Despite the fact that employees have long been allowed to set aside pre-tax wages for retirement savings and are often eligible to have a portion matched by their employers, one out of every four workers who can participate in 401(k) defined contribution (DC) plans don't. And while a percentage of those consciously choose not to because they can't afford to lose the take-home, there is a sizable group that simply can't get its act together to sign up.
Thanks to a small provision in the recently enacted Pension Protection Act, that inertia is less likely to jeopardize their retirement. The new law addresses legal ambiguities that discourage employers from implementing automatic enrollment for their 401(k) programs, and the expectation is that many more plan sponsors will now embrace it, eventually pushing average participation rates in plans closer to 90%. While much of the new law remains controversial, this is one of the few sections to receive almost universal support. "This act clears up a lot of uncertainty and says that the government favors automatic enrollment," says Leslie Smith,
a director in Deloitte Consulting LLP's human capital practice.
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For many years, the motivation behind automatic enrollment was viewed as too paternalistic; let workers evaluate their own needs and act accordingly, critics would say. But as many defined benefit (DB) plans have fallen into disrepair and find it difficult to close funding gaps, more experts and plan sponsors see that it is incumbent upon them to devise ways to enhance DC plans to make them address income adequacy on retirement as DB plans once did. "Most employees welcome automatic enrollment," says Lori Lucas, formerly of Hewitt Associates and currently senior vice president and DC practice leader at Callan Associates Inc. "They are glad to be in the plan and appreciate the ability to join without complications."
That sentiment is also made clear by the fact that only about 10% of those automatically enrolled end up opting out when given an opportunity. Here's where a degree of inertia works to an employee's benefit.
So what does this new law mean to employers? With the uncertainties about whether auto-enrollment violates state laws against involuntary garnishment of wages resolved, retirement experts advise plan sponsors to regard auto-enrollment and auto-enhancement–that is, automatic increases in the percentage of pay to be contributed–as among the easiest things they can do to enhance the value of their DC plans for both workers and the company. "When they talk about what the most progressive plan sponsors are doing, and what plan sponsors in general should be doing to enhance their 401(k)'s, these are usually a given," says David Wray, president of the Profit Sharing/401(k) Council of America.
Under the new law, companies do not need to run average deferral percentage testing, also known as non-discrimination testing, if they adopt automatic enrollment that begins at a 3% deferral rate with a step-up of 1% per year and cap of 6%. Companies must also offer a 100% match on the first 1% and 50% on the next 5% with a two-year vesting period. Without non-discrimination testing, highly compensated employees–those earning over $100,000 a year–are permitted to put a maximum of $15,000, tax-deferred, into the plan annually. While this does not differ significantly from the prior law, it does put to rest any uncertainty for highly compensated workers come tax time.
The law basically provides fiduciary cover in a number of places to plan sponsors. For example, the act instructs the Labor Department to issue guidelines on how default funds can be invested. Historically, companies have invested those funds in low-yielding, low-risk money market accounts. The expectation is for the new guidelines to free up employers to place these funds into better-yielding, age-based lifecycle or balanced investment funds, which in general have a significant equity component. While the risk level is higher, these funds "are more appropriate investments from a long-term perspective," says Jeff Bograd, vice president and managing ERISA consultant for NYLIM Retirement Plan Services.
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