The Automation of DC Plans (Auto Enrollment, Contributions, and Qualified Default Options)

The Pension Protection Act of 2006 (PPA) opens the possibility for a new meaning to the defined contribution (DC) retirement saving landscape. The PPA opened the door for private sector employers to take a more commanding role in how their employees save for their retirement future and presents those plan sponsors with a new series of considerations.

DC plans were created to be optional savings plans, designed to supplement the retirement income stream supplied by a defined benefit pension plan and social security. The idea that 'if you build it, they will come' didn't turn out to be the case for many DC plans. Motivating employees to participate has continually been an uphill battle for plan sponsors. The passing of PPA dramatically alters this aspect of the DC landscape.

The PPA included three autos for ERISA plans: automatic enrollment, automatic escalation and automatic default investment alternatives .These three features may give public sector plan sponsors some additional thoughts when considering the overall retirement picture of their employees. It is important to note that none of the provisions of the PPA apply to non ERISA plans

In the past, the typical default feature of DC plans was generally to make no contributions on an employee's behalf unless the employee opted into the Plan. If the Public Plan Sponsor undertakes the legislative, contractual, and procedural process to legally put in place automatic enrollment, all parties may decide to specify that the default is to reduce the employee's pay by a specified amount and to contribute the amount withheld to the plan for the benefit of the individual employee. Historically, plan sponsors have used a purely educational approach to help employees voluntarily enroll in the offered plans. According to the 2006 Retirement Confidence Survey conducted by the Employee Benefits Research Institute (EBRI), only half of all Americans age 55 or older have saved $50,000 or more for retirement.

Employee inertia became a top challenge for plan sponsors, and auto enrollments/auto contributions could reverse the inertia. With the provisions for automatic enrollment, plan sponsors no longer have to entice employees into action. Automatic enrollment shifts the burden to the employee and pulls the plan sponsor out of the enrollment process. If employee inertia continues as it has in the past, it now has the potential for a positive outcome.

Automatic enrollment presents plan sponsors with a new decision tree. Making the decision to enroll new employees going forward at the time of hire appears an obvious one, and although there may be many legislative and contractual details to attend to, the plan sponsor may decide that the journey will ultimately help employees as they head towards retirement. Enrollment becomes just one more aspect of employee orientation, a time when an employee is focusing on all of the employee benefit options. Presented as a condition of employment, the employee may be more unlikely to take the initiative to opt out of the Plan than they were to enroll in the past. The PPA requires that the plan sponsor permit the employee 30 days from enrollment to the time of first deferral to opt out of the Plan. This period is known as the opt-out period. PPA also provides an additional escape route for the employee. Once deferrals have begun, a participant has 90 days from the time of enrollment to make a penalty-free withdrawal of the value of his or her account. Those deferrals would then be included in taxable income for the year.

But what are the considerations facing plan sponsors if they elect to initiate automatic enrollment for existing employees? Change is not always met with approval especially when it means another deduction in their paycheck. Ultimately, the question arises, hasn't the existing employee already opted-out by not enrolling in the first place? Plan sponsors will need to ensure that they have solid communication plans in place if and when they decide to sweep existing employees into the plan. Communications must be crystal clear about the opt-out provisions, especially when it comes to the timing of the first deferral vs. the date of enrollment. Even then, to be prudent, follow-up notice should be made as the 90-day window approaches to give additional notice reminding employees who might wish to opt-out that they need to do so to avoid tax penalties.

The rate for deferral is thought by many to be second only to plan participation itself in the successful accumulation of retirement savings. So if enrollment is automatic, how does a plan sponsor determine how much is enough to defer? Basing a reasonable initial deferral amount on your employee demographics is a key consideration. A quantitative analysis of participating vs. non-participating employees is a first step. Secondly, plan sponsors need to consider who automatic enrollment is designed to benefit. If the goal of automatic enrollment is to get the lower compensated employees to participate in the plan, then the initial rate of deferral shouldn't be too high to force them to opt out. Maybe the saying, 'start small to build big' is the key here. Plan education can then shift from the need to enroll to the need to increase deferral amounts over time.

Auto escalation (amount, frequency and decision responsibility)

For ERISA-covered DC Plans, the PPA created the qualified automatic contribution arrangement (QACA). If the plan's automatic enrollment feature is designed to meet the requirements of a QACA, then the plan will be treated as meeting the actual deferral percentage (ADP) and actual contribution percentage (ACP) tests and will be exempt from top-heavy testing. The QACA must provide the following automatic deferral rates:

• On initial eligibility - between 3% and 10%
• In the second year of participation - at least 4%
• In the third year of participation - at least 5%
• In subsequent years of participation - at least 6%

The QACA must also contain a matching provision of either (1) at least 100% on the first 1% of deferrals plus at least 50% on the next 5% of deferrals, or (2) a 3% nonelective contribution.

The QACA must be 100% vested after no more than 2 years. Distributions of a QACA are subject to the regular 401(k) rules.

While the safe-harbor provision doesn't directly apply to public sector plans not covered under ERISA, aspects of it might be considered for implementation as the decision to institute any type of escalation formula into your plan is one that should be carefully considered by all decision making parties. It is important to note that both elective and non elective deferrals (like an auto escalation type deferral) are both counted towards the maximum deferral amount in 457 Plans. Particular care must be given to ensure that Plan escalation provisions do not negatively impact each employee's maximum elective deferral limit.

Qualified Default Investments Alternatives (QDIA) (target date funds, managed accounts, blended, value of stable value funds)
For automatic enrollment to exist, so must the designation of a default vehicle. The Department of Labor (DOL) regulations identified three Qualified Default Investment Alternatives (QDIAs) for plans with automatic enrollment programs. The utilization of one of the QDIAs generally means that plan fiduciaries won't be held liable for losses that arise from participants' investment in a QDIA. The approved QDIAs are:

• Lifecycle or Target Retirement Date Funds,
• Managed Accounts - professionally managed portfolios that allocate account balances among existing plan options, taking into account the individual's age or retirement date, and
• A Balanced Fund that takes into account the characteristics of the group as a whole.

Also, a stable-value or capital preservation fund can be a temporary QDIA, to hold participant's money for a maximum of 120 days, ensuring principal protection during the enrollment and opt-out period.

The intent of the QDIA is to provide a single investment, capable of meeting a participant's investment goals over the long term. Plan sponsors may choose to offer a different default investment option, but in doing so the plan would not receive the benefits of automatic fiduciary protection with regard to the default investment. The selection of the appropriate QDIA for ERISA covered plans will depend on a number of factors; the number of funds in you're the plan's current fund line-up, whether the plan currently offers Lifecycle or Target Retirement Date Funds, and.whether the plan has the capability of offering professionally managed separate accounts. These guidelines would be appropriate to follow in a public sector plan. Following is a brief discussion of each QDIA:

Lifecycle or Target Retirement Date Funds - Many DC plans have already introduced the use of Lifecycle or Target Date Retirement Funds. These funds have become extremely popular with plan sponsors trying to increase participation and are regularly marketed to participants as the 'easy' fund to select when trying to figure out how to create an appropriately diversified account. There are usually a series of funds, generally with five or ten year intervals between funds, and one fund designed to provide income during retirement. In most cases they are 'funds of funds' of the investment manager, meaning they invest in other mutual funds from within the fund complex. The mix of allocations to the underlying funds shift over time to become more conservative as the fund nears its target date. In other words the allocations to equity and fixed income options shift over time. The longer range of the fund, the higher the concentration in equity funds, the closer to the target date, the higher the concentration in fixed income.

Managed Accounts - These funds are managed by a professional investment management team using existing core funds already established within the Plan. Rather than being 'off the shelf' funds like Target Date mutual funds, this combination of funds have the ability to be tailored in their design, taking into consideration information provided by each employee concerning factors deemed to be important by that individual. Plan sponsors can also tailor the managed accounts to the range of retirement dates generally seen in the government sector.

Balanced Funds - Generally viewed as the least 'personalized' QDIA when compared to the other two based on its 'one-size-fits-all' design. Balanced funds are a combination of equities (55 - 70% of the portfolio) and bonds (30% -45% of the portfolio), and maintain their ratio between equity and bond holdings, whereas target date funds adjust their holdings as the target date approaches. There are three types of balanced funds: conservative, moderate, and aggressive. Each has a different ratio between equities and bonds in the portfolio. Many believe that this is not necessarily appropriate to what can be the primary long-term investment vehicle for a participant. They generally do not take into account the changing age and needs of the employee as they approach retirement. However, the simplicity of a balanced fund may make it a reasonable alternative and possibly a good choice for plan sponsors looking to limit their involvement in the QDIA selection process. Selection of the investment manager is also a key consideration if considering a Balanced Fund as the QDIA, as it is with the selection of any investment manager.

The continued value of Stable Value Funds
The DOL approved the use of Stable Value Funds as the temporary holding vehicle for initial deferrals during the first 120 days of participation. This reduces the risk of investment loss due to market volatility during the first 90 days of participation, the period in which an employee may make a penalty-free withdrawal of the account. Once the opt-out period has expired, the Plan sponsor has an additional 30 days to sweep the account balance into one of the three approved QDIAs. The whole process, which includes the opt out and sweep, must happen within 120 days.

Target Risk vs. Core Investments vs. Non traditional investments (REIT, brokerage windows, DB blends, and separately managed portfolios)

The question now on the table is where do the traditional core investments fit within the future of DC plans? If participant inertia continues as it has in the past, then participants who default into one of the QDIAs are more than likely to stay in that fund for the duration. But what is best for the participant willing to assume more or less risk than the QDIA offers? Are they now back where they started - needing to build a whole portfolio from scratch to get slightly more or less risk?

Target risk funds, pre-mixed funds with different risk profiles, diversified and built on sound portfolio construction principles, might be the preferred complement to the QDIA choice. For the participant looking to make a simple risk adjustment to their QDIA depending on their personal situation, selecting a single pre-mixed fund designed to be more or less risky might be a beneficial move.

Will plan sponsors really need to offer a full spectrum of fund offerings for the few looking to build diversified accounts using asset allocation models? Undoubtedly the core funds will continue to hold a place in DC plans due to the size of the assets currently held in them, but the emphasis will likely shift away from them. An argument can even be made that access to most funds can be made through the introduction of a brokerage window and, therefore, for the few looking to build this kind of account they will have even more freedom.

The brokerage window also satisfies the needs of those at the far end of the investment spectrum - those looking for the most freedom and control over their investments. On introducing a brokerage window plan sponsors should be diligent on making it clear to participants that utilization of the brokerage window is done fully at their own risk.

Much has been written recently about the impact of fees on the participant's account. An important consideration when deciding what types of investment alternatives to include in your Plan design is the cost-effectiveness of each to the participant. When considering non-traditional investments Plan sponsors will be wise to consider the cost implications upon the general populace. Will you be satisfying the needs of a few yet burdening the majority?

The ever changing and evolving question of how to help the population of the United States plan and save for retirement is one that captures the attention of all those concerned about the current aging population and each generation of employees as they take their 'turn' in the retirement process. New ideas, options, and educational techniques must be constantly studied, evaluated, and (based on each individual plan's needs) implemented for the benefit of the employees. Tastes and motivational triggers seem to change over time and so too do employee needs in terms of retirement planning. Many plan sponsors, legislatures, collective bargaining groups etc., have decided to expand options and educational opportunities for their employees based on proven successful DB concepts. Time will only tell if these ideas are successful, however, the underlying and motivational intention will always be the 'quality of life' felt by all of our employees.

Neither NAGDCA, nor its employees or agents, nor members of its Executive Board, 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.

Copyright 2008 NAGDCA

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