On August 17, President
Bush signed the Pension Protection Act of 2006 (PPA) into law. The
new law, heralded by many as the most important change to the rules
governing retirement benefits since the passage of the Employee
Retirement Income Security Act of 1974 (ERISA), aims to increase
employee participation in 401(k) and other defined contribution
plans by explicitly allowing for the automatic enrollment of
employees. It also provides a safe harbor for plan sponsors and
other fiduciaries who invest automatically enrolled participants’
contributions in a qualified default investment alternative.
Introduction to Automatic Enrollment
Automatic enrollment is not a novel concept in the defined
contribution plan world. Plans that currently have the feature
deduct a specified percentage of an employee’s wages without the
employee’s consent and then invest the money in the 401(k) plan’s
default investment option. Research has shown that companies with
such an option see drastically increased participation.
Despite the benefits of automatic enrollment to both plans and
participants, it has not been widely implemented because plan
sponsors feared that withholding and investing employee wages
without affirmative investment instructions from the participant
could result in liability under ERISA. Moreover, there has been
concern that automatic enrollment would run afoul of state laws that
forbid withholding without employee consent. The PPA alleviates
employer fears by explicitly authorizing automatic enrollment.
PPA Automatic Enrollment Provisions
The PPA allows a percentage of an employee’s wages to be
automatically withheld and contributed to a defined contribution
plan. The basic rules are as follows:
- The employer may withhold a specified percentage of an
employee’s wages and invest them in the plan;
- The employee must have the option of opting out of the plan or
changing the contribution level;
- Employees that have been swept into a plan without making an
affirmative election to do so may make withdrawals of automatic
deferrals within 90 days of the first contribution without a
penalty. By doing so, they forfeit any employer-provided matching
contributions;
- The plan must notify employees of automatic enrollment when
they are hired, just before they become eligible and once a year
thereafter. The notice has to inform the employee that he can opt
out of the plan and/or change his contribution level; and
- A plan with automatic enrollment may avoid nondiscrimination
testing if it enrolls all new employees at a deferral percentage
of at least 3%, the plan automatically increases the employee
contribution percentage by 1% each year until it reaches 6% and
the employer makes certain matching contributions which are fully
vested after two years of service.
Deferring employee wages because of automatic enrollment will not
be subject to state prohibitions on withholding wages without
consent.
By itself, the express authorization of automatic enrollment
under the PPA would not necessarily be enough to make plan sponsors
change their salary deferral plans because a question would still
remain as to what type of investments should be used for those
participants that were automatically enrolled. Fortunately, the PPA
addressed this issue as well.
Default Investments
Generally, plan sponsors and other fiduciaries are not liable for
the investment decisions of participants in defined contribution
plans. The theory is that fiduciaries should only be liable in
instances where they exercise discretion or control over plan
assets. However, prior to the PPA, the U.S. Department of Labor
(DOL) took the position that in situations like automatic
enrollment, where there is no affirmative participant investment
election, plan fiduciaries might be liable for losses resulting from
the default investment.
Congress was aware of this impediment to automatic enrollment
and, as a result, addressed this issue in the PPA. The PPA reverses
the DOL’s prior position and extends protection to fiduciaries that
invest the account balances of auto-enrolled participants in a
default investment, provided that the plan gives the participant
notice of how contributions will be invested in the absence of
instructions and the participant’s right to reallocate the
investments.
As required by the PPA, the DOL has issued proposed regulations
that clarify the rules for default investments. Final regulations
are expected by February at the latest.
DOL’s Proposed Regulations
The DOL’s proposed regulations provide protection from liability
to plan sponsors and other fiduciaries that invest participant
account balances in a way that meets the following conditions:
- A fiduciary may invest a participant’s assets in a default
option only after the participant has been given the opportunity
to direct the investment of the assets in his account and fails to
do so;
- Plan terms must provide that any material provided to the plan
relating to a participant’s investment (such as prospectuses,
proxies, account statements) will be provided to the participant
or beneficiary;
- A participant must be able to transfer out of the default
investment option without financial penalty on the same terms as
any other investment option and at least as frequently as once
within any three-month period;
- The plan must provide a notice to participants at least 30
days before the first plan investment and at least 30 days before
the beginning of each subsequent plan year. The notice must
describe the default option, the circumstances under which plan
accounts will be invested in the default option and the
participant’s rights with respect to directing assets to other
options under the plan. These notice requirements and the notice
relating to auto enrollment could likely be met in a single
notice;
- The plan must have a variety of different investment options;
and
- Most importantly, the default investment must be invested in a
"qualified default investment alternative."
Qualified Default Investment Alternative
The chief requirement for any default investment option is that
it meets the requirements of a "qualified default investment
alternative." The regulations explain that a qualified default
investment alternative:
- May not generally hold employer securities, such as employer
stock, except for employer securities held in certain types of
"pooled" investment alternatives;
- May not impose penalties or restrict the ability of a
participant to transfer out of the investment alternative;
- Must be a registered investment company under the Investment
Company Act of 1940 or managed by an investment manager;
- Must be diversified so as to minimize the risk of large
losses; and
- Must qualify as one of the three approved types of investment
products or services.
Investment Products and Services Approved
by the DOL
After surveying the various types of investment products and
services available to plans and their relative merits, the DOL
determined that only three types were suitable for use as a
qualified default investment alternative:
- The first type of qualified default option is a fund or
portfolio designed to provide varying degrees of long-term capital
appreciation and capital preservation based on a participant’s
age, retirement date or life expectancy. This could be a
stand-alone product or a "fund of funds" comprised of various
investment options available under the plan. Examples include
"life cycle" or "retirement date" funds. A participant’s account
would be invested in the appropriate fund or portfolio based
solely on the participant’s age, life expectancy or retirement
date.
- The second type of "qualified" default option is a single
default option for all plan participants. This option is described
as an investment fund or model portfolio designed to provide
long-term appreciation and capital preservation through a mix of
equity and fixed income exposures consistent with a target level
of risk appropriate for the plan as a whole. According to the DOL,
an example of such an option may be a balanced fund. Like the
first option, it could be a stand-alone investment product or a
fund of funds utilizing other options otherwise available under
the plan.
- Third, a plan could select an investment management service
through which a professional investment manager allocates the
assets of a participant’s account among equity and fixed income
investments based solely on the participant’s age, life expectancy
or target retirement date.
The DOL acknowledged that the only relevant information that plan
fiduciaries may have regarding a participant who fails to provide
investment instructions is the participant’s age. Accordingly, none
of the permissible default investments require the plan or manager
to take into account other factors that could affect retirement
asset allocations such as risk tolerance, other assets, level of
income or lifestyle preferences.
Products That Do Not Qualify
Significantly, the DOL specifically rejected the use of capital
preservation investment products, such as stable value and money
market funds, as qualified default investment options, stating that
those investments would be unlikely to generate a sufficient rate of
return to provide adequate retirement savings for participants. The
omission of stable value products is especially surprising since
many plans currently use them as default options.
Plan Sponsor Liability
Fiduciaries that provide default investments meeting the
requirements of the regulation would not be liable for losses that
result from the investment of the participant’s account balance in a
qualified default investment alternative or for investment decisions
made by the manager of the investment alternative.
Nonetheless, like any other investment option, fiduciaries could
still be liable for decisions made concerning plan assets,
including:
- Any losses that result from imprudently selecting and
monitoring the default option;
- Improper management of the qualified default investment
options by investment managers; and
- Excessive investment fees and expenses.
As a result, plan fiduciaries should continue to monitor and
periodically reassess the prudence of their default investment and
be aware of the relative fees and expenses when selecting among
different options.
Conclusion
The PPA’s automatic enrollment and default investment provisions
will go a long way to encouraging 401(k) plan investment and
shielding plan fiduciaries from liability. Plan sponsors thinking
about making changes to their plans should carefully consult their
advisors, consultants and counsel before taking any action.
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