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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