Auto Enrollment

Paper discussing the various aspects of the new automatic enrollment provisions including the EACA and the QACA.

 

AUTOMATIC ENROLLMENT PROVISIONS

By

Pamela D. Perdue

Summers, Compton, Wells & Hamburg

                                                            Copyright 2008

 

I.       Introduction

 

Given the undeniable movement away from traditional defined benefit

plans and towards Section 401(k) plans, coupled with the increasing  concern that the rate of savings in such plans will not be sufficient to provide for retirement, Congress, as part of the Pension Protection Act of 2006 (“PPA”) codified rules allowing for automatic enrollment.

 

II.      Automatic Contribution Arrangement

 

A.      Preemption

 

Previously, where a Section 401(k) plan wanted to provide for automatic enrollment such that an eligible employee who fails to make an affirmative election is deemed to have elected to participate in the plan rather than being treated as having defaulted out of participation, and thus have amounts withheld from his paycheck and contributed to the plan, issues arose as to whether state laws imposing restrictions on when amounts can be withheld from a participant’s wages, might interfere.

 

Specifically, since most states have laws precluding an employer from withholding amounts from a participant’s paycheck absent either an affirmative election by the employee or a specific state statutory authorization, questions arose as whether such state laws were preempted by ERISA.

 

The PPA has now alleviated those concerns. Specifically, ERISA is amended to explicitly provide that it preempts any state law that would directly or indirectly prohibit or restrict the ability of a plan to contain an automatic contribution arrangement. [ERISA Section 514(e)(1)]

 

 

 

 

 

B.      Requirements to constitute an Automatic Contribution Arrangement

 

An automatic contribution arrangement means, for this purpose, a cash or deferred arrangement under which:

 

1.                 a participant may elect to have the plan sponsor make payments as contributions under the plan on behalf of the participant or to the participant directly in cash;

 

2.                 a participant is treated as having elected to have the plan sponsor make contributions in an amount equal to a uniform percentage of compensation provided under the terms of the plan until the participant makes an affirmative election; and

 

3.                 contributions are invested in accordance with the regulations prescribed by the DOL under ERISA Section 404(c)(5).

 

[ERISA Section 514(e)(2)]

 

This third requirement necessitates that the contributions be invested in a Qualified Default Investment Alternative in accordance with DOL regulations at Labor Reg. Section 2550.404c-5(c).

 

The regulations also provide that nothing in the regulations governing automatic contribution arrangements precludes a pension plan from including an automatic contribution arrangement that does not meet the requirements Labor Reg. Section 2550.404c-5(a) through (e). [Labor Reg. Section 2550.404c-5(f)(4)]

 

C.      Regulatory Expansion of Preemption

 

DOL regulations expand the application of the preemption provision by providing for the preemption of any State law that would directly or indirectly prohibit or restrict the inclusion in any pension plan of an automatic contribution arrangement regardless as to whether the plan includes an automatic contribution arrangement as defined in the regulations, that is, including satisfaction of the requirements under Labor Reg. Section 2550.404c-5(a) through (e). [Labor Reg. Section 2550.404c-5(f)(2)] This means that an arrangement may constitute an automatic contribution arrangement even though the amounts are not invested in accordance with Labor Reg. Section 2550.404c-5(a) through (e).

 

Moreover, unlike the basic preemption provision of ERISA which supersedes State laws only “insofar” as they satisfy the “relates to” standard set forth in ERISA Section 514, this provision supersedes a State law that would directly or indirectly prohibit or restrict the inclusion in any pension plan of an automatic contribution arrangement. [Labor Reg. Section 2550.404c-5(f)(2)]

 

D.      Notice Requirement        

 

In addition to the three requirements necessary to constitute an automatic contribution arrangement, the statute also includes a notice requirement. Specifically, the plan administrator must, within a reasonable period before each plan year, provide to each employee eligible to participate in the arrangement a written notice of the employee’s rights and obligations under the arrangement which: (1) is sufficiently accurate and comprehensive to apprise the employee of such rights and obligations, and (2) is written in a manner calculated to be understood by the average employee to whom the arrangement applies. [ERISA Section 514(e)(3)(A)]

 

A notice will not be treated as satisfying these requirements unless the notice:

 

1.       includes an explanation of the employee’s rights under the arrangement to elect not to have elective contributions made on the employee’s behalf (or to elect to have such contributions made at a different percentage);

 

2.       ensures that the employee has a reasonable period of time after receipt of the notice and before the first elective contribution is made to make such an election, and

 

3.       explains how contributions made under the arrangement will be invested in the absence of any investment election by the employee.

 

[ERISA Section 514(e)(3)(B)]

 

If the plan administrator fails to provide the notice, the DOL may assess a penalty of not more than $1,000 a day for each violation. [ERISA Section 502(c)(4)]

 

The plan administrator of an automatic contribution arrangement will be considered to have satisfied the notice requirement if notices are furnished in accordance with Labor Regulation Sections 2550.404c-5(c)(3) and (d), i.e., the notice required with respect to a qualified default investment alternative. Labor Reg. Section 2550.404c-5(f)(3)] This reference would also peg the “reasonable period of time” requirement as at least 30 days in advance of the date of plan eligibility, and generally at least 30 days in advance of subsequent plan year. [Labor Reg. Section 2550.404c-5(f)(3)(i) and (ii)]

 

E.      Civil Penalties

 

PPA provided for a civil penalty of not more than $1,000 a day for each violation of the notice requirement of Section 514(e)(3). [ERISA Section 502(c)(4)]

 

The DOL has issued proposed regulations [72 Fed. Reg. No. 243, December 19, 2007] establishing procedures for the calculation and assessment of various civil penalties including those arising under Section 514(e)(3).

 

The proposed regulations provide that the amount to be assessed for each separate violation is to be determined by the DOL, taking into consideration the degree or willfulness of the failure or refusal to furnish the notice. However, the amount assessed for each violation shall not exceed  $1000 a day (or such other maximum amount as may be established by regulation pursuant to the Federal Civil Penalties Inflation Adjustment Act of 1990, as amended) computed from the date of the administrator’s failure. [Prop. Amendment Labor Reg. Section 2560.502c-4(b)(1)]

 

 For purposes of calculating the penalty, each failure or refusal to provide the required information with respect to any person entitled to receive it is to be treated as a separate violation. [Prop. Amendment Labor Reg. Section 2560.502c-4(b)(2)]

 

Prior to assessing the penalty, the DOL is to provide the administrator with a written notice indicating the DOL’s intent to assess a penalty, the amount of such penalty, the number of individuals on which the penalty is based, the period to which the penalty applies and the reason for the penalty. [Prop. Amendment Labor Reg. Section 2560.502c-4(c)]

 

The DOL may determine in response that part or all of the penalty in the notice of intent to assess a penalty will not be assessed on a showing that the plan administrator did in fact comply or on a showing of mitigating circumstances regarding the degree or willfulness of the noncompliance. [Prop. Amendment Labor Reg. Section 2560.502c-4(d)]

 

Upon issuance of a notice of intent to assess the penalty, the administrator would have 30 days from the date of service of the notice to file a written statement of reasonable cause why the penalty should not be assessed or should be reduced. The statement must contain a declaration by the administrator that the statement is made under penalties of perjury. [Prop. Amendment Labor Reg. Section 2560.502c-4(e)]

 

F.      What Kinds of Plans are eligible for Automatic Contribution       Arrangements?

 

The statute provides that Section 514(e) supersedes any state law which would directly or indirectly prohibit or restrict the inclusion in any plan of an automatic contribution arrangement. However, the DOL is interpreting its application in a narrower context.

 

In Advisory Opinion 2008-02A, February 8, 2008. the DOL concluded that a Kentucky wage withholding law, which only allowed for withholding from a participant’s wages either where Federal or State law required or where the participant had consented in writing, was preempted. As a result, a company could continue to allow for automatic enrollment under its cafeteria plan.

 

What is significant here is that, although the Advisory Opinion was issued long after the enactment of Section 514(e), the DOL analyzed the provision in the context of Section 514(a) instead. In doing so, the DOL states in a footnote that “the Department views the PPA provisions as addressing only individual account pension plans.”

 

 

 

 

 

III.     Eligible Automatic Contribution Arrangement

 

A.      Defined

 

An Eligible Automatic Contribution Arrangement means an automatic contribution arrangement under an applicable employer plan (i.e., Section 401(k), 403(b) and Section 457(b) arrangement) under which, for the plan year

 

1.       a participant may elect to have the employer make payments as contributions under the plan on behalf of the participant, or to the participant directly in cash;

 

2.       the participant is treated as having elected to have the employer make such contributions in an amount equal to a uniform percentage of compensation provided under the plan until the participant specifically elects not to have such contributions made (or specifically elects to have such contributions made at a different percentage);

 

3.       in the absence of an investment election by the participant, contributions described in (2) are invested in accordance with regulations prescribed by the Secretary of Labor under ERISA Section 404(c)(5), and

 

          4.       the plan satisfies a notice requirement.

 

[Section 414(w)(3)]

 

An automatic contribution arrangement for this purpose means an arrangement that provides for a cash or deferred election that provides that in the absence of an eligible employee’s affirmative election, a default applies under which the employee is treated as having elected to have default elective contributions made on his or her behalf under the plan. The default election ceases to apply with respect to an employee if the employee makes an affirmative election (that remains in effect) to: (1) not have any default elective contributions made on his or her behalf, or (2) have default elective contributions made in a different amount or percentage of compensation. [Prop. Treas. Reg. Section 1.414(w)-1(e)(2)]

 

The uniformity requirement is not violated merely because the percentage varies in a manner permitted for Qualified Automatic Contribution Arrangements under Prop. Treas. Reg. Section 1.401(k)-3(j)(2)(iii) except that the rules are applied without regard to whether the arrangement is intended to be a Qualified Automatic Contribution Arrangement. [Prop. Treas. Reg. Section 1.414(w)-1(b)(2)]

 

B.      Notice Requirement

 

Under the Proposed Regulations, the notice requirement will be deemed satisfied if each eligible employee is given notice of the employee’s rights and obligations under the arrangement. The notice must be sufficiently accurate and comprehensive to apprise the employee of such rights and obligations, and be written in a manner calculated to be understood by the average employee to whom the arrangement applies. [Prop. Treas. Reg. Section 1.414(w)-1(b)(3)(i)]

 

The notice must include the provisions found in Treas. Reg. Section 1.401(k)-3(d)(2)(ii) to the extent those provisions apply to the arrangement. However, a notice is not considered sufficiently accurate and comprehensive unless the notice accurately describes:

 

1.                 the level of elective contributions which will be made on the employee’s behalf if the employee does not make an affirmative election;

 

2.                 the employee’s rights to elect not to have default elective contributions made to the plan on his or her behalf or to have a different percentage of compensation or amount of elective contributions made to the plan on his or her behalf;

 

3.                 how contributions made under the arrangement will be invested in the absence of any investment election by the employee, and

 

4.                 the employee’s rights to make a permissible withdrawal, if applicable, and the procedures to elect such a withdrawal.

 

[Prop. Treas. Reg. Section 1.414(w)-1(b)(3)(ii)]

 

The notice must be provided within a reasonable period before the beginning of each plan year (or, in the year an employee becomes an eligible employee, within a reasonable period before the employee becomes an eligible employee). A notice satisfies the timing requirements only if it is provided sufficiently early so that the employee has a reasonable period of time after receipt of the notice and before the first elective contribution is made under the arrangement to make the election. [Prop. Treas. Reg. Section 1.414(w)-1(b)(iii)(A)]

 

The timing requirement is deemed satisfied if at least 30 days (and no more than 90 days) before the beginning of each plan year, the notice is given to each eligible employee for the plan year. In the case of an employee who does not receive the notice within the period because the employee becomes an eligible employee after the 90th day before the beginning of the plan year, the timing requirement is deemed to be satisfied if the notice is provided no more than 90 days before the employee becomes an eligible employee (and no later than the date the employee becomes an eligible employee). [Prop. Treas. Reg. Section 1.414(w)-1(b)(iii)(B)]

 

C.      Permissible Withdrawals

 

If the plan so provides, an employee who has default elective contributions made under an Eligible Automatic Contribution Arrangement may elect to make a “permissible withdrawal” of such contributions (and attributable earnings). If done in accordance with the statute, then:

 

1.       the amount of the withdrawal is includible in gross income for the taxable year of the employee in which the distribution is made;

 

2.       no tax is imposed under Section 72(t) with respect to the distribution, and

 

3.       the arrangement shall not be treated as violating any restriction on distributions solely by reason of allowing the withdrawal.

 

Where the employee elects to make such a withdrawal, any employer matching contribution shall be forfeited or subject to such other treatment as the Secretary of the Treasury may prescribe.

 

[IRC Section 414(w)(1)]

 

The Preamble provides that a plan that decides to include a permissible withdrawal provision is not required to make it available to all employees eligible under the EACA. This means, for example, that the employer may decide to make it available only to employees for whom no elective contributions have been made under the CODA (or a predecessor CODA) before the EACA is effective. However, under a Section 401(k) or a Section 403(b) plan, the employer would be precluded from conditioning the right to take the withdrawal on the employee making an election to have no future elective contributions made on the employee’s behalf. However, the employer could provide in the withdrawal election form a default election under which elective contributions would cease unless the employee makes an affirmative election.

 

An applicable employer plan that includes an Eligible Automatic Contribution Arrangement will not fail to satisfy the prohibition on in-service withdrawals under Section 401(k)(2)(B), 403(b)(7), 403(b)(11) or 457(d)(1) merely because it permits withdrawals that satisfy the requirements for a permissible withdrawal. [Prop. Treas. Reg. Section1.414(w)-1(c)(2)]

 

A “permissible withdrawal” means any withdrawal made from an “eligible automatic contribution arrangement which meets the requirements of Section 414 and which: (1) is made pursuant to an election by the employee, and (2) consists of elective contributions made pursuant to a deemed election in an amount that is a uniform percentage of compensation provided under the plan until the participant specifically elects not to have such contributions made (or specifically elects to have such contributions made as a different percentage) and the earnings thereon. [IRC Section 414(w)(2)]

 

In order to be treated as a permissible withdrawal, the election to withdraw must be made no later than 90 days after the date of the first default elective contribution under the Eligible Automatic Contribution Arrangement. The date of the first default elective contribution is the date that the compensation that is subject to the cash or deferred election would otherwise have been included in gross income. The effective date of an election cannot be later than the last day of the payroll period that begins after the election is made. [Prop. Treas. Reg. Section 1.414(w)-1(c)(2)]

 

The amount of the distribution must be equal to the amount of default elective contributions made under the Eligible Automatic Contribution Arrangement through the effective date of the election (adjusted for allocable gains and losses to the date of distribution). If default elective contributions are separately accounted for in the participant’s account, then the amount of the distribution will be the total amount in that account. However, if not separately accounted for then the amount of the allocable gains and losses will be determined under rules similar to those provided under Treas. Reg. Section 1.401(k)-2(b)(2)(iv) for the distribution of excess contributions. [Prop. Treas. Reg. Section 1.414(w)-1(c)(3)(i)]

 

The distribution amount may be reduced by any generally applicable fees. However, the plan may not charge a different fee for a distribution under Section 414(w) than applies to other distributions. [Prop. Treas. Reg. Section 1.414(w)-1(c)(3)(ii)]

 

D.      Tax and Reporting Treatment of Permissible Withdrawals

 

The amount of the withdrawal, other than any Roth contributions, is includible in the employee’s gross income for the taxable year in which the distribution is made. [Prop. Treas. Reg. Section 1.414(w)-1(d)(1)(i)]

The distribution is not subject to the early distributions tax of Section 72(t). [Prop. Treas. Reg. Section 1.414(w)-1(d)(1)(ii)]

 

The amount of the withdrawal is reported on Form 1099-R. [Prop. Treas. Reg. Section 1.414(w)-1(d)(1)(iii)]

 

E.      Corrective Distributions from Eligible Automatic Contribution Arrangement

 

The time for making corrective distributions of excess contributions or excess aggregate contributions from an eligible automatic contribution arrangement (as defined in Section 414(w)(3)) is increased from the prior 2 ½ month period previously applicable to all Section 401(k) plans to 6 months. [IRC Section 4979(f)(1)] Further, any amount distributed will be treated as earned and received in the recipient’s tax year in which the distributions are made. [IRC Section 4979(f)(1)]

 

 

 

IV.     Qualified Automatic Contribution Arrangement–QACA

 

In order to encourage Section 401(k) plans to adopt an automatic enrollment feature, the Act creates a new “qualified automatic contribution arrangement” A plan that adopts a qualified automatic contribution arrangement is treated as satisfying the special ADP nondiscrimination requirements (i.e., the ADP test) [IRC Section 401(k)(13)(A)] and is also treated as meeting the top heavy requirements. [IRC Section 416(g)(4)(H)] The plan will also be treated as meeting the requirements of the ACP test if the plan constitutes a qualified automatic contribution arrangements and the contributions satisfy the requirements for the matching contribution safe harbor test under Section 401(m)(11)(B). [IRC Section 401(m)(12)]

The Service has issued proposed regulations. The Proposed Regulations are proposed to be effective for plan years beginning on or after January 1, 2008. However, plans and sponsors may rely on the proposed regulations pending the issuance of final regulations. In the event the final regulations are more restrictive, the more restrictive provisions of the final regulations will be applied without retroactive effect.

 

The proposed regulations provide that generally in order to satisfy the safe harbor requirements, the plan provisions satisfying the requirements of the safe harbor must be adopted before the first day of the plan year and must remain for an entire 12-month plan year. [Prop. Treas. Reg. Section 1.401(k)-3(e)(1)]

 

To the extent that the requirements to be a Qualified Automatic Contribution Arrangement (QACA) are the same as those for the safe harbor described in Section 401(k)(12) and 401(m)(11), the Preamble provides that these proposed regulations would apply the existing rules currently in Treas. Reg. Sections 1.401(k)-3 and 1.401(m)-3 to a QACA.

 

Under the proposed regulations, an automatic contribution arrangement for this purpose is a cash or deferred arrangement that provides that in the absence of an eligible employee’s affirmative election, a default applies under which the employee is treated as having made an election to have a specified contribution made on his or her behalf under the plan. The default election applies with respect to an eligible employee if the employee makes an affirmative election to: (1) have elective contributions made in a different amount on his or her behalf (in a specified amount or percentage of compensation); or (2) not have any elective contributions made on his or her behalf. [Prop. Treas. Reg. Section 1.401(k)-3(j)(1)(ii)]

 

An automatic contribution arrangement will not fail to be a QACA merely because the default election is not applied to an employee who was an eligible employee under the cash or deferred arrangement (or a predecessor plan) immediately prior to the effective date of the QACA and on that effective date had an affirmative election in effect (that remains in effect to): (1) have an elective contribution made on his/her behalf (in a specified amount or percentage), or (2) not have elective contributions made on his/her behalf. [Prop. Treas. Reg. Section 1.401(k)-3(j)(1)(iii)] The Preamble states that generally this would require that the employee have completed an election form and chosen an amount or percentage (including zero) of his compensation to be deferred.

 

To constitute a qualified automatic contribution arrangement (QACA): (1) the elective contribution must satisfy the “qualified percentage”; (2) the match or nonelective contribution must be made in accordance with the statute; (3) the match or nonelective contribution must vest in accordance with the statutory requirements and be subject to the restrictions on withdrawal that apply to Section 401(k) contributions, and (4) the plan must issue a notice.

 

With respect to the qualified percentage, this requirement will be met if the percentage is applied uniformly and does not exceed 10 percent and, for the applicable year is at least:

 

1.                 3% during the period ending on the last day of the first plan year which begins after the date on which the first elective contribution is made with respect to the employee;

 

2.                 4% during the first plan year following the plan year described in (1);

 

3.                 5% during the second plan year following the plan year described in (1), and

 

4.                 6% during any subsequent plan year.

 

[IRC Section 401(k)(13)(C)(iii)]

 

The proposed regulations make it clear that an eligible employee’s initial year of default participation to which the 3% minimum contribution applies may last as long as two plan years. That is, the period begins when the employee first participates in the automatic contribution arrangement that is a QACA and ends on the last day of the following plan year. [Prop. Treas. Reg. Section 1.401(k)-3(j)(2)(ii)] Thereafter the qualified percentage increases 1% for each subsequent plan year. The proposed regulations clarify that the qualified percentage is a minimum and that a QACA can provide a greater qualified percentage but not to exceed 10%.

 

While the qualified percentage must be a uniform percentage, the proposed regulations recognize some exceptions including that the plan will not run afoul of the uniformity requirement merely because the qualified percentage varies based upon the number of years the employee has participated in the plan. Further, the uniformity requirement is not violated because the plan suspends employees from making an elective contribution for six months following a hardship withdrawal. The uniformity requirement is similarly not violated because the rate of elective contributions under a cash or deferred election that is in effect immediately prior to the effective date of the default percentage under the QACA is not reduced. Finally, the uniformity requirement is not violated merely because the rate of elective contributions is limited so as not to exceed the limits of Section 401(a)(17), 402(g) (determined with or without catch-up contributions and Section 415. [Prop. Treas. Reg. Section 1.401(k)-3(j)(2)(iii)]

 

With respect to the employer contribution, the employer must either make a dollar-for-dollar match of the first 1% plus 50% of the elective contribution that exceeds 1% but does not exceed 6% of compensation for each non-highly compensated employee, or a nonelective contribution equal to at least 3% for each non-highly compensated employee. [IRC Section 401(k)(13)(D)(i)]

 

In the event that the plan satisfies its contribution requirement by virtue of use of the 3% nonelective contribution, such contributions may not be taken into account for purposes of permitted disparity (including the imputation of permitted disparity under Treas. Reg. Section 1.401(a)(4)-7. [Prop. Treas. Reg. Section 1.401(k)-3(h)(2)] However, under the general rule applying the same rules as applied to the pre-PPA safe harbor, nonelective contributions could be used to satisfy the top heavy minimum as well as counted for purposes of Section 401(a)(4).

 

In all events, employer contributions must be fully vested with respect to any employee who has at least 2 years of service and must be subject to the general withdrawal restrictions that apply to elective contributions. [IRC Section 401(k)(13)(D)(iii)]

 

The notice requirement is satisfied if, within a reasonable period before each plan year, each employee eligible to participate in the arrangement receives written notice of the employee’s rights and obligations under the arrangement which: (1) is sufficiently accurate and comprehensive to apprise the employee of such rights and obligations, and (2) is written in a manner calculated to be understood by the average employee to whom the arrangement applies. [IRC Section 401(k)(13)(E)(i)] Further, the notice:

 

1.                 must explain the employee’s rights under the arrangement to elect not to have elective contributions made on the employee’s behalf (or to elect to have such contributions made at a different percentage);

 

2.                 in the case of an arrangement under which the employee may elect among 2 or more investment options, the notice explains how contributions made under the arrangement will be invested in the absence of any investment election by the employee, and

 

3.                 must ensure that the employee has a reasonable period of time after receipt of the notice and before the first elective contribution is made to make either such election.

 

[IRC Section 401(k)(13)(E)(ii)]

 

V.      IRS and DOL Sample Notice

 

The Service, in conjunction with the DOL, has issued a Sample, but not a Model Notice that can be used to satisfy the notice obligations for EACAs, QACAs and QDIAs. [see IRS Employee Plans News, Special Edition, 11/15/2007)]

 

Because of the potential variance in plan provisions, the Service found it impossible to issue a Model Notice and thus the notice is issued as a Sample Notice. Plans will need to conform the provisions of the Notice to the actual plan provisions. For example, the notice assumes a calendar year plan that allows employees to participate as of their date of hire and to make changes in their contribution and investment elections at any time without restriction. In addition, the notice assumes that the plan allows for permissible withdrawals of automatic contributions.

 

 

           

 

 

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