For millions of workers, voluntary enrollment in 401(k) plans may suddenly become a thing of the past. The Pension Protection Act of 2006 allowed for automatic enrollment in these popular plans, and a growing number of employers are taking advantage of this opportunity. This article explores the mechanics of this clause and its impact on employers and workers.

Types of Automatic Contributions
There are two classes of contributions now being used to fund automatic enrollment plans. The first type is known as an eligible automatic contribution arrangement (EACA) and the second is called a qualified automatic contribution arrangement (QACA).

The first type mandates automatic enrollment at an arbitrary uniform percentage for any employee who did not initially elect to participate in the plan. EACAs provide employees with a 90-day exit window that allows them to opt out of the plan and withdraw their contributions. Employers are usually granted six months after the end of the plan year to distribute excess contributions without penalty.

QACAs are an optional safe harbor provision that take the previous arrangement a step further by increasing the contribution percentage each year. Automatic contributions under QACA start at 3% and increase by 1% each year until they reach 6% of compensation, assuming the employee has not already opted for a higher contribution percentage. However, employees can opt out of this portion of the arrangement at any time. Employers who use this feature must match all of the first 1% of employee contributions, plus half a percent for each percentage of all additional contributions up to a total of 6% of employee compensation, bringing the total required match up to 3.5% (5 x 0.5% + 1%). Employers must also issue notice to their employees before each new year, alerting them to the specifics of the QACA features in the plan. (For more, read our 401(k) And Qualified Plans Tutorial.)

Advantages for Employers
Employers who adopt the mandatory participation provisions in their plans can obviously expect both plan size and participation to increase substantially. A study done by Brigitte Madrian and Dennis Shea indicated that plan participation among women, Hispanics and low-income workers increased dramatically, sometimes as much as sevenfold. A 2006 study by EBRI also revealed that about two-thirds of workers surveyed indicated that they were in favor not only of automatic enrollment, but also of an increasing contribution percentage and automatic employer investment allocation. Employers should also note that instituting the QACA feature into their plans exempts them from both nondiscrimination and ADP/ACP top-heavy testing requirements, as well as protects them from state garnishment laws. The QACA provision should be especially attractive for employers that have failed these tests or have large contingents of low-paid employees. Lower turnover may be another positive side effect of automatic enrollment as employees begin to receive their monthly 401(k) statements and see their balances grow.

Advantages for Employees
Of course, the obvious advantage is that a large percentage of employees, many of whom may be underprivileged or uneducated, will begin automatically saving for their futures with matching employer contributions. One of the best features for them is the retirement saver's tax credit that they can receive as a result of their mandatory contributions. Participation in the plan may also incline them to stay at one job and build up tenure with a single employer. Turnover among higher-paid employees may also decline as the rise of lower-paid employee participation allows them to defer higher levels of their own income. Of course, employees who voluntarily elected to participate in their 401(k) plan can still control their own levels of contributions and investment allocations. (For more, see Pick 401(k) Assets Like A Pro.)

A Word of Caution
Employers who automatically invest employee contributions should take care to ensure that their employees are thoroughly educated about the investments their assets are placed in. Although the Pension Protection Act offers some protection in this area to employers provided they use "reasonable" investment options, the fear of legal reprisal has prompted some employers to play it safe by investing all mandatory contributions in money market funds. Others have selected target-date funds that mature at a given employee's estimated retirement age. However, this estimate is not always accurate and employees should make certain that they understand exactly when this date is and whether it needs to be adjusted. They have the power to adjust both their rates of deferral and investment choices, and should consult their plan sponsor about other investment options if they feel their contributions are not being invested properly. (To read more, see Is Your 401(k) On Track?)

The Bottom Line
Automatic 401(k) plan enrollment can provide retirement benefits to millions of working-class Americans, and increased benefits for the highly compensated. Employees should be properly educated about their plan contributions and make certain that they match their objectives. Ultimately, this measure that was quietly instituted in the Pension Protection Act of 2006 may go a long way toward rectifying the retirement income shortfall faced by so many Americans today. (For more, read our related article Introduction To SIMPLE 401(k) Plans and our special 401(k) Guide.)

Related Articles
  1. Investing

    2 Common Ways to Misuse Target Date Funds

    The world of asset classes is just as complicated as taking vitamins. How much should you take of small caps? Intermediate bonds? Emerging market stocks?
  2. Mutual Funds & ETFs

    What Target-Date Funds Can Teach About Investing

    Target-date funds are a popular way to invest for retirement. Here's what they can teach the novice investor.
  3. Stock Analysis

    3 Stocks that Are Top Bets for Retirement

    These three stocks are resilient, fundamentally sound and also pay generous dividends.
  4. Professionals

    How to Protect Retirement and Help Adult Kids

    Parents can both protect their retirement money and help their adult kids. Here's how.
  5. Retirement

    10 Ways to Save Your Retirement: It's Not Too Late

    It's not too late to start saving for your retirement, even if you took longer to start thinking about it and doing something about it.
  6. Investing

    Why Is Financial Literacy and Education so Important?

    Financial literacy is the confluence of financial, credit and debt knowledge that is necessary to make the financial decisions that are integral to our everyday lives.
  7. Investing

    10 Ways to Effectively Save for the Future

    Savings is as crucial as ever, as we deal with life changes and our needs for the future. Here are some essential steps to get started, now.
  8. Professionals

    How to Protect Your Portfolio from a Market Crash

    Although market crashes are usually bad news for your portfolio, there are several ways to minimize losses or even profit outright from market movement.
  9. Retirement

    How Robo-Advisors Can Help You and Your Portfolio

    Robo-advisors can add a layer of affordable help and insight to most people's portfolio management efforts, especially as the market continues to mature.
  10. Professionals

    3 Benefits of Working Longer (and Retiring Later)

    There are many reasons why folks in their 60s may want to keep working until at least age 70. Here are three.
  1. What are the risks of rolling my 401(k) into an annuity?

    Though the appeal of having guaranteed income after retirement is undeniable, there are actually a number of risks to consider ... Read Full Answer >>
  2. How does a Roth IRA grow over time?

    Your Roth IRA account grows over time thanks to two funding sources: contributions and earnings. While your contributions ... Read Full Answer >>
  3. Can my 401(k) be seized or garnished?

    As long as your retirement funds are held in your 401(k) and you do not take them as distributions, your 401(k) cannot be ... Read Full Answer >>
  4. Can my IRA be taken in a lawsuit?

    Whether your IRA can be taken in a lawsuit depends largely on your state of residence and the judgment in question. There ... Read Full Answer >>
  5. Are mutual funds considered retirement accounts?

    Unlike a 401(k) or Individual Retirement Account (IRA), mutual funds are not classified as retirement accounts. Employers ... Read Full Answer >>
  6. Can my IRA be garnished for child support?

    Though some states protect IRA savings from garnishment of any kind, most states lift this exemption in cases where the account ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!