Automatic Enrollment in Section 401(k) Plans

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Most employers that sponsor retirement savings plans under §401(k) of the Internal Revenue
Code (IRC) require employees to decide whether to enroll in the plan. The Internal Revenue
Service (IRS) has issued rulings to inform employers that it is permissible under current law to
enroll employees in these plans automatically, provided that the employee is notified in advance
and is permitted to leave the plan if he or she chooses to do so. Automatic enrollment, in which a
percentage of the employee’s salary is placed in an individual account without requiring the
worker to take any action, has been shown to increase worker participation in §401(k) plans and
similar salary reduction retirement savings plans. In 2004, automatic enrollment had been adopted
by an estimated 11% of §401(k) plans. About 1% of plans with fewer than 50 participants and
31% of plans with 5,000 or more participants had automatic enrollment in 2004. The Pension
Protection Act of 2006 (P.L. 109-280) includes provisions to promote automatic enrollment in

401(k) plans.

Types of Retirement Plans..................................................................................................1
Enrollment Practices...........................................................................................................1
IRS Rulings.........................................................................................................................2
Plan Participation................................................................................................................2
Policy Issues.......................................................................................................................3
The Pension Protection Act.................................................................................................5
Author Contact Information............................................................................................................6

About half of all workers in the United States participate in an employer-sponsored retirement
plan, a figure that has remained relatively stable for the past quarter-century. Over the past 20
years, however, there has been a shift in coverage from traditional pensions, also called defined
benefit plans, to defined contribution plans such as those authorized under §401(k) of the Internal
Revenue Code (IRC). According to the Bureau of Labor Statistics, only 21% of workers in the
private sector participated in a defined benefit plan in 2005, whereas 42% participated in a
defined contribution plan. About 11% of private-sector workers were in both types of plan at their
current job in 2005. Defined benefit (DB) plans typically are funded entirely by the employer, and
they are required by law to offer the retiree the option to receive his or her benefit in the form of a ¹
guaranteed life-long annuity. Defined contribution (DC) plans consist of individual accounts in
which workers can accumulate savings for retirement. Prior to enactment of the Revenue Act of

1978 (P.L. 95-600), DC plans also were typically funded exclusively by employer contributions.

This law added §401(k) to the IRC, allowing employees to make pre-tax contributions to
employer-sponsored retirement savings plans.
In 2006, workers can defer taxes on up to $15,000 of wage or salary income that is directed to an ²
employer-sponsored retirement plan established under §401(k). After 2006, the maximum annual ³
deferral will be indexed to the Consumer Price Index. Employers also can contribute to §401(k)
plans. Section 415(c) of the Internal Revenue Code defines the maximum allowable contribution
to a §401(k) plan, including both employer and employee contributions. The maximum
contribution is $44,000 in 2006.
In a traditional defined benefit plan, employees typically do not need to enroll in the plan to
accrue benefits. Workers automatically earn benefits under a DB plan, provided that they are in a ⁴
covered group of workers and work the required number of hours per year. In contrast, most
employers who sponsor §401(k) plans require employees to enroll in these plans voluntarily. One
reason for this difference is that DB plans in the private sector usually are funded entirely by the
employer, whereas most DC plans (and all §401(k) plans) require the employee to contribute to
the plan. Employers who require employees to enroll voluntarily in §401(k) plans do so for
several reasons: (1) participants in most DC plans must decide how much to contribute (up to the
legal limit or a lower limit established by the plan sponsor); (2) participants in many DC plans
must decide how to invest their contributions; and (3) several states have laws that require
employers to secure a worker’s permission before making any payroll deductions other than those
required by law, such as income tax withholding and the Social Security and Medicare payroll
taxes.

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Because enrollment in most §401(k) plans is voluntary, not all workers whose employers offer a
plan choose to participate. The Bureau of Labor Statistics reports that in 2005, 53% of workers in
the private sector were employed at establishments that offered a DC plan, but just 42% of
employees at private establishments participated in a plan. Consequently, the participation rate
among employees whose employer offered a DC plan was 79%. In contrast, the BLS reports that
22% of workers in the private sector were employed at establishments that offered defined benefit
plans and 21% participated in those plans, yielding a participation rate in these plans of 95.5%.
Employers who sponsor §401(k) plans often promote participation among their employees by
providing them with information on the importance of saving for retirement and the tax savings
that result from participating. One way to achieve high rates of plan participation is to enroll
employees automatically. Rather than the default option being that the employee will not be
included in the plan unless he or she actively enrolls, the default under automatic enrollment is
that some of the employee’s pay will be deducted and directed into a retirement account unless he
or she instructs the employer not to do so. The IRS has issued several rulings in recent years to
clarify for employers that they are permitted to enroll employees in §401(k) and §403(b) plans
automatically through payroll deduction, provided that the employee is notified in advance and
has the option to drop out of the plan. Unless the employee elects otherwise, he or she is
presumed to be participating, and an amount set by the employer (such as 3% of pay) is deducted
from the employee’s (pre-tax) pay and contributed to the §401(k) plan.
In 1998, the IRS issued a ruling clarifying that automatic enrollment in §401(k) plans is
permissible for newly hired employees (Revenue Ruling 98-30). The IRS issued a second ruling
in 2000 stating that automatic enrollment also is permissible for current employees who have not ⁵
already enrolled in the plan (Revenue Ruling 2000-8). In 2004, the IRS published a general
information letter that clarified two previously ambiguous points. The letter stated that (1) the
amount deducted from the employee’s pay and contributed to the plan can be any amount that is
permissible under the plan up to the annual contribution limits under IRC §402(g), and (2) the
plan can automatically increase the employee’s contribution over time, such as after each pay
raise. Again, the IRS emphasized that employees must be fully informed of these plan provisions
and they must have the option to change the amount of their contribution or to stop contributing
to the plan altogether.
The IRS has promoted automatic enrollment through these official announcements mainly to
increase participation among moderate- and lower-income workers. The IRS has noted that “the
rate of participation in elective retirement savings plans tends to be lowest among these ⁶
workers.” Evidence from surveys and case studies suggests that automatic enrollment results in
higher rates of participation in §401(k) plans. In 2001, the Profit Sharing/401(k) Council of
America (PSCA) surveyed 25 companies that had adopted automatic enrollment. Nine provided

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information on participation rates before and after the implementation of automatic enrollment.
The average participation rate at these companies increased from 68% three months before
automatic enrollment was implemented to 77% at the time of the survey. Studying the effect of
automatic enrollment at three companies that adopted it between 1997 and 1998, economists
James Choi, David Laibson, and Brigitte Madrian found that participation increased to between
86% and 96% after automatic enrollment took effect. After three years of service, the
participation rate among employees hired under automatic enrollment was 30 percentage points ⁷
higher than among employees hired before automatic enrollment was implemented.
According to the PSCA, 11% of §401(k) and profit-sharing plans used automatic enrollment in
2004. Automatic enrollment was more common in large plans than in small plans. It had been
adopted by 1% of §401(k) plans with fewer than 50 participants and by 31% of plans with 5,000
or more participants. In a survey of mainly large firms, the benefits consulting firm Hewitt
Associates found that 24% used automatic enrollment in 2005, up from 14% in 2003. Deloitte
Consulting recently reported that 23% of the 830 plan sponsors it surveyed in 2005 and 2006 had
instituted automatic enrollment.
Automatic enrollment has been shown to increase participation rates in §401(k) plans among
eligible employees. There are, however, two other important decisions that participants in a
§401(k) plan must make, or that must be made for them: how much to contribute to the plan and
how to invest those contributions. Plan sponsors who have adopted automatic enrollment
generally have been conservative in setting the contribution amount and in choosing investments
for employees who have been enrolled automatically. Both the PSCA and Deloitte Consulting
report that the most common contribution rate for employees who are enrolled in a plan
automatically is 3% of pay. These contributions are typically invested in a stable value fund, ⁸
money market fund, or target retirement date fund. Many plan sponsors are reluctant to set the
default contribution rate for automatic enrollment higher than 3% of pay because that rate was
used in examples of permissible automatic enrollment practices published by the IRS. Employers
also tend to choose conservative investments—those with little risk of capital loss, such as money
market funds and stable value funds—due to concerns about their liability as plan fiduciaries if
the investments they have chosen decline in value. Financial analysts generally agree that a
contribution equal to 3% of pay is too small, and that the rate of return on money market funds
and stable value funds is too low for most workers to build an adequate retirement fund over the ⁹
course of their careers. Life-cycle funds and target retirement date funds allocate contributions
among investments based on generally agreed upon principles of diversification. They are more
likely then money market funds or stable value funds to result in adequate retirement savings over
a lifetime.

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Low default contribution rates and conservative default investment funds typical in plans that
have automatic enrollment would be of less concern to policy-makers if participants took an
active role in managing their contribution amounts and investment choices. Unfortunately, many
participants in retirement plans behave passively, and for them the default choices often become
permanent. This is a concern not only for workers who would not otherwise have enrolled in the
plan, but also for participants who would have elected voluntarily to participate in the plan and
who—if not for the plan’s default contribution rate and default investment funds—would have
chosen a higher contribution rate and more appropriate investments for their retirement accounts.
Researchers have found that there is a substantial amount of inertia among participants in §401(k) ¹⁰
plans with respect to managing their accounts. A relatively small percentage take great interest
in managing their retirement funds, regularly increasing their contributions and re-balancing their
accounts. Many plan participants, however, seem to accept the default contribution percentages
and investment choices associated with automatic enrollment as implicit investment advice, or as
an endorsement by their employer that these are somehow the “right” choices for them.
To clarify its interpretation of federal law with respect to contribution rates under automatic
enrollment, the IRS issued a general information letter on March 17, 2004, stating that the
automatic contribution level may be more (or less) than the 3% that it had used in previously
published examples of acceptable practices under automatic enrollment. If the employer offers
matching contributions, for example, the automatic contribution rate can be higher or lower than
the percentage that is matched by employer contributions. The letter also stated that the automatic
contribution percentage can be increased (or decreased) over time under a specified schedule—
one based on years of service, for example. The employer must describe the details of the change
in the required notice to employees of their right to select another contribution rate. The IRS letter
also stated that increases in the automatic contribution percentage can be triggered by future
increases in an employee’s pay or by bonuses. Again, the required employee notice must describe
exactly how this would affect participating employees.
The rulings and letters issued by the IRS may encourage more firms to adopt automatic
enrollment, and to couple it with automatic increases in the contribution rate until the employee
reaches some agreed-upon maximum contribution level. Analysts point out, however, that
employers who adopt automatic enrollment should be sure to put the participant’s contributions
into appropriate investment funds as he or she gets older. Life-cycle funds, for example,
progressively invest more in bonds and less in stocks as the employee approaches retirement age,
lessening the chance of large capital losses. Employees also should be reminded continually that
they have the right to change their contribution amount or to choose alternative investment funds.
One successful model of automatic enrollment coupled with progressive increases in the
employee contribution rate was developed by economists Richard Thaler of the University of
Chicago and Shlomo Benartzi of UCLA. Called Save More Tomorrow (SMarT), it asks workers
to contribute a portion of their future raises into their §401(k) plan. This way, workers can raise
their future contribution rate without experiencing a drop in take-home pay. In a case study of the
SMarT plan, Thaler and Benartzi found that most workers (78%) who were asked to participate
agreed to do so and most who joined (80%) continued with scheduled increases through at least

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the fourth pay raise. (Even those who eventually dropped out continued to contribute a higher
percentage of pay than they were contributing before the program began). Those who participated ¹¹
raised their average contribution rate from 3.5% of pay to 13.6% of pay over a 40-month period.
The Pension Protection Act of 2006 (P.L. 109-280) amended ERISA §404(c) to extend to default
investments under automatic enrollment plans the same protections that participant-directed
investments receive, thus relieving employers of fiduciary liability for investment losses. The law
provides that beginning in 2008, §401(k) plans with automatic enrollment that satisfy certain
requirements will be deemed to meet the nondiscrimination requirements of the Internal Revenue ¹²
Code. It also provides that plans consisting solely of contributions made through automatic ¹³
enrollment will not be subject to the top-heavy rules. To be deemed as satisfying the
nondiscrimination rules, a plan with automatic enrollment must meet requirements with respect to
(1) automatic deferral of pay; (2) matching or nonelective contributions; and (3) notice to
employees.
The PPA provides that a plan may limit eligibility for automatic enrollment to employees who
were not eligible for the plan prior to the date it began automatic enrollment. The plan must
provide that, unless an eligible employee elects otherwise, the employee will defer a percentage
of pay not to exceed 10%, but at least equal to 3% of pay for the first year; 4% during the second
year; 5% during the third year; and 6% during the fourth year and thereafter. The percentage must
be applied uniformly to all eligible employees. The employer also must either make (1) a
matching contribution on behalf of each nonhighly compensated employee equal to 100% of the
first 1% of pay the employee defers and 50% of the next 5% of pay the employee defers, or (2) a
nonelective contribution equal to at least 3% of pay on behalf of each eligible nonhighly
compensated employee. If the employer makes matching contributions, the match rate for a
highly compensated employee cannot be greater than the match rate with respect to the same rate
of deferral of a nonhighly compensated employee. Also, if the plan makes matching
contributions, it must assure that matching contributions are not provided for elective deferrals in
excess of 6% of pay, and that the match rate does not increase as the rate of an employee’s
elective deferrals increases. Plans with automatic enrollment must provide that employees with at
least two years of service are 100% vested in employer contributions. (Employees are always

100% vested in their own contributions.)

Each employee eligible to participate in the plan must receive notice of his or her right to elect
not to have automatic deferrals made on the employee’s behalf or to elect to defer a different
amount. The employee must be informed how contributions made under the automatic enrollment
arrangement will be invested in the absence of any investment election by the employee.

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Erroneous automatic deferrals may be distributed from the plan within 90 days after the date of
the first deferral. The 10% early withdrawal tax will not apply to distributions of erroneous
automatic deferrals. In addition, the excise tax on excess contributions will not apply if the excess
contribution, and any income attributable to the contribution, is distributed within six months
after the close of the plan year. The PPA also preempts any state law that would directly or
indirectly prohibit or restrict the inclusion in a plan of an automatic contribution arrangement.
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