Automatic Contribution Arrangements in Government DC Plans
September 2006
By: Jamie Kalamarides, Prudential Financial
Faced with low participation rates, inadequate salary deferral percentages and inappropriate asset allocation despite the efforts of traditional education, marketing, and one-on-one counseling methods, government plan sponsors are looking to 'automatic contribution arrangements' as a potential solution to improve the likelihood that their employees achieve a secure retirement. To adopt these arrangements governments may need to revise legislation and state wage laws.
This brochure:
- Defines automatic contribution arrangements
- Explores the reasons why employers are considering automatic enrollment
- Reviews the impact of the Pension Protection Act of 2006
- Offers a simple assessment to determine whether an automatic contribution arrangement may be right for your plan
- Identifies the key decisions necessary to set up such arrangements in government plans
- Discusses critical implementation considerations
What is an 'Automatic Contribution Arrangement'?
While there are many variations of automatic contribution arrangements, most experts agree that these arrangements have the following features:
- Automatic Enrollment -Employees are automatically enrolled in the defined contribution plan on their eligibility date. Employees are given the option to opt-out.
- Automatic Contribution Rate - Participants' contributions are automatically started at a meaningful level.
- Automatic Escalation - Participants' contributions are automatically increased annually to a specified maximum amount.
- Default & Balanced Investments - Participants' contributions are automatically invested in a prudent fund and rebalanced on a periodic basis.
Why consider Automatic Contribution Arrangements?
Whether you are contemplating your fiduciary responsibilities, troubled by the future liabilities attributable to today's workers or just altruistic - you have to be concerned about the retirement security of government employees.
The facts are startling:
- The U.S. personal savings rate as a percentage of disposable income is near 100-year lows i
- Most workers (52%) have less than $25,000 saved, not including their primary residence ii
- 59% of all workers feel as though they are behind schedule in saving towards retirement. iii
- 52% of Americans in their 30s are saying 'just tell me what to do.' iv
- 80% of participants are not engaged or involved in retirement planning. v
- 46% of participants never change their asset allocation vi
You may have tried a variety of traditional approaches to change participants' behavior - like one-on-one counseling, direct marketing and signature only enrollment cards - only to be frustrated by their unwillingness to change due to inertia.
Academics and industry experts are very excited about the potential benefits of automatic contribution arrangements.vii They have found that for many employees, it is primarily inertia that has caused a failure to save.viii Under automatic enrollment arrangements, inertia works in favor of savings for those employees who want to save. The data indicates that automatic contribution arrangements materially increase the savings levels among low and middle-income employees.ix
What is the impact of the Pension Protection Act of 2006?
The Pension Protection Act of 2006 ('Act') defines 'automatic contribution arrangements' for ERISA plans in section §902.
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The Act gives ERISA plan sponsors the choice to adopt qualified automatic contribution arrangements to avoid nondiscrimination testing and enable employees to reap the benefits of behavioral economics. The Act provides for the pre-emption of state wage laws that currently prohibit employers from automatically enrolling eligible employees in ERISA-covered defined contribution plans. Automatically enrolled participants must contribute at least 3% in the first year, 4% in their second, 5% in the third, and 6% thereafter but not to exceed 10%. To qualify, employers must provide 100% match up to 1% of compensation and 50% match on elective contributions from 1 to 6% of employee contributions. Plan sponsors are not to be required to retroactively enroll non-participants. Also, under §624, ERISA sponsors have fiduciary protection for default investments whose objectives may include capital preservation and long-term capital appreciation.
However, the Act does not address automatic contribution arrangements for section 457 government deferred compensation plans and other non-ERISA plans. Why? Some say Congress was reluctant to consider legislation that states can create themselves. Others did not want Congress to pre-empt states' wage law for their own employees. Still others wanted to avoid defining fiduciary protection for default investments in non-ERISA plans based on ERISA.
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What does this all mean to government plan sponsors? To enable automatic contribution arrangements for government plans, each plan must adopt its own 'automatic contribution arrangement' and modify, if necessary, any wage laws that restrict employers from withholding wages without the employee's written consent. Moreover, local instrumentalities are also dependent on their states' legislation.
Is an Automatic Contribution Arrangement appropriate for your government DC plan?
While there are a number of considerations often unique to each situation, ask yourself the following questions and count the number of 'yes' answers.
- Is your organization's primary retirement plan a defined contribution plan?
- Does your defined contribution plan have lower participation than desired?
- Is the eligible workforce not contributing enough to get a match (if applicable)?
- Do fewer than 10% of participants increase their contributions over time?
- Are assets concentrated in just a few investments for many age cohorts?
- Do fewer than 10% of participants rebalance their assets periodically?
- Is the eligible workforce younger and likely to vest?
- Can your organization afford to pay a match (if applicable) to more participants?
- It is impractical or too expensive to increase participation, contributions or diversification through traditional techniques such as one-on-one counseling or targeted marketing?
- Is your enrollment process currently paperless?
- Do you have benefits and an investment philosophy that is altruistic or paternalistic?
If you answered 'yes' to 7-11 questions, you may want to seriously consider adopting an automatic contribution arrangement. If you answered 'yes' to 4-6 questions some of your employees may realize real benefits from automatic contribution.
If you answered 'yes' to fewer than three questions you may want to consider more focused solutions - rather than automatic contribution arrangements - to achieve your goals. For example:
- lifecycle funds,
- simplified enrollment methods like postcards and using electronic signatures, or
- starting a match.
What are the key decisions required to implement automatic contribution arrangements in government DC plans?
To implement an automatic contribution arrangement, a plan needs to determine its approach to the following implementation choices. You should seek early assistance on these topics from your administrator and record-keeper to understand any implementation constraints and additional costs.
| Implementation Decision | Considerations |
| What are your goals from automatic contribution arrangements? | Write them down before you answer the rest of these questions as they will guide your decision-making. |
| What percentage or dollar amount should eligible participants automatically contribute? | Three percent of wages may become the market standard based on the Pension Protection Act of 2006. |
| What time of year should the arrangement automatically increase salary deferral? | Your employees won't miss the increase if you match the timing with annual salary increases. |
| By what amount should salary deferrals be increased? | One percent of wages or 50% of negotiated dollar wage increases are common. |
| What is the maximum amount that should be deferred? | Many employers are deciding between 10% and 15% of wages. |
| Should non-participating employees be enrolled retroactively? | Retroactive enrollment will increase participation faster for older and longer-tenured workers. |
| Will you provide a match or base contribution? | Matches give tangible incentives to stay enrolled. |
| In what investments will you invest automatic contributions? | Use your written goals and investment policy to determine the appropriate solution for your plan. Typical alternatives include stable value funds, target maturity funds, lifecycle funds and balanced funds. |
| How will funds be rebalanced? | Rebalancing is often done quarterly or annually. |
| What will be the form and frequency of opt-out notification? | Opt-out notification should occur before automatic contributions start and at least annually thereafter. |
| Will you market to those who have opted-out to reconsider? | Non-participants' situations may change in future years. |
| Will you re-examine the default payout vehicle for retirees and terminations? | To create a retirement paycheck for life from participants' DC balances, some sponsors are considering moving the default payout away from lump-sum toward annuitization or guaranteed withdrawal provisions. |
| If you currently have multiple retirement plan providers/ administrators, which will keep records and invest the automatic contributions? | Your plan may want to consider consolidating providers first and/or issuing an RFP to determine the most competitive offer for automatic contributions. |
About NAGDCA
The National Association of Government Defined Contribution Plan Administrators is composed of deferred compensation and defined contribution plan administrators from the 50 states and over 100 local governments and entities, as well as the private industry plan providers. NAGDCA is an organization in which the members work together to improve government 457 plans through a sharing of information on investments, marketing, administration and laws relating to public sector deferred compensation/defined contribution plans.
For more information visit www.nagdca.org.
About the Author
John J. (Jamie) Kalamarides is senior vice president of the Tax-Exempt Segment for Prudential Retirement, a unit of Prudential Financial, Hartford, CT. He chaired the 2006 NAGDCA Taskforce on Automatic Enrollment.
The author would like to acknowledge the NAGDCA 2006 Automatic Enrollment Taskforce for their contributions to this brochure. The taskforce included: Robert Hansel, NAGDCA; Kris Heurich, ICMA/RC; Elaine Lewter, State of Michigan; Jay Mitchell, Mass Mutual; Alex Turner, State of Arizona; Susan White, Susan White Associates; and, Cathy Woodard, City of Anaheim. The author would also like to acknowledge the input of his Prudential colleagues: Sanford Koeppel, Lynn Whitmore-Christiano and Tom Porcello.
NAGDCA and the author do not intend to provide legal or tax advice.
Notes:
i US Department of Commerce, Bureau of Economic Analysis, National Income and Product Accounts of the US.
ii Retirement Confidence Survey conducted by Employee Benefit Research Institute (EBRI), American Savings Council (ASEC), and Matthew Greenwald & Associates (Greenwald), 2005.
iii Prudential's Four Pillars of Retirement Series, 2005.
iv ibid.
v Retirement Services Roundtable, 2006.
vi ibid.
vii 'Save More Tomorrow: Using Behavioral Economic to Increase Employee Savings,' by Thaler and Bernatzi August 2001. 'Saving for Retirement on the Path of Least Resistance' by Choi, Laibson, Madrian and Metrick, Updated: July 2004. 'Coming Up Short: The Challenge of 401(k) Plans', by Munnel and Sunden, 2004.
viii Retirement Confidence Survey.
ix 'The Importance of Default Options for Retirement Savings Outcomes: Evidence from the United States' by Boshears, Choi, Laibson, and Madrian, 2006.
Neither NAGDCA, nor its employees or agents, nor its contributing authors, provide tax, financial, accounting or legal advice. This memorandum should not be construed as tax, financial, accounting or legal advice; it is provided solely for informational purposes. NAGDCA members, both government and industry, are urged to consult with their own attorneys and/or tax advisors about the issues addressed herein.