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Thanks to a new law and a proposed regulation, employers have a double-barreled approach to make 401(k) plan automatic enrollment nearly irresistible, observers say.
Tucked in the Pension Protection Act signed by President Bush in August is a provision trumping state laws that ban employers from putting a percentage of employee salaries into a 401(k) savings plan. Meanwhile, the Department of Labor in September released a proposed regulation clarifying default investments in an effort to protect employers from fiduciary lawsuits.
"In light of the Pension Protection Act and (Department of Labor) proposed regulation, this does make automatic enrollment very appealing" to employers, said Linda Wauson, senior defined contribution consultant at Watson Wyatt Worldwide in Houston.
Automatic enrollment isn't new. The feature has been available since 1998, when the Internal Revenue Service gave its blessing to the program. Automatic 401(k) enrollment can be used provided it is explained to employees and they are given the opportunity to opt out, the IRS said. One of the reasons employers didn't jump at the idea previously is some states' payroll rules say employers cannot withhold wages without employee permission. The new pension law pre-empts state rules.
Milwaukee-based Rexnord Industries L.L.C. is currently freezing its defined benefit plans and instituting automatic enrollment to its $160 million 401(k) plan for new employees. Eric Green, Rexnord's manager for compensation and benefits, says the companywhich has about 4,000 employees nationwide and manufactures power transmission componentswas already moving in that direction when the new pension law solidified its decision.
"We are making it as easy as possible for employees to get into the program and start contributing ASAP," Mr. Green said. "Our employee participation is decent (73%), not great, but decent already, but new hires are traditionally slow to join."
The new pension law also creates an option employers can use to pass the IRS non-discrimination test: New enrollees must contribute 3% of pay during the first year and must increase one percentage point annually until hitting 6% of pay in the fourth year. Plus, employers must make the following match: 100% on first 1% of pay deferred and 50% on deferrals between 1% and 6%.
Regular non-discrimination tests are used to ensure the average aggregate contributions by highly compensated employeesthose earning at least $100,000 in 2007generally are not exceeded by more than two percentage points of the average aggregate contributions made by rank-and-file employees.
While the new law's option may seem like a great incentive to pass non-discrimination testing, deductions may seem like pay cuts over time when employees see larger percentages of pay diverted to 401(k) plans, said Steve Metz, principal at PricewaterhouseCoopers L.L.P. in Philadelphia.
"The escalation could backfire somewhat and get some people to back out," Mr. Metz said. "In years two, three and fourÖto get that increase to 6% is possibly overreaching."
According to the Profit Sharing/401(k) Council of America's survey of 1,106 plans in 2005, the vast majority60.3%of plans with automatic enrollment defer 3% of pay. Nearly 11% of auto-enrollment plans defer 4%, while more than 7% of plans defer 6% of pay or more, the survey found. PSCA President David Wray said he expects more companies to increase deferral rates annually because employers want employees to accumulate significant savings over time.
According to a 2004 study from The Vanguard Group Inc., automatic enrollees usually remain at lower contribution rates. While automatic enrollment encourages people to save, typically they save too little at too slow a rate, said Stephen Utkus, director of the Vanguard Center for Retirement Research in Valley Forge, Pa.
The problem, Mr. Utkus said, is that employers want to boost participation rates in their 401(k) plans without routinely increasing deferral rates and offering appropriate funds.
"This combination provides exactly the wrong result," Mr. Utkus said. "You have to escalate savings rates and get out of (guaranteed investment contracts)."
This is where the Department of Labor's proposal comes into play. The proposed regulation would allow employers to deposit deferrals in specific accounts without the fear of fiduciary lawsuits. Those accounts are: lifecycle funds, where equity and fixed-income investments adjust to reflect the employees' age; balanced funds, a mix of equity and fixed-income investments; and managed accounts, where a professional investment manager oversees employees' portfolios.
The Department of Labor estimates that the proposal will increase aggregate 401(k) plan account balances by between $45 billion and $90 billion.
"This gives direct guidance to employers on what is an acceptable default option," said Watson Wyatt's Ms. Wauson. "These are probably the best plans for (employees) to get started in."
Rexnord's Mr. Green said the company plans to automatically enroll new employees into a money market fund in January 2007. Once a lifecycle fund is set up, new employees will move into that account. Currently, the company offers a so-called lifestyle fund, which is a mix of equities and fixed-income investments selected by the employee. This type of investment requires participants to understand risk and balance more than lifecycle funds, he said.
"We are most likely going to implement auto increases up to a certain percent as well," Mr. Green said, adding that the Department of Labor's proposed regulation played a major role in moving to a lifecycle fund. "Once that is under way, we will probably have a campaign to enroll more active employees."
Congress' endorsement of automatic enrollment, increased deferral rates for non-discrimination testing and approved investment options are exciting advancements for 401(k) plans, Mr. Utkus said.
"It may not happen for five years or 10 years, but this could potentially become a requirement or a standard," he added.
Interestingly, with the decline of defined benefit plans, the new rules for automatic 401(k) enrollment create a safety net quite similar to defined benefit plans, Ms. Wauson said.
"In automatic enrollment, although the employee bears the investment risk, (employees) aren't asked whether they want to be in the plan and to make (investment) decisions," she said. "Even if they don't do anything, they still have something."