Automatic Enrollment
Automatic enrollment (also known as “automatic employee contribution”) is a procedure for encouraging worker participation in 401(k) retirement savings plans. As the name suggests, an employer that sponsors a plan and that chooses to use automatic enrollment enrolls its employees in the plan automatically, by salary reduction, without requiring them to take any initiative or action in order to participate.
• Unless an employee elects otherwise, the employee is presumed to be participating, and the employee’s take-home pay is reduced by a stated amount (such as 3%), which is contributed to the 401(k) plan.
• The contributions are “pretax” (excludable from income for income tax purposes), are invested in a manner designated by the plan (unless and until the employee chooses a different investment), and accumulate earnings that are not taxed until withdrawn from the plan.
• Although employees must be given adequate notice and opportunity to opt out of the plan, automatic enrollment creates a “positive presumption” in favor of saving.
Percent of 401k Plans With Automatic Enrollment, 2004-2007
Automatic enrollment is permitted and encouraged by the IRS as a means of increasing retirement paln participation, particularly among low and moderate income groups:
“Also, in an effort to encourage more workers to enroll in the 401(k)s that are already available to them, we have made it clear that employers can automatically enroll workers in the 401(k) plan unless the workers themselves choose to opt out . . . . It sounds like a small thing, but it’s one thing that can really affect a very large number of people in getting them into the business of saving for their own retirement.”
President Clinton, June 4, 1998
The government has released a guide for small businesses wanting to learn more about automatic 401k enrollment:
Automatic 401k Enrollment
CODA (Cash or Deferred Arrangement)
The IRS (Section 1.401(k)–1(a)(2)) defines a cash or deferred arrangement (CODA) as an arrangement under which an eligible employee may make a cash or deferred election with respect to contributions to, or accruals or other benefits under, a plan that is intended to satisfy the requirements of section 401(a). Contributions that are made pursuant to a cash or deferred election under a qualified CODA are commonly
referred to as elective contributions.
In simple terms, a qualified cash or deferred arrangement (CODA) is a qualified profit-sharing, stock bonus or money purchase plan that is commonly referred to as a 401k plan. A CODA allows an employee to choose between receiving cash or electing to have the cash placed in a qualified pension plan thereby deferring current recognition of income
In order for a CODA to be a qualified CODA, it must satisfy a number of requirements. For example, contributions under the CODA must satisfy either the nondiscrimination test set forth in section 401(k)(3), called the actual deferral percentage (ADP) test, or one of the design-based alternatives in section 401(k)(11), 401(k)(12), or 401(k)(13). Under the ADP test, the average percentage of compensation
deferred for eligible highly compensated employees (HCEs) is compared to the average percentage of compensation deferred for eligible non-highly compensated employees (NHCEs), and if certain deferral percentage limits are exceeded with respect to HCEs, corrective action must be taken.
According to the Investment Company Institute, the CODA concept originated with banks in the 1950's:
In the 1950s, a number of companies, particularly banks, added to their profit-sharing plans a new feature that came to be called a “cash or deferred arrangement,” or CODA. Each year, when employees were awarded profit-sharing bonuses, they were given the option to deposit some or all of the bonus into the plan instead of receiving the bonus in cash. Even though the employee had the right to receive the bonus in cash, which normally would trigger immediate income tax, a CODA sought to treat any amount the employee contributed to the plan as if it were an employer contribution, and therefore tax-deferred. In 1956, the IRS issued the first in a series of rulings allowing profit-sharing plans to include a CODA and still be eligible for the favorable tax treatment accorded employer contributions. The IRS reaffirmed its favorable view of CODA's in 1963 after a court case that same year suggested that immediate taxation of employee contributions might apply.
EACA (Eligible Automatic Contribution Arrangements)
EACA stands for "eligible automatic contribution arrangement". This one of two plan design approaches to 401k automatic enrollment authorized by the Pension Protection Act of 2006 (PPA). (See also QACA.) Adopting an EACA enables employers to unilaterally enroll employers in their 401(k) plans at a specified percentage of compensation and invest contributions in government-approved default investment funds without fear of fiduciary liability, and without being subject to state garnishment law restrictions.
Under an EACA, an employee may affirmatively elect to participate in the plan by having the employer make salary reduction contributions to the plan. Absent such an election, the employee will be treated as having elected to have the employer make a salary reduction contribution to the 401(k) plan at a uniform percentage of compensation. The contribution will be made until the participant specifically elects not to have the contribution made or specifically elects to have the contribution made at a different percentage.
Eligible Automatic Contribution Arrangements (EACAs) permit the penalty-free distribution of “accidental” automatic deferrals and provide a six-month period to distribute excess contributions and excess aggregate contributions without imposition of the 10% excise tax;
EBRI (Employee Benefit Research Institute)
EBRI stands for Employee Benefit Research Institute.
The EBRI was founded in 1978 with a stated mission "to contribute to, to encourage, and to enhance the development of sound employee benefit programs and sound public policy through objective research and education."
According to the EBRI website:
EBRI is funded by member dues, grants, publication sales, and investment earnings on reserves. Any organization can become a member of EBRI. Our current membership includes unions, businesses, government agencies, universities, associations, think tanks, actuarial firms, and more. The common understanding: EBRI will approach all of its work in an objective manner. The facts will always tell the story, and EBRI will always publish the results of any work it undertakes. EBRI will not, to repeat from above, function as an advocate or opponent of any position.
EBRI's work extends to all areas of economic security. We have established the American Savings Education Council (www.asec.org) to take data and education to the public, and have developed the Choose to Save® education program (www.choosetosave.org) and its "tools" to help all Americans understand the need to plan in order to have a future – particularly a retirement – that is economically secure.
FRA (Full Retirement Age)
The Social Security Full Retirement Age (FRA) is simply the age at which individuals are eligible to receive their full Social Security benefit.
Under 1983 legislation, Full Retirement Age increases were enacted, beginning with those born in 1938 (turning 62 in 2000) and are fully phased in for those born in 1960 (turning 62 in 2022). The increase in the FRA is a form of benefit cut – either individuals wait longer to claim their full benefit and receive it for fewer years or they claim before age 67 and receive a reduced benefit.
The following chart shows the official Social Security Full Retirement Age (FRA) by year of birth. (Note: If a birthday is on January 1st, Social Security figures the benefit as if the birthday was in the previous year.)
Full Retirement Age (FRA) By Year Of Birth
| Year of Birth | Full Retirement Age (FRA) |
|---|---|
| 1937 0r Earlier | 65 |
| 1938 | 65 and 2 months |
| 1939 | 65 and 4 months |
| 1940 | 65 and 6 months |
| 1941 | 65 and 8 months |
| 1942 | 65 and 10 months |
| 1943 - 1954 | 66 |
| 1955 | 66 and 2 months |
| 1956 | 66 and 4 months |
| 1957 | 66 and 6 months |
| 1958 | 66 and 8 months |
| 1959 | 66 and 10 months |
| 1960 and Later | 67 |
A description of the benefit impacts of the FRA changes is found at Social Security Online.
PPA (Pension Protection Act)
The Pension Protection Act of 2006 is legislation adopted in recognition of the increasingly important role played by 401k plans (and the corresponding declining importance of traditional pension plans) in the retirement planning landscape. With respect to 401k planning, PPA addressed three major problem areas:
- Encouraged Automatic Enrollment - To encourage greater participation in 401k plans, PPA removed legal obstacles faced by employers who wanted to automatically enroll their workers in the plans. Studies show that automatic enrollment increases participation by as much as 41 percent and that the vast majority of workers automatically enrolled still participate after 3-4 years.
- Sanctioned Increases in Default Contribution Rates - To promote higher levels of retirement savings, PPA encouraged 401k plan sponsors to increase the deferral percentage by at least 1 percentage point annually up to 6 percent of compensation – or until the employee stops the increases. Sponsors can continue the increases up to 10 percent of compensation.
- Broadened Investment Options - Prior to PPA, "default" investment options generally consisted of conservative money market funds having little or no risk of principal loss. Not being skilled investors, many 401k participants simply allowed assets to accumulate in the default funds despite the fact that there was little hope of accumulating an adequate retirement nest egg. PPA encouraged 401k sponsors to offer default investment options more in line with sound retirement planning by removing fiduciary liability concerns associated with defaulting workers into investments where they potentially could lose money.
Department of Labor regulations adopted with passage of PPA provide for:a list of “qualified default investment alternatives” that included target date funds (funds that change asset allocation based on a participant’s age), balanced funds (funds with a target risk level appropriate for the plan’s participants as a whole), and managed accounts (accounts managed by an investment service that determines allocations based on age and target retirement date). Plans that place a participant’s defaulted contributions in these investments avoid fiduciary liability; the liability shifts to the participant.
QACA (Qualified Automatic Contribution Arrangement)
A QACA (qualified automatic contribution arangement) is a 401k automatic enrollment arrangement provided for in the Pension Protection Act (PPA) of 2006. (See also EACA.) To be a QACA, an automatic contribution arrangement must provide a specified schedule of automatic contributions, an employer contribution, and notices to participants describing the plan provisions. The minimum required deferral amount increases following a participant’s initial period of participation (automatic escalation), but automatic deferrals may never exceed 10% of compensation. For example, automatic deferral percentages may be increased from 3% in the first year to 4% in year two, 5% in year three...up to a maximum 10%.
The QACA plan design provides a safe harbor plan design that exempts 401k plans from having to perform certain cumbersome nondiscrimination tests.
QDIA
QDIA stands for "qualified default investment alternative".
Under the Pension Protection Act (PPA) of 2006, fiduciary relief was provided for 401k plan sponsors who automatically place participants (who do not specifically choose other investments) into alternatives such as target-date or balanced fund investments.
QDIAs are intended to help ensure that plan participants who may not be comfortable or knowledgeable about making investment decisions are invested in well diversified investment portfolios with appropriate time horizons. According to the Department of Labor website:
A QDIA must satisfy the following requirements:
- A QDIA may not impose financial penalties or otherwise restrict the ability of a participant or beneficiary to transfer the investment from the qualified default investment alternative to any other investment alternative available under the plan.
- A QDIA must be either managed by an investment manager, or an investment company registered under the Investment Company Act of 1940.
- A QDIA must be diversified so as to minimize the risk of large losses.
- A QDIA may not invest participant contributions directly in employer securities.
- A QDIA may be:
Life-cycle or targeted-retirement-date fund;
Balanced fund; or
Professionally managed account.
Replacement Ratio
A Replacement Ratio is a person’s gross income after retirement, divided by his or her gross income before retirement. For example, assume someone earns $60,000 per year before retirement. Further, assume he or she retires and receives $45,000 of Social Security and other retirement income. This person’s replacement ratio is 75 percent ($45,000/$60,000).
Typically, a person needs less gross income after retiring, primarily due to several factors:
- Income taxes go down after retirement. This is because extra deductions are available for those over age 65, and taxable income usually decreases at retirement.
- Social Security taxes (FICA deductions from wages) end completely at retirement.
- Social Security benefits are partially or fully taxfree. This reduces taxable income and, therefore, the amount of income needed to pay taxes.
- Other forms of retirement income, like pensions, are often are exempt from taxation by states
- Saving for retirement is no longer needed.
RMD (Required Minimum Distribution)
RMD stands for required minimum distribution.
Required Minimum Distributions (RMDs) generally are minimum amounts that a retirement plan account owner must withdraw annually starting with the year that he or she reaches 70 ½ years of age or, if later, the year in which he or she retires. The RMD rules apply to all employer sponsored retirement plans, including
profit-sharing plans, 401(k) plans, 403(b) plans, and 457(b) plans. The RMD rules also apply to traditional IRAs and IRA-based plans such as SEPs, SARSEPs, and SIMPLE IRAs.
The RMD rules also apply to Roth 401(k) accounts. However, the RMD rules do not apply to Roth IRAs while the owner is alive.
To determine your required minimum distribution, use our RMD calculator.
This IRS publication provides more detailed RMD information.
SCF (Survey of Consumer Finances)
The Survey of Consumer Finances SCF is sposored every 3 years by the Federal Reserve Board to provide detailed information on the balance sheet, pension, income, and other demographic characteristics of U.S. families. The SCF also gathers information on the use of financial institutions. The 2007 survey is the most recently published survey. Data from the SCF are widely used by branches of the U.S. government and major economic research centers. The SCF is widely recognized as the best source of information on the financial circumstances of U.S. households including 401k participation, contributions and general readiness for retirement.
SCF survey work is actually conducted by the National Opinion Research Center (NORC) at the University of Chicago, under contract with the Federal Reserve. According to the NORC website:
The SCF is unique. No other survey collects data on the household finances of a probability sample of Americans. Data from the SCF are used to inform monetary policy, tax policy, consumer protection, and a variety of other policy issues. The data also serve as a basis for longer-term research on the economic state of the American family. The survey is thus of enormous consequence not only to the Board, which commissions it and has developed and shaped it, but also to millions of US taxpayers who have no idea of its existence.
The survey collects information from approximately 4,500 respondents. Its content is of both a highly sensitive and technical nature. The confidentiality of participants’ information is paramount. The survey employs highly secure data systems and talented interviewers who are able to communicate that message to often skeptical respondents. Interviewers also play a critical role in working with participants to record their sometimes complex information accurately in the interview. NORC conducted this survey for the sixth time in 2007 and has been awarded a contract to conduct the 2010 SCF.
SPD (Summary Plan Description)
A document provided by the 401k plan administrator that includes a plain language description of important features of the plan, e.g., when employees begin to participate in the plan, how service and benefits are calculated, when benefits become vested, when payment is received and in what form, and how to file a claim for benefits. Participants must be informed of material changes either through a revised Summary Plan Description or in a separate document called a Summary of Material Modifications.
The Employee Retirement Income Security Act (ERISA) requires plan administrators to give to participants and beneficiaries a Summary Plan Description (SPD) describing their rights, benefits, and responsibilities under the plan in understandable language. The SPD includes such information as:
New employees must receive a copy of their plan sponsor’s latest Summary Plan Description within 90 days after becoming covered by the plan; all employees should automatically get an updated copy every 10 years (5 years if the plan has been amended). Plan sponsors are not required to file the Summary Plan Description with the Department of Labor (DOL), although they are required to provide it to DOL upon request.
In addition to the Summary Plan Description, plan participants are entitled to receive a Summary of Material Modifications when there is a material modification in the terms of the plan or any change to the information in the Summary Plan Description. The Summary of Material Modifications must be written in a manner that the average participant can understand. The material must be furnished within 210 days after the close of the plan year in which the modification was made.
Key DOL SPD and Other Retirement Information Requirements
TDF (Target Date Fund)
TDF's are 401k investment funds that allocate investments among various asset classes and automatically shift to lower-risk, income-producing investments as a "target" retirement date approaches. TDFs generally shift investment allocations from equity investments to fixed income and money market investments as the "target" retirement date approaches. This shift in TDF asset allocation is commonly referred to as the fund’s "glide path." Sometimes TDFs have significant equity exposures at the retirement date and even at the endpoint of the glide path.
Example: A TDF could be designed for workers expecting to retire many years in the future and would typically have a much greater allocation to equities and a lesser allocation to fixed-income investments. Conversely, a fund designed for workers nearing retirement age would tend to have a greater allocation to fixed-income investments. TDFs thus offer participants a potentially beneficial long-term asset allocation strategy while lowering risks as the participant approaches retirement age.
According to GAO, 401k plans with automatic enrollment policies overwhelmingly adopted TDFs as a default investment - the investment used if the participant makes no other explicit investment choice.
While TDFs may help ensure that workers have a more age-appropriate mix of investments, some experts have stated that TDFs may pose certain challenges, as recent events in the financial markets have illustrated. For example, as a result of the 2008 stock market decline, some TDFs designed for those expecting to retire in or around 2010 lost 25 percent or more in value.
Vesting
Vesting can be thought of as ownership of the plan benefit by the participant. By law, all employees must be fully (100%) vested in their own elective 401k plan contributions. 401k vesting typically refers to the participant's ownership of the employer matching contribution. Typically, employers that match employee contributions require participant's to earn full ownership (vest) of these matching contributions by staying with the company for specified periods of time.
Plans may require completion of a specific number of years of service for vesting in other employer or matching contributions. For example, a 401k plan may require that the employee complete 2 years of service for a 20% vested interest in employer contributions and additional years of service for increases in the vested percentage. There are two types of vesting schedules common in 401k plans:
- With graded vesting, the plan participant owns an increasing portion of the employer contribution each year they are with your company. If the company has a five-year graded vesting schedule, the particpant could be 20 percent vested after one year, 40 percent vested after two years, etc.
- With cliff vesting, the employer contribution goes from zero to 100 percent vested after a set period of time. So if the vesting requirement is three years and the participant leaves the company after two years, they won't get any of the employer contributions.
