The Revenue Ruling considered the following scenario: ABC Company ("ABC") maintains the ABC Company 401(k) Savings Plan ("ABC Plan") for the benefit of its eligible employees. Under the ABC Plan, an employee may elect to have the employer contribute a portion of his or her compensation to the ABC Plan. In the case of a new employee, ABC Company automatically withholds three percent of the employee's pay and contributes it to the ABC Plan unless the employee affirmatively elects to receive cash compensation in lieu of a contribution to the ABC Plan. Each new employee is given a notice when he or she is hired explaining the employee's right not to have a contribution made to the ABC Plan and is given a reasonable period of time after receiving the notice to elect to receive cash. An employee may elect to stop or to adjust the contribution amount (either upward or downward) at any time.
The IRS concluded that since employees were given an opportunity to receive cash in lieu of the contribution to the ABC Plan, and to adjust the amount of the contribution, the amounts contributed to the ABC Plan would be considered elective contributions within the meaning of the IRS regulations regarding 401(k) contributions and thus permissible and in accordance with Treas. Reg. §1.401(k)-1(g)(3). In reaching its conclusion, the IRS focussed on the full disclosure given to employees before any automatic contributions were made.
One potential benefit of negative or automatic elections may be to assist a plan in passing the nondiscrimination tests imposed by the Internal Revenue Code of 1986, as amended ("Code"). For example, if a 401(k) plan has a low participation rate among nonhighly compensated employees ("NHCEs"), automatic elections should increase the participation rates among NHCEs and in some instances may permit a higher rate of permissible deferrals for highly compensated employees.
However, some potential pitfalls surround the use of negative or automatic election. Although the IRS ruling permits negative or automatic elections, such elections could violate state wage deduction laws. Another potential pitfall to the use of negative or automatic 401(k) elections is the interaction of such elections with ERISA Section 404(c) protection.
Generally, ERISA Section 404(c) provides that if a plan sponsor offers certain types of investment options and complies with certain other requirements, a plan fiduciary will be relieved of liability for investment losses arising from a participant's exercise of control over the investment of his or her 401(k) plan account. In the negative election context, the employer/plan sponsor would initially exercise investment discretion over amounts automatically deducted from an employee's compensation until such time as the employee acts to direct his or her account. The Department of Labor previously has concluded that an employer/plan sponsor would lose ERISA Section 404(c) protection when plan assets are placed in a default investment option.
Absent ERISA Section 404(c) protections, plan fiduciaries' investment decisions on account of an employee who becomes a participant through an automatic election may result in increased fiduciary responsibilities. Moreover, employers wishing to establish an automatic or negative election feature should be careful to give the employees adequate notice of the automatic enrollment and an opportunity to opt out of or change the contribution percentage prior to the date the first contribution is made, and set a standard percentage of payroll which all newly eligible employees will have automatically contributed to the plan. If you have any questions on amending your plan to provide an automatic enrollment feature, please contact a member of the Employee Benefits and Executive Compensation Group.