Solutions to Prevent Automatic Enrollment Inertia

There’s been a lot of discussion recently about whether the automatic enrollment feature in many 401(k) plans actually leads to lower overall retirement savings rates. This blog post gives a brief overview of the issue and proposes a couple of solutions to combat automatic enrollment inertia and enhance employee engagement in the retirement plan.

Background: Automatic enrollment is an optional 401(k) plan feature which allows employers to defer employee compensation into their 401(k) accounts, even if they haven’t elected to do so (they can always opt out). A recent article explained how 401(k) automatic enrollment may have unintended consequences.

Automatic enrollment can overcome employees’ initial inertia to saving more than 0% in the 401(k) plan (Participation Inertia), but it could unintentionally cause some employees to get stuck at the default rate (Default Inertia) instead of saving more.

If we can agree that automatic enrollment is a good idea because it helps overcome Participation Inertia, then we just need to devise a solution to the Default Inertia problem.

Solution #1: Add auto-escalation to the automatic enrollment option. As mentioned in the WSJ article, this feature automatically increases the default deferral rate each year that an employee participates in the plan. For example, the automatic deferral rate might be 3% for new employees with 1% annual increases up to an ultimate deferral rate of 6% of pay after 3 years. Read more…

Strategic 401(k) Design: Preventing ADP Failures

If your 401(k) plan is failing the Actual Deferral Percentage (ADP) test, then it’s time to consider some plan design changes. You need to figure out a way to encourage non-highly compensated employees (NHCEs) to save more retirement money in their 401(k) accounts while keeping benefit costs under control. This post will guide plan sponsors through some strategic (yet straightforward) benefit changes that can improve your plan’s chances of passing the ADP test next year.

1. Add a 401(k) match. If your plan doesn’t already have a 401(k) match, adding one will encourage employees to at least defer a minimal amount into their 401(k) accounts. More NHCE deferrals = better ADP test results.

2. Enhance the current 401(k) match. If your plan already has a match but it isn’t getting NHCEs to defer, then there are a couple of options:

Increase the match: Maybe that 1% match just isn’t worth it for some folks. A 3% match is about average, and any increase can be factored-in when considering an employee’s total compensation package.

“Extend” the match: The goal here is to increase the amount of compensation eligible for a match while not increasing employer costs. For example, if you currently match 50% of the first 6% deferred then consider amending the plan to match 40% on the first 7½% deferred. Both formulas have a potential match of 3% of compensation, but the latter encourages employees to save at a higher rate in order to earn the full match.

3. Add an automatic enrollment feature. An Eligible Automatic Contribution Arrangement (EACA) is a feature where new participants are automatically enrolled in the 401(k) plan at a uniform deferral rate, unless they elect to opt out. If your 401(k) plan is suffering the ADP failure blues because few new hires are deferring, then this is a great way to increase your ADP rate and encourage employees to save for retirement. There’s also the Qualified Automatic Contribution Arrangement (QACA) option, which is a safe harbor plan combined with an automatic enrollment feature.

4. Add a “safe harbor” plan design. If you adopt one of these IRS-prescribed benefit formulas, then you get a “free pass” on ADP testing. Safe harbor benefits are 100% vested immediately and you must provide notice of the safe harbor status to participants at least 30 days prior to the start of the plan year. The minimum safe harbor benefit formulas are:

– At least a 3% automatic (i.e., non-matching) employer contribution to each participant’s 401(k) account; or

– An employer match of at least 100% on the first 3% deferral plus a match of at least 50% on the next 2% deferral (i.e., a potential match of 4% of pay).

If you have a cross-tested profit-sharing plan or cash balance plan, then the 3% non-elective option is often the best choice since those benefits count towards the non-discrimination tests whereas the matching formula does not.

Each of the options above has variations and can be combined with the others. Combined with a thorough campaign to educate participants about the changes, they’ll improve your chances of passing the ADP tests next year and avoid having to refund HCE deferrals as taxable income.

Roth 401(k) Rollover Bill Update

The Small Business Jobs Act of 2010 (H.R. 5297) passed the Senate last week and is expected to be signed into law by the President. As we mentioned in a previous post, there are a couple of retirement plan changes included in this bill. They include:

– Add a Roth option for 457(b) plans. This puts 457(b) plans for state and local governments on a similar footing with corporate 401(k) plans with regards to offering Roth deferrals.

– Allow eligible rollover distributions from a traditional 401(k) plan [or 403(b) or 457(b)] to be converted to Roth accounts within an employer’s current Roth 401(k) plan.

There is a great summary of these two provisions that was published by the American Benefits Council. It has lots of legal and tax details, as well as a couple of rough numerical examples. A couple of the points that they highlight:

– The Roth conversion is only available for “eligible rollover” distributions. In a traditional 401(k) plan, this generally means that the participant is at least age 59 ½ and eligible to take their money out of the plan. The conversion option in NOT generally intended for a young employee who just wants to convert their traditional 401(k) to a Roth 401(k).

– The taxes paid on the Roth conversion can be paid from non-plan dollars instead of with assets within the plan. Thus, a participant could convert $100,000 of traditional 401(k) into $100,000 of Roth 401(k), and just pay the tax on the $100,000 from their personal assets.

Roth 401(k) Rollover Changes

Employers (large and small) will want to be aware of a provision included in a Senate jobs bill last week: the potential to allow eligible rollovers from a traditional 401(k) plan into a Roth 401(k) plan. Business Insurance has a good summary of some of the details, and here are some of the highlights:

  • The main benefit of the change will be for employees who are looking for tax diversification. You pay income taxes on the Roth contributions up-front, while you pay taxes on the traditional 401(k) assets on the tail-end.
  • Under the proposed legislation, employees could elect to spread the tax payments for the Roth conversion 401(k) balance over a two-year period (2011 and 2012).
  • Small employers who are afraid that tax rates will rise in the future may consider adding a Roth 401(k) option in order to pay their taxes at a known rate now.
  • By keeping 401(k) dollars in an employer-sponsored plan (instead of rolling over to an individual IRA), participants can keep certain ERISA protections.
  • The bill would also allow 457 plans to add a Roth option, for tax years beginning after 2010.

It remains to be seen how this bill might be modified or move forward in the House, but we’ll keep you posted on developments. If the legislation progresses, employers who don’t offer a Roth 401(k) plan will want to consider whether their employees would like to take advantage of such an option.