This article was prepared by Gary Howell and incorporates many helpful comments from Barbara Cronin and Tim Stanton.

Automatic enrollment of eligible employees in a 401(k) or 403(b) plan is attractive: it gives them a push toward participating in the plan and helps the plan meet Tax Code nondiscrimination tests. Uncertainty as to how far an employer could go with automatic enrollment design has deterred some employers, but new IRS guidance allows considerable flexibility and provides comfort for employers.

Automatic Enrollment: Not New, But Now Improved

"Automatic enrollment" refers to plan provisions under which a participant who satisfies the plan’s eligibility requirements to make salary deferral contributions is deemed to have made a deferral election at a level specified in the plan unless he or she specifically elects either a different level of deferral or no deferral at all.

Automatic enrollment in 401(k) plans is not new. Since 1998 (Rev. Rul. 98-30) the Internal Revenue Service has sanctioned these arrangements, and they are specifically approved in the 401(k) Proposed Regulations issued last summer. Such arrangements were reaffirmed for 401(k) plans in Rev. Rul. 2000-8 and extended to 403(b) arrangements by Rev. Rul. 2000-35. Recent guidance from the Service in a General Information Letter addresses some common issues faced by employers.

The Service’s earlier guidance for 401(k) plans involved plans in which the default election amount was 3% of compensation, and the 403(b) guidance involved a plan with a 4% default election. Some employers have wondered whether they could go beyond these limits.

In the General Information Letter, dated March 17, 2004, the Service makes it clear1 that a plan’s automatic enrollment provisions can:

  • be for any percentage of compensation that is otherwise permitted under the plan;
  • contain an automatic schedule under which the percentage changes over time; and
  • automatically apply to compensation increases such as a pay raise or bonus.

In each case, the plan must clearly set out the rules, and the rules must be clearly explained in notices to employees that describe the operation of the provisions and clearly state how an employee may elect out.

Also, employers must be aware that some states have wage payment laws that require employee consent to any deductions from wages. The effect of these laws must be taken into account when considering automatic enrollment.

But What Do We Do with the Money?

Employers now have comfort in designing a variety of automatic enrollment provisions for 401(k) and 403(b) plans. Once the deferrals occur, though, they must be invested. The employee subject to automatic enrollment may not have made an investment election. In plans that offer multiple investment options, this means that the investment of the deferrals must be provided for. This is typically done through a "default investment fund."

In each of its Revenue Rulings on automatic enrollment, the Service noted the Department of Labor’s position on default investment funds under ERISA:

While ERISA section 404(c) may serve to relieve certain fiduciaries from liability when participants or beneficiaries exercise control over the assets in their individual accounts, the Department of Labor has taken the position that a participant or beneficiary will not be considered to have exercised control when the participant or beneficiary is merely apprised of investments that will be made on his or her behalf in the absence of instructions to the contrary.

Therefore, the selection of the default investment fund is a fiduciary act of asset management under ERISA and is, therefore, subject to ERISA’s standards of fiduciary duty. Whoever has the authority to designate the default fund is, in effect, managing the accounts of the participants who have not made an investment election. To require that all such amounts be invested in a low-return money market fund or in company stock invites scrutiny under ERISA’s "prudence" standard. The selection of the default investment fund must be treated as an ERISA investment management decision.

Footnote

1 A "General Information Letter" is described by the Service as "a statement ... that calls attention to a well-established interpretation or principle of tax law without applying it to a specific set of facts."

Copyright 2004 Gardner Carton & Douglas

This article is not intended as legal advice, which may often turn on specific facts. Readers should seek specific legal advice before acting with regard to the subjects mentioned here.