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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