The Pension Protection Act of 2006 (PPA) included several intertwined provisions designed to encourage wider participation in employer retirement savings plans by providing incentives for employers to automatically enroll employees.
The PPA’s automatic deferral provisions were added to the Internal Revenue Code as new sections 414(w) and 401(k)(13). Prior to these statutory automatic contribution arrangements, the IRS’s guidance permitted automatic deferrals. However, employers were reluctant to add this feature to their 401(k) plans due to state wage reduction laws that prohibited salary reductions without employee consent and fiduciary liability concerns regarding the investment of these contributions in the absence of participant investment instructions. In response to these employer concerns, the PPA added new ERISA § 514(e), which resolves the potentially conflicting state laws concern, and ERISA § 404(c)(5), which allows plan fiduciaries to limit their liability by placing the assets within qualified default investment alternatives.
This is the first in a series of articles about the statutory and regulatory guidance surrounding automatic contribution arrangements (ACAs) and qualified default investment alternatives (QDIAs). This article discusses the various types of ACAs, employer incentives for adopting these features and the practical application of these alternatives.
I. What Is an ACA?
An ACA, also referred to as an automatic deferral, automatic enrollment, a negative election, a default election or an automatic contribution arrangement, automatically reduces an employee’s compensation by a fixed percentage and has the amount contributed to the employer’s 401(k) plan. The default election ceases to apply if the employee makes an affirmative election to not have any default elective contributions made on his or her behalf or to have elective contributions made in a different amount or percentage of compensation.
A. Does the ACA Satisfy the 401(k) Cash or Deferral Election Requirement?
Yes. Prior to the PPA, the IRS’s administrative guidance and regulations permitted the application of the automatic default approach to 401(k) contributions, provided the employee is provided with notice of an effective opportunity to opt out of an automatic contribution and receive cash.
B. Can ACAs Be Designated as Roth Contributions?
Yes. The 2006 amendments to the 401(k) regulations clarified that an ACA could provide that all or a portion of the contribution may be designated as a Roth contribution, provided the plan document specifies the extent to which the default deferral contributions are to be treated as pre-tax elective or designated Roth contributions.
C. What Are the Statutory ACAs Implemented by the PPA?
Effective for plan years beginning on or after January 1, 2008, the PPA added new Code § 414(w), eligible automatic contribution arrangements (EACAs), and new Code § 401(k)(13), qualified automatic contribution arrangements (QACAs).
II. What Is an EACA?
Under EACAs, participants are treated as having elected to defer an amount equal to a uniform percentage of compensation provided under the plan until they specifically opt out of the arrangement. In the absence of investment instructions by the participant, the deferred amounts are invested in default investments that satisfy the requirements of ERISA § 404(c)(5) pertaining to qualified default investment alternatives (the topic of a subsequent article). In addition, the participant must be given an initial and annual notice explaining his or her rights and obligations under the arrangement. An EACA also may permit participants to withdraw automatic deferrals (and related earnings) within a 90-day window period. Under an EACA, the employer is provided with an extended period to refund any excess contributions, as determined by the ADP/ ACP testings, without incurring excise taxes.
A. What Is the “Uniform Percentage of Compensation” Rule Under EACAs?
The specified automatic deferral percentage under the EACA must be a uniform percentage of compensation. The proposed regulations provide that the uniformity requirement is not violated if the percentage varies in a manner permitted under a QACA (described in #3(a) below).
B. What Are the Initial and Annual Notice Requirements for EACAs?
An initial notice must be provided to newly eligible employees not more than 90 days before the employee becomes eligible to participate in the plan and no later than the date the employee becomes eligible. Annual notices must be provided 30 – 90 days before the beginning of each plan year. The notice must describe the level of the default elections, the employee’s rights to discontinue the default elective contributions or change the amount of the contributions, the default investments and the right to make a permissible withdrawal, if applicable.
C. What Is the Optional 90-Day Withdrawal Period for EACAs?
Plans with EACAs may, but are not required, to permit participants who are automatically enrolled to withdraw their automatic contributions, provided the election is made within 90 days after the first automatic contribution. The amount of the withdrawal is included in the employee’s income for the taxable year in which the distribution is made, unless the deferrals were designated as Roth contributions. In the case of an employee’s withdrawal, any employer matching contributions with respect to the amount withdrawn must be forfeited.
D. What Is the Extended Corrective Distribution Period for EACAs?
Plans that adopt EACAs can make any corrective distributions determined to be necessary after running the ADP/ACP tests within six months (instead of only 2½ months under the general rule) following the close of the plan year without the employer incurring a ten percent excise tax for late distributions.
III. What Is a QACA?
Under a QACA, all eligible employees (current and new hires) who have not made an affirmative election to defer or decline participation are treated as having elected to defer an amount equal to a qualified percentage of compensation. The QACA provides an ADP and ACP safe harbor alternative. An employer that implements a QACA may provide for a lower amount of matching contributions than the traditional safe harbor arrangement and still qualify for relief from performing the ACP test. In addition, the participant must be given an initial and annual notice explaining their rights and obligations under the arrangement.
A. What Is the Automatic Deferral Percentage for QACAs?
During the initial period, the automatic deferral percentage (or the qualified percentage) must be at least three percent of compensation for the initial period (commencing when the employee first participates in the QACA and ending on the last day of the following plan year), at least four percent for the second plan year, at least five percent during the third plan year and at least six percent for the fourth and subsequent plan years. The qualified percentage may exceed the minimal requirement, but cannot exceed ten percent. The qualified percentage must be applied uniformly to all eligible employees. A plan does not fail to satisfy the uniform percentage requirement merely because the percentage varies based on the number of years an employee participated in the QACA. A participant may affirmatively elect not to have such elective contributions made or to make the elective contributions at a different level.
B. What Are the Required Employer Contributions for QACAs?
As an alternative to the traditional safe harbor matching contribution of 100 percent on the first three percent of a participant’s compensation and 50 percent on the next three percent of compensation (for a maximum matching contribution of 4.5 percent), an employer adopting a QACA may contribute a lower matching contribution and still be relieved from performing the ACP test. Under a QACA, an employer must match 100 percent of automatic deferrals up to the first one percent of compensation and 50 percent of automatic deferrals on the next five percent of compensation (for a maximum matching contribution of 3.5 percent). In the alternative, the employer may make non-elective contributions of at least three percent of compensation, which is also required for a traditional safe harbor arrangement. An employee who completes two years of service must be 100 percent vested in the employer QACA contributions, in comparison to the immediate vesting requirement of the traditional safe harbor arrangement. In addition, the top-heavy rules do not apply to a plan that meets the automatic enrollment safe harbor requirements for employee deferrals and employer matching.
C. Can a QACA Contain EACA Features?
Yes. A QACA may, but is not required, to meet the requirements of an EACA in addition to satisfying the ADP and ACP safe harbor requirements. If a QACA satisfies the EACA requirements, then participants are permitted to withdraw automatic deferral amounts and related earnings during the 90-day window period. In addition, the employer may take advantage of the extended six-moth period for making any corrective distributions in the event the QACA does not apply the ACP safe harbor.
D. What Are the Initial and Annual Notice Requirements for QACAs?
An initial notice must be provided to employees sufficiently early so that the employee has a reasonable period of time after receipt of the notice and before the first automatic deferral is made under the arrangement to change or opt out of the contribution arrangement. Similar to the EACA notice requirements, an annual notice must be provided to the participants. The notice must describe the level of the default elections, the employee’s rights to discontinue the default elective contributions or change the amount of the contributions, the default investments and the right to make a permissible withdrawal, if applicable.
Employers may consider adding the EACA, QACA or both features to its 401(k) plan to encourage employees to save for retirement, to improve its ADP testing, to enhance employee retention and reduce employee turnover counts, among other reasons. Generally, the safe harbor provisions, which grant relief from the ADP/ACP testings, must be adopted prior to first day of the plan year. For employers considering adopting the automatic enrollment features for the upcoming plan year, White & Case is available to help determine the practical implications and prepare the required plan amendments and participant notices.