Voluntary 401(k) Contributions: A Thing Of The Past?

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.)