax-advantaged accounts.

WHY BOTHER?

Companies that have installed automatic enrollment plans typically have a target group in mind: low-wage, young employees. This hard-to-reach population is not prepared to think about retirement savings.

"You could practically hold their hands, and they wouldn't sign up," says Wray. "You could have a very rich match, and they still wouldn't participate. Something more aggressive needs to be attempted to get a higher participation level from this group."

Employers strive for higher participation levels out of genuine concern for helping low-wage employees achieve a higher level of economic security via retirement savings. But greater participation among low-wage employees can also boost the level of savings permitted among highly paid workers, including company executives. Under complex federal nondiscrimination formulas, the more a company's lower-paid workers defer into a 401(k) plan, the more that highly paid workers may defer.

Some companies soon will stop having to fear failing nondiscrimination tests, thus eliminating a reason to install all automatic enrollment plan, says Dennis Coleman, a principal with tile Kwasha Lipton Group of Coopers and Lybrand in Fort Lee, N.J. Congress included two safe harbor provisions in the Small Business Job Protection Act, which became law in the fall of 1996.

Effective ill 1999, companies will be exempted from nondiscrimination testing if they make an across-the-board 401 (k) contribution of 3 percent to all eligible employees, regardless of whether the workers contribute to the plan. A second safe harbor exempts companies that match an employee's 401(k) contribution up to 3 percent and also match 50 cents on every dollar of deferral between 3 percent and 5 percent of pay.

"You won't need to be as concerned about signing up everyone" once the new safe harbor regulations go into effect, says Coleman. Once a company meets the safe-harbor test, "all the highly compensated employees will be able to contribute without regard to non-highly compensated employee contributions."

Wray contends that automatic enrollment only incrementally boosts the amount that highly paid employees may defer. "The real issue is that automatic enrollment helps to bond employees to the company," says Wray. "Companies have these plans to build a bridge to their workers."

IS IT LEGAL?

The legal footing for automatic enrollment plans is not as firm as many benefits professionals would like. To date, the Internal Revenue Service has issued no official ruling. But the agency's field offices have routinely issued "determination letters" approving retirement plans that include automatic enrollment. "Companies that get favorable determination letters can rely on them," says a spokesman in IRS headquarters. "A favorable determination letter is binding with respect to that company's plan."

Meanwhile the IRS is reviewing whether to continue approving plans that include automatic enrollment, according to the spokesman. At issue is the interpretation of section 1.401(k)-1(e)(2) of the regulations. It reads in part: "A cash or deferred arrangement satisfies this paragraph (e) only if the arrangement provides that the amount that each eligible employee may defer as an elective contribution is available to the employee in cash."

Says the spokesman: "The regulations say deferrals must be available in cash. Does this arrangement [automatic enrollment] constitute availability in cash? We still have that under consideration."

There is ample precedent, however, for automatic enrollment, says Wray. "Most government pension plans require automatic contributions, and you can't elect out" as is standard with private-sector automatic enrollment plans. The Denver public schools, for example, automatically enrolled Wray's wife when she worked there, taking 6 percent out of her salary for the pension plan, he says. "The fact is, we've had mandatory contributory retirement plans for a long time."

Even if the IRS ultimately has no problem with automatic enrollment, some states may, warns Grudzien. "There is a controversy in the ERISA [Employee Retirement Income Security Act] community over whether automatic enrollment is pre-empted by state garnishment laws. Many states have rules that to deduct anything from an employee's check, you must first have written permission." In those states, asks Grudzien, how can an employer adopt automatic enrollment without violating state laws?

To avoid problems with state regulators, Grudzien recommends that plans include built-in safeguards for employees. Making sure the following questions are answered affirmatively, he says, should smooth the way for state authorities to approve an automatic enrollment plan.

* Are employees informed of the automatic enrollment procedure before becoming eligible to participate?

* Are employees given a reasonable opportunity to avoid automatic enrollment by returning a sign-up form before deductions begin?

* After amounts are deducted from an employee's pay, can employees stop the deferrals at any time?

* Are deferred amounts held in trust for a participant in a fully vested account that is credited with earnings, so there is no garnishment in favor of a third party?

* Are deferred amounts matched with employer contributions?

WHERE TO STASH THE CASH

Automatic enrollment also raises some difficult questions about how to invest the deferred funds on behalf of employees. Under the Department of Labor's 404(c) regulations, an employer who provides multiple investment choices greatly reduces fiduciary liability for poor investment performance. That protection does not extend to automatic enrollment plans because the employee does not actively make an investment choice. Because of heightened employer exposure to fiduciary issues, Grudzien suggests that companies stick to conservative investments, like money market accounts, guaranteed investment contracts (GICs) or lower-risk mutual funds.

Finally, automatic enrollment may create administrative headaches for unsuspecting employers. Companies with high turnover may end up with a large number of small 401(k) accounts and all the attendant problems of management and reporting.

"If these people don't have enough gumption to sign a form to enroll, what's going to happen when they leave?" asks Grudzien. "If an account balance is under $5,000, the employer can return the money without the employee's permission. If the account is over $5,000, you may have that account on the books for years, paying for the administration. And you may have a former employee whom you may never find."

Additional non-profit websites that include relevant unbiased information about 401k plans include: www.401k-limits.com

ANOTHER APPROACH

Given the potential legal and fiduciary hazards surrounding automatic enrollment plans, Coleman of Kwasha Lipton regards them as dangerous. He prefers instead an approach called "simplified enrollment," which increases participation rates without the legal or asset allocation problems accompanying automatic enrollment plans.

Under simplified enrollment, the employer specifies a default amount to be deferred from a new employee's paycheck and how the money will be allocated among available investment options. "Each new hire, as part of the orientation program, enrolls in the plan by signing a form agreeing to this contribution rate and investment allocation," Coleman explains. Those who want to pick a different deferral rate, investment option, or opt out altogether may do so in writing during orientation.

Requiring new hires to sign a form accepting or rejecting the company's retirement plan makes a big difference in participation, concluded a study last year by Access Research of Windsor, Conn., now a division of the Spectrem Group. The study, conducted for CIGNA Corp., found that 70 percent of the 401(k) plans with participation levels exceeding 80 percent require employees to decline through a written form. Only 55 percent of plans with participation rates of less than 80 percent have the same requirement.

The act of signing a form eliminates any question about involuntary deferral of wages. Moreover, the simplified enrollment approach requires employees to make an afFirmative choice for the default investment option. That eliminates the potential for problems that might arise under the automatic enrollment.

Some companies use a variation of simplified enrollment. Autodesk, a computer-assisted design software firm in San Rafael, Calif., enrolls its entire eligible staff in the company 401(k) plan and makes quarterly contributions of $250, says Christine Tsingos, vice president and treasurer. Hence, the company has 100 percent participation.

When the company started the plan four years ago, the 401(k) participation rate hovered around 65 percent. In addition, the company had failed nondiscrimination tests because of the large number of young employees who did not participate.

Now, 87 percent of the firm's employees contribute to the 401(k) plan, which triggers an additional match from the company, says Tsingos. "Once you start to get an investment statement and see your nest egg grow, it tends to draw people in. They see that it works," she says. Moreover, Autodesk no longer has any problem passing nondiscrimination tests. "It's been a win-win outcome for everyone," she says.

While no one counts the number of companies that adopt automatic or simplified enrollment 401(k) plans, Coleman says he knows of several that have adopted the simplified approach and knows of several more that are considering it. "Over time, I think it will get a reasonably large foothold, maybe 10 percent of all plans."

Whatever approach a company takes to boosting employee participation in retirement savings, one thing remains constant: the need for effective communication.


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