Pension Protection Act of 2006: New Opportunities for Passing 401(k) Plan Discrimination Tests
By Dave Horvath, Crowe Chizek and Company LLC

The Pension Protection Act of 2006 (the “Act”) provides 401(k) plan sponsors with an additional way to qualify for safe harbor treatment and automatically pass the ADP/ACP discrimination tests.

The current safe harbor provisions that allow employers to make minimum matching or non-elective employer contributions to satisfy the discrimination tests are still available. In addition, the Act creates an automatic enrollment safe harbor procedure that works as follows:

The 401(k) plan document is amended to automatically enroll participants to make 401(k) deferrals. The percentage of compensation these participants defer must initially be set between 3 percent and 10 percent of compensation.

1. If the automatic enrollment percentage is initially set at 3 percent of compensation, it is raised to no less than 4 percent of compensation in the second year of participation, 5 percent in the third year and 6 percent in any subsequent year of participation.
2. The automatic enrollment arrangement would not have to apply to employees already participating (or who have elected not to participate).
3. The employer must provide a matching contribution of at least 100 percent of the first 1 percent deferred and at least 50 percent of the next 5 percent deferred, or at least a 3 percent non-elective (profit sharing type) contribution. Vesting on contributions would have to be 100 percent after no more than two years, rather than the immediate vesting rule for other safe harbor 401(k) plans.
4. An annual notice to participants summarizing the automatic enrollment provisions and employer contributions is required.

The Act contains special rules concerning a distribution of “erroneous contributions” – those contributions made by automatic enrollment that the employee decides he/she did not want to have. The employees’ election would have to be made within 90 days after the first payroll period when the automatic enrollment took effect and would apply to all elective deferrals made since the automatic enrollment started. The amount distributed would not be included in the discrimination test, would not be subject to the 10 percent early distribution penalty, and would be treated as compensation. Distributions of erroneous contributions would have to be made by April 15 of the following year.

The Act clarifies that ERISA preempts state laws that directly or indirectly prohibit automatic enrollment provisions, provided the employer provides notice to affected employees within a reasonable period before each year. The effective date of these rules is the first plan year beginning in 2008, except the ERISA preemption rule is effective immediately.

The employer should also notify participants of the “default” investment fund in which these automatic enrollment contributions will be held. Certain default investment guidelines will be treated as satisfying ERISA section 404(c) even if a participant does not make an affirmative investment election.

In our view, these automatic enrollment provisions provide a reasonable alternative for plan sponsors that want to eliminate the possibility of failing the ADP / ACP discrimination test and thus avoid the need to distribute excess contributions and earnings to affected highly compensated employees. The employer matching contribution requirement under the automatic enrollment safe harbor is up to a maximum 3 ½ percent of compensation (100 percent of first 1 percent of compensation deferred and 50 percent of the next 5 percent). This is slightly less than the 4 percent of compensation the employer is required to match under the current safe harbor formula of 100 percent of the first 3 percent of compensation deferred and 50 percent of the next 2 percent. Each employer will need to consider the contribution cost and the safe harbor benefits to determine which of the two safe harbor methods, if either, is right for them.

The automatic enrollment provisions contained in the Act also continue a trend toward legislation designed to increase 401(k) plan participation rates, particularly among lower paid workers.

Dave Horvath will be a speaker at the 2007 Employee Ownership Conference in San Diego, California. He is a frequent speaker on employee benefit programs and has authored several articles on retirement and health and welfare programs for industry publications. He is the author of "401(k) Plans: Managing Compliance Requirements", a text used for nationwide continuing education programs through Professional Development Institute – a Division of the AICPA.

Back

Print this page