Do Automatic Enrollment Options in 401(k) Plans Obtain the Desired Result?

8/4/2011

By Charles J. Garrison, CPA

The Pension Protection Act of 2006 (PPA) cleared the way for many more employers to automatically enroll employees in a 401(k) plan, including automatic employee contributions, but it is unclear if this has resulted in the desired effect. While employee participation rates have dramatically increased, the contribution percentage by employees has declined.

Prior to 2006, only 24% of employers automatically enrolled employees in 401(k) plans according to a study by the Employee Benefit Research Institute. The PPA allowed many more employers to engage in automatic enrollment and the study indicates that participation rates have increased to 85%, compared to 67% for companies without auto-enrollment programs. Yet the average contribution rate has declined as many employers auto-enroll employees at a 3% rate, which tends to be lower than many employees would contribute voluntarily.

For many plans that are not designed to take advantage of any “safe harbor” provisions, discrimination testing is still required. This testing is designed to ensure that “highly compensated employees” (HCEs) cannot contribute relatively higher amounts than non-highly compensated employees (NHCEs). Discrimination testing is a two-part test that measures both the percentage of employees that participate as well as the dollar amount that employees contribute. These tests are defined as the Average Deferral Percentage (ADP) and the Average Contribution Percentage (ACP), respectively. A 401(k) plan that does not utilize a safe harbor provision must pass both tests in that HCEs must not significantly surpass NHCEs on either test.

The PPA of 2006 has made the ADP largely irrelevant as the rate of participation by NHCEs has increased to the extent that it rivals that of the HCEs. A problem arises, though, in that the automatic enrollment contribution of typically 3% is generally lower than employees would contribute voluntarily, and much lower than the typical rate of HCEs. This tends to make the pass rate of the ACP lower than plans without automatic enrollment.

The lesson from this study is that employers who choose to utilize an automatic enrollment option should consider a higher contribution amount that does not negatively impact the contribution percentage while improving the participation percentage. Otherwise, employers might be better served by a manual enrollment that encourages lower participation rate with higher contribution rates that passes the discrimination testing.