The risks and rewards of sec. 401(k) plan negative elections.

• Author: Arsenault, Stephen J.

Sec. 401 (k) plan sponsors can automatically enroll employees on eligibility. Why should an employer do this? To increase the plan contributions that can be made by highly compensated employees. But, as this article shows, there are a number of related issues to consider, including Employee Retirement Income Security Act of 1974 and state law concerns.

One of the most interesting recent developments in Sec. 401(k) plan design has been the introduction of the so-called "negative election" or automatic enrollment of plan participants. In contrast to the traditional method of requiring an employee to elect to participate in an employer-sponsored Sec. 401(k) plan, several public companies have redesigned their plans to automatically enroll eligible employees. The employees are deemed to have elected to defer a specified percentage of compensation (often 1% to 3%), unless they affirmatively elect not to participate or elect a different deferral percentage. In some cases, the employer directs how automatic contributions will be invested; in other cases, the employer designates a conservative investment choice (e.g., money market fund) for the initial investment and the employee can change the investment selection later.

McDonald's was one of the first large, publicly traded companies to use negative elections. Other companies, including J.C. Penney, Hewlett-Packard, Motorola, Venator Group, Inc. (formerly Woolworth Corporation) and the Federal Home Loan Mortgage Corporation (Freddie Mac) have also taken this approach.(1) The Clinton Administration recently endorsed this technique to increase employee participation in retirement savings plans and the national savings rate in general.(2) Until recently, however, neither the IRS nor the Department of Labor (DOL) had issued formal guidance on negative elections. Employers and their advisers were concerned that, because participants in a negative election Sec. 401(k) plan do not affirmatively elect between receiving cash and having contributions made to the plan on their behalf, negative elections might cause plan contributions to fail as elective deferrals under Regs. Sec. 1.401(k)-1(g)(3); this would cause the plan to fail as a qualified cash or deferred arrangement.

The Service recently addressed these concerns in Rev. Rul. 98-30,(3) concluding that when employees have the opportunity to elect out of the automatic deferral provisions, contributions made under a negative election will not fail to be considered elective deferrals. With the issuance of this ruling, more U.S. employers will likely wish to consider using negative elections to increase employee participation in their Sec. 401(k) plans.

Benefits of Negative Elections

Helping Employees Save for Retirement

Negative elections encourage employees to save for retirement via the employer's Sec. 401(k) plan. Employees who would not voluntarily elect to defer a portion of their pay into retirement savings often receive psychological encouragement to continue (and even increase) their rate of retirement savings when their account balance is growing. For example, Freddie Mac has found that approximately 30% of its automatically enrolled employees have increased their deferral rates. While approximately 65% have kept their deferrals at the automatic 3% level prescribed by the plan, only 4% have opted out of participation. The plan's participation rate has increased from 81% to 83% and is expected to continue to increase over time with employee turnover.(4)

An employer that wishes to further increase the incentive for employee participation might also consider two other plan design issues. First, an employer might reduce the eligibility period from one year to three to six months; some employers have eliminated the eligibility period entirely. While reducing or eliminating the eligibility period may result in some additional administrative costs if the employer has high employee turnover, it will generally increase plan participation.

In addition, an employer might consider adding a matching contribution feature or making an existing match more generous. For example, an employer that makes a 3% automatic contribution might include a matching contribution of 50% of the first 6% of deferred compensation; the effect would be an additional 4.5% of compensation being added to the employee's account under the plan. The additional employer contribution is likely to have a significant effect on employee participation; when combined with a negative election program, it will likely increase the rate of employee retirement savings significantly.

Helping a Plan Pass the ADP Test

Perhaps more importantly, negative elections make it easier for a plan to meet the Code's qualification requirements, including the actual deferral percentage (ADP) test and the average contribution percentage (ACP) test. The Sec. 401(k)(3)(A)(ii)ADP test compares the average percentage of compensation deferred by eligible highly compensated employees (HCEs) with the average percentage deferred by eligible nonhighly compensated employees (non-HCEs). The Sec. 401 (m) ACP test compares the average percentage of compensation added to non-HCEs' accounts as matching and voluntary after-tax employee contributions with the average percentage of compensation added to HCEs' accounts as such contributions. Both tests prevent a plan from discriminating in favor of HCEs.

For purposes of the ADP and ACP tests, an HCE is defined by Secs. 414(q)(2) and 416(i)(1 (B)(i) as any...