When Congress passed the Pension Protection Act (PPA) in 2006 the primary focus was on defined benefit plans designed to protect pension plans funded by employers. Defined contribution plans like 401(k) plans, however, were also largely affected by the legislation. In fact, the act created plan incentives to help employers and employees reap more benefits from 401(k) contributions. One of those such provisions is the automatic enrollment feature referred to as “the automatics.” In this post, we explore the benefits for plan sponsors and for employees from the regulations. We also evaluate the effect on 401(k) deferrals to date.
401(k) Plan Automatic Enrollment
The passage of PPA incentivizes 401(k) plan sponsors to automatically enroll employees into 401(k) plans instead of automatically notenrolling them. The step is a change in behavioral finance after numerous research studies found that approximately 1/3 of all employees offered a 401(k) plan never enrolled in one. Similarly, employees very rarely make changes to their 401(k) status; meaning employees who didn’t sign up at the beginning of their employment were very unlikely to sign up in the future. The new ruling instead created a precedent of enrollment and allowed employees to opt out. Additionally, plans automatically invest contributions into age-appropriate life-cycle funds on behalf of employees.. For example, greater risk and growth allocations for younger employees and more stable issuances for employees nearing retirement.
Plan sponsors are granted incentives for automatically enrolling participants. For employers the most important incentive is automatic qualification in previously complicated compliance regulations. The act makes helping employees save for retirement beneficial for both sides; employees are automatically enrolled into plans with company matching – historically 3% – and employers receive tax breaks for contributions.
Automatic Enrollment Trends Upward
In recent years, automatic enrollment in small 401(k) plans, determined as plans with less than 49 participants, has increased significantly following broader market trends of defined contribution plans. According to Plan Sponsor Council of America (PSCA), in 2015 automatic enrollment plans saw a nearly 26% increase in participation. Today 57.5% of all plans have an automatic enrollment component.
Additionally, company matching rates, typically set at 3%, are increasing. Currently, 51.6% of all plans now offer higher matching incentive rates than 3%. This is good news for plan participants who are incentivized to contribute more towards their retirement accounts with the lure of higher employee matching. Companies offering higher matching benefits earn higher yearly tax deductions. The increased matching is also helpful to retain and attract top talent.
The following charts reflect the findings from the recent PSCA report on automatic enrollment in small-sized 401(k) plans:
Statistically, larger plans with 5,000 or more participants have had the highest number of automatic enrollment components. Roughly 67% of large plans utilize the function. Small and mid-sized plans are following suit but tend to adopt trends later than the larger organizations.
Pros of Auto-Enrollment
- Plans have higher participation rates.
- Plans have higher account balances.
- Plans can allow for automatic increase of the contribution rate each year.
- Automatic enrollment helps meet complicated testing requirements like nondiscrimination tests (requiring qualified employees of all income levels equal benefit in plans).
Cons of Auto-Enrollment
- Participant notices must be provided explaining the automatic enrollment process.
- Plans often set the default contribution rate lower than employees would elect.
- If the automatic enrollment rate is too high, participants may opt out.
- Plans may lack an annual automatic contribution escalation.
For more information on automatic enrollment options for 401(k) plan sponsors and how this can benefit your business and employees, contact your TrueNorth Retirement Services financial advisor.