Note: On September 27, the U.S. Department of Labor issued proposed regulations that would clarify acceptable "default" investment choices under QACAs. The full text of the proposed regulation may be downloaded here:

• http://ww.dol.gov/ebsa/regs/fedreg/proposed/2006008282.pdf

What is Automatic Enrollment?

Automatic enrollment began as a small idea that keeps getting bigger, because it is increasingly seen as the solution to a huge national problem.

For the past decade, the U.S. personal savings rate has been plummeting. From the 1960s through the mid 1990s, Americans saved on average a steady 5% to 10% of their pay, according to the Federal Reserve. But from the mid-1990s through early 2005, the U.S. savings rate descended from about 5% to zero. Since April of 2005, the rate has been negative every single month. This is perhaps the most dismal macro-economic statistic of modern times, because no nation can prosper when it consistently spends all the income that it earns (and then some).

http://research.stlouisfed.org/fred2/series/PSAVERT/112

There is only one bright spot in the U.S. savings picture participant-directed retirement plans. In 2005, the EBRI / Investment Company Institute (ICI) Participant-Directed Retirement Plan Data Collection project estimated that 43 million Americans held $2.1 trillion in 460,000 employer-sponsored 401(k) plans. The average account balance among those with at least five years of participation increased from $60,926 to $91,042 over just two years. Other statistics indicate that the average plan balance has since grown to well above $100,000.

However, even in 401(k) plans, there is a savings disparity. Nationally, 73% of all workers eligible for these plans participate through elective deferrals or employer contributions (or both), yet among younger and lower-paid workers, participation drops sharply. For example, PlanSponsor.com has reported participation rates of just 37% among the lowest-paid cohort of workers in their 20s, and 47% among the lowest-paid workers in their 30s. Anecdotal evidence suggests that many younger and lower-paid workers feel too overwhelmed by complexities and financial pressures to enroll in plans, even when employers offer attractive matching contributions.

The essential force behind automatic enrollment is inertia. Each participant's active enrollment choice isn't necessary, because all employees automatically begin making deferrals and receiving any matching contributions as soon as they become eligible.

A Decade of Favorable Rulings

Over the past decade, automatic enrollment has steadily gained support as a solution to the U.S. savings debacle and plan participation disparity. Two Department of Labor Advisory opinions in the mid-90s (94-27A and 96-01) paved the way by allowing ERISA to preempt New York and Puerto Rican wage withholding restrictions. In 1998, an IRS revenue ruling (98-30) defined an acceptable arrangement as one with at least a 3% "default deferral rate." In subsequent revenue rulings, the IRS approved automatic enrollment for current workers (as well as new hires) and also authorized the use of this concept in 403(b) and 457(b) plans.

In a basic automatic enrollment program, every eligible worker becomes a plan participant and a default deferral rate (typically 3%) is deducted from pay and diverted into the plan. To hold this money, plan trustees must choose a "default investment option," which traditionally has been a stable value or money market fund. Adopting automatic enrollment can have two important advantages for plans: 1) It increases participation rates; and 2) It can improve non-discrimination test results, which in turn allow Highly Compensated Employees (HCEs) to defer more money.

According to a 2006 survey by Hewitt Associates, 25% of large 401(k) plans reported that they already had adopted automatic enrollment, and another 23% said they were considering adoption in 2006. The main drawback to increased acceptance has been the lack of a "safe harbor" from fiduciary responsibility for the default investment choice. In other words, if a plan selects a more aggressive default investment choice than a money market or stable value fund and a participant loses money, plan fiduciaries can be held personally liable. This liability currently exists even in plans that have adopted 404[c] protections for investment choices made by participants.

How to Eliminate "Safe Harbor" Confusion

The Pension Protection Act of 2006, enacted in August, has created an important new safe harbor connected to automatic enrollment, but it is different than the one described above. The existence of two separate "safe harbor" concepts is sure to create confusion in the market, which you can help to resolve, starting with the information that follows:

Safe Harbor #1

As defined in the new law, this is a structure for a QACA, which is effectively a new type of participant-directed retirement plan. When 401(k) or 403(b) plans follow the law's template for automatic enrollment, employer contributions, and participant notification, they can become permanently exempt from non-discrimination tests (ADP/ACP) and top-heavy requirements while also enjoying more favorable vesting requirements than in an existing 401(k) safe harbor. The table below compares the Pension Protection Act's QACA safe harbor, which will take effect on January 1, 2008, with the 401(k) safe harbor currently in effect (available since 1999).

* A 403(b) plan is subject to ACP testing but not ADP testing or top-heavy rules. Some 403(b) plans currently can qualify for safe harbor protection from ACP testing.

** The employer may choose to make either a non-elective or a matching contribution.

*** Annual notification is required of the default investment choice and opportunity to "opt out."

The current 401(k) safe harbor has been a niche solution, at best, because it is complex for plan sponsors to understand and adopt. It requires an election to use the safe harbor each year (prior to December 1 of the previous year), with timely annual notification made in advance to all non-highly compensated participants. In some cases, it has been difficult for plans to implement an affordable matching arrangement that provides relief from ACP/ADP non-discrimination tests and top-heavy rules.

The primary market for the new QACA safe harbor includes manufacturing, retail, food-service, and temporary employment services with large numbers of younger and lower-paid workers and fairly high job turnover. In such companies, HCEs often are precluded from meaningful plan participation by non-discrimination tests and top-heavy rules. Also, the immediate 100% vesting requirement of the existing safe harbor has made matching expensive for such companies, while creating no incentive for worker retention.

The new QACA structure is far more favorable for such companies. For example, the maximum QACA annual matching contribution – assuming that every worker participates and defers 6% of salary – is 3.5% of salary. But workers are not required to be enrolled in the QACA until completing one year of service, and up to two additional years may be required for employer contributions to be vested.

If only a fraction of the work force stays employed for three full years (and forfeitures are subsequently used to make matching contributions), the matching cost could easily be below 1% of compensation for rank-and-file workers. Yet the employer would be allowed to contribute 3.5% of pay for all HCEs while enjoying freedom from non-discrimination tests and top-heavy rules. Also, all HCEs could defer up to the maximum allowed. If the company elects to include in the QACA only those employees hired after its adoption, the matching cost could be lower yet.

The Shape of Automatic Enrollment Plans to Come

The Pension Protection Act of 2006 has defined how automatic enrollment plans will be structured in the future. Ever since Revenue Ruling 98-30 specified a minimum 3% default deferral rate, the number has stuck as a standard. Some employees who were automatically enrolled at 3% years ago are still deferring at that rate today. However, Congress and the Department of Labor now recognize that a flat 3% deferral is not enough to provide future retirement security, and they have responded by including a concept called "auto deferral step-up" in the new law. To qualify as a QACA, the plan must begin with a deferral rate of 3% in the first year (but not more than 10%) and then defer at least 4% in the second year, 5% in the third year, and 6% in the fourth year and after. (At any time, a participant may opt out of the QACA by choosing a lower deferral rate. It is unclear if a participant who opts out of the QACA will be entitled to required minimum employer contributions.)

It is a good bet that the majority of 401(k) plans in the U.S. will soon adopt an "auto deferral step-up" QACA structure. Recordkeepers and turnkey plan providers will encourage this design to simplify systems and choices.

The 2006 legislation has further encouraged adoption of the QACA template by confirming that ERISA preempts all state laws in this area and by allowing corrective distributions of both employee deferrals and employer excess contributions, when required for safe harbor compliance purposes. The ERISA preemption is effective immediately and apparently opens the door to QACAs in states such as California, where wage withholding law restrictions have been greatest.

Safe Harbor #2

The developments described above leave one remaining impediment in the way of massive adoption of QACAs – a regulatory safe harbor that protects plan fiduciaries when they select an appropriate default investment choice. The new law mandates that the Department of Labor must establish final regulations that include default investment choices under Section 404[c] fiduciary protections not later than six months after enactment, provided that affected participants are given adequate notice. Preliminary regulations were published in late September.

In essence, the proposed regulations recognize two key points that are becoming widely accepted by policymakers: 1) Inertia is a powerful force, and many participants tend to stay in their original plan investment choice for years; and 2) Money market and stable value funds are not the most suitable default choices for accumulating enough assets to meet retirement goals.

In written comments to the Department of Labor made a year ago, the Investment Company Institute (ICI) argued for a regulation that will include as default investments options that: 1) are intended to provide broad diversification across a range of asset classes (i.e., balanced and asset allocation funds); and 2) target date or lifestyle funds.

The proposed DOL regulations issued in September would require that participants receive notice "within a reasonable period of time of at least 30 days in advance" of the first automatic deferral investment and annually thereafter. Also, the participant must be allowed to transfer money out of the default investment choice into another choice without financial penalty. The default investment chosen must be managed by an investment manager or investment company. It must be diversified so as to minimize the potential for large losses. And it must be one of three types of products: 1) target date ("life cycle"); 2) balanced funds; or 3) managed accounts.

Marketing Ideas

• Use FreeERISA's Form 5500 database to identify participant-directed plans in which participation rates are below the national average of 73%. Many companies will disclose the total number of employees whom they hire. The total number of active participants is shown on line 7a. Participant-directed plans are identified with a code of 2G or 2H on line 8.
• Look for plans that exclude Highly Compensated Employees from plan coverage due to non-discrimination test or top-heavy issues. These plans will be identified by checking box 3b on Form 5500, Schedule T.
• Call up the plan decision-makers identified on Form 5500 and ask if they would like more information on automatic enrollment. Since this is a hot topic, you may be surprised how many decision-makers welcome this information. Ask the plan vendors whom you represent for approved literature on automatic enrollment that you can deliver to clients and prospects. Also, team up with a third-party administrator in your market who has expertise in automatic enrollment.
• Focus primarily on plans with: 1) low participation rates; 2) a large number of young, lower-paid, or short-term workers; and 3) HCEs who are not able to fully participate;
• Ask if it is the company that wishes to encourage retention among rank-and-file workers for up to three years. If so, the combination of a safe harbor from testing plus two-year delayed cliff vesting can make QACAs an attractive option.
• While QACAs will not become effective for more than a full year (1/1/08), now is the time to begin discussing automatic enrollment options with clients and prospects, due to the lead time required for plan decisions and new vendor implementations.
• Don't overlook 403(b) plans offered by non-profit organizations and school districts. Many participant-directed 403(b) plans have not previously been offered automatic enrollment. Use the "Tax Exempt Organization" database of FreeERISA to identify tax-exempt organizations in your market.

• Become an expert on target date ("lifestyle") mutual funds, which may become the most popular QACA default investment of the future. Focus on choices that bundle a variety of asset classes into one fund, with gradual risk reduction over time.

• In some cases, you may be able to suggest changes in plans that will comply with QACA rules without costing much more money.

  For example:

Before: Employer matching is at 50% of the first 5% of salary. Vesting is 3-year cliff. The plan has a 50% participation rate. Due to non-discrimination and top-heavy test requirements, HCEs are not fully able to participate.

After: Employer matching and vesting are conformed to QACA guidelines. The plan has automatic enrollment, an 80% participation rate, a safe harbor from testing and top-heavy rules, and all HCEs are fully able to participate. The additional employer cost is less than 1% of total compensation, most of which goes to HCEs.

Even in a QACA, it will be a good idea to invite all new hires to an enrollment meeting, at which retirement savings can be emphasized and all options explained. If participants then choose to do nothing, they will at least have had exposure to professional financial guidance. And by default, they will begin making steady progress toward retirement goals.

It's sad but true: You can make a difference helping the U.S. get its personal savings rate back above zero.