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Are Automatic PlanFeatures the Answer?

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Looking to the Future Choosing a DefaultInvestment

Recent Developments inBenefit Plans

Inside

What Is the Successor Plan Rule?The successor plan rule prohibits anemployer from terminating a 401(k)plan, distributing the plan assets to par-ticipants, and, then, starting a new planwithin 12 months after the original planis terminated. However, as with everyrule, there are some exceptions.

The Rule’s Purpose

Because 401(k) plans are for retirementsavings, in-service distributions of elec-tive deferrals generally cannot be madebefore a participant reaches age 59½.The successor plan rule was created tostop employers from circumventing thisrestriction by terminating a plan andturning around and starting a new one.In most instances, if an employer does so,both the original plan and the successorplan lose their tax-exempt status and theplan sponsor — and possibly, the partici-pants — becomes liable for substantialtax penalties.

Exceptions

Tax regulations provide two exceptions tothe successor plan rule. First, an employercan terminate a 401(k) plan and replace itwith an employee stock ownership plan,a defined benefit plan, or a simplifiedemployee pension plan (SEP). Proposed401(k) regulations would add SIMPLEIRAs, 403(b) tax-sheltered annuities, and

participants could create a 401(k) planwithin 12 months of the terminationwithout violating the successor plan rules.

Sales and Acquisitions

No successor plan issues arise if a 401(k)is terminated before the sale of the assetsof the business or the entity becomes part of the buyer’s controlled group(because of the acquisition of its stock).However, if the plan is terminated afterthe acquisition is completed, then theemployer that maintains or creates another plan would be subject to therules. Some exceptions apply.

The successor plan rules are complicated.Please talk with us if you are contemplat-ing a plan termination.

governmental 457 plans to the list ofacceptable replacement plans. The earliestthis change would take place is January 1,2006 (for calendar-year plans).

Second, if during the 24-month periodbeginning 12 months before the termi-nation, fewer than 2% of the eligibleemployees in the terminating 401(k) plan were eligible to participate in thereplacement plan, the replacement plan is not considered a successor plan.Eligible employees are those who werebenefiting under the original plan on the termination date.

Another exception exists for the termina-tion of a retirement plan that does nothave elective deferrals. For example, anemployer that terminates a profit sharingplan and distributes the plan assets to

2004 Issu

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Are Automatic Plan Features the Answer?

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Employers are always looking for ways to increase participation in their 401(k)plans. Adding plan features that auto-matically make retirement decisions foremployees — such as automatic enroll-ment — is one approach increasing numbers of plan sponsors are trying.Recent IRS guidance on the automaticenrollment rules may enhance sponsors'— and employees’ — success.

The Path of Least Resistance

One much-cited study shows thatemployees tend to settle for the path of least resistance when it comes toretirement planning.1 For example,few employees who are automaticallyenrolled in a plan opt out of that enroll-ment. Other research from BostonCollege’s Center for Retirement Researchfinds that many employees are not avail-ing themselves of the opportunitiesoffered by their employers’ plans.2

For example, according to the BostonCollege research:

■ One out of four eligible employeesnever joins his or her employer’s retirement plan.

■ Nearly half of plan participants don’tcontribute enough to receive the fullemployer matching contribution.

■ Less than 10% of participants con-tribute the maximum amount allowedunder their plans.

These studies suggest that automatic planfeatures could help sponsors increaseplan participation and employees saveenough for retirement.

Enrollment

With automatic enrollment — or nega-tive election — preset elective employeedeferrals to a 401(k) or 403(b) plan begin as soon as an employee becomeseligible to participate in his or heremployer’s plan, unless the employeeelects to receive cash or have anotheramount contributed. The set percentageof the employee’s compensation is withheld automatically and deposited in the employee’s plan account.

For example, Company’s 401(k) plan pro-vides for an automatic enrollment contri-bution of 3% of eligible compensation.Jessica begins working for Company andis immediately eligible to participate in theplan. She does not elect to receive cash inplace of making a plan contribution. Nordoes she choose to contribute a differentamount to her plan account. Thus,Company automatically withholds 3% ofJessica’s compensation from her paycheckand contributes it to her plan account.

Automatic enrollment is not limited tonew employees. An employer that addsthis feature to its plan can, then, auto-matically enroll all eligible employees,provided the employees are given thechance to decline participation.

Requirements

To implement automatic enrollment, aplan sponsor must:

■ Determine whether his AdoptionAgreement or Plan Document needs tobe amended. Please contact us if youwould like to discuss this.

■ Provide each eligible employee with anopportunity to elect not to participatein the plan,

■ Notify the employee of the automaticenrollment arrangement and of his or her right to choose not to makesalary deferral contributions as soon as the employee becomes eligible toparticipate in the plan,

■ Allow the employee sufficient time after receiving notice to elect not to participate, and

■ Give the employee the option ofchanging the election in the future.

Deferral percentages

While previous IRS revenue rulings setout deferral limits of 2%, 3%, and 4% ofcompensation, a recent general informa-tion letter from the IRS said that there is“no special maximum limit” — and no safeharbor — on a salary deferral plan’s auto-matic compensation reduction percentage.3

The Boston College researchers suggestsetting the contribution percentage so

that participants receive the full companymatch. An employer can set it higher,though. The IRS information letterspecifically said that the compensationreduction percentage does not have to be limited to the employer’s matchingpercentage.

The letter also stated that an employercan increase the automatic compensationreduction percentage over time, as longas the increases are made in accordancewith a specific schedule. The requiredemployee notice must describe theamount of, and schedule for, any plannedchanges to the automatic compensationreduction percentage.

The letter further said that an employercan provide for percentage increases to be applied to future raises and bonuses.Such increases could apply only if therequired notices described how the auto-matic compensation reduction electionwould apply to raises or bonuses.

An Added Benefit

Studies show that automatic enrollmentincreases plan participation. The BostonCollege research cites one instance whereadding automatic enrollment increasedparticipation from 49% to 86% of eligi-ble employees. For employees earning less than $20,000, participation increasedfrom 20% to 80%.

In addition to helping plans satisfy thenondiscrimination requirements,increased plan participation generated by automatic enrollment may allow higher paid employees to make largercontributions to their accounts. A higheractual deferral percentage for nonhighlycompensated employees raises the per-centage limits for highly compensatedemployees.

1Defined Contribution Pensions: Plan Rules, ParticipantChoices, and the Path of Least Resistance, James J. Choi andDavid Laibson, Department of Economics, HarvardUniversity; Brigette C. Madrian, Graduate School ofBusiness, University of Chicago; and Andrew Metrick,Wharton School of Business, University of Pennsylvania. 2Coming Up Short: The Challenge of 401(k) Plans, AliciaMunnell, director of Boston College’s Center for RetirementResearch, and Annika Sunden, economist and research asso-ciate with the Center for Retirement Research, the BrookingsInstitution Press, 2004. 3IRS General Information Letter, 3/17/2004.

Many employers use their 401(k) plans toattract and retain qualified employees.However, these plans are failing to engagethe interest of employees just entering thelabor market — the “Millennials.” For401(k) plans to remain a useful employ-ment tool in the future, employers needto consider how younger employees’ val-ues and beliefs differ from those of theirBaby Boomer elders and, possibly,rethink how their plans are designed and presented.

Live for Today

Some of the differences are common generational differences. For example, inthe third annual Workplace Report onRetirement Planning* more than half ofthe Millennials surveyed said their topfinancial concern is meeting everydayexpenses or saving for a new house andcar. When asked to describe their retire-ment planning state of mind, nearly half(49%) of the Millennials surveyed chosethe response, “I’m living for today.”

Baby Boomers, in contrast, cited savingfor retirement as their top financial con-cern, followed by paying for their chil-dren’s college education, and payingeveryday expenses. They were far morelikely than Millennials to say they are“eager beavers” in their approach toretirement planning (35% versus 21%).

These differences aren’t surprising,considering that Millennials are justbeginning the accumulation phase oftheir adulthood, while Baby Boomers are ostensibly winding down theirs. Andmany employers’ employee educationprograms address this Millennial charac-teristic by stressing the advantages of taxdeferral and employer matching contri-butions to show younger employees howthey can afford to participate in theiremployer-sponsored retirement plan.

Looking to the FutureDon’t Worry About Tomorrow

But, unlike their co-workers, theseyoungest employees don’t seem to beconcerned about whether they can affordto save for retirement or save enough forretirement. Rather, the report seems toindicate that, as a group, they simplydon’t see a need or purpose for saving, ormay see saving as futile. Part of this could be due to differences cited in the reportthat are more fundamental to the timesin which the different groups grew up.

For instance, more than 44% ofMillennials said their view of saving hasbeen negatively affected by political insta-bility in the world and ongoing reports of corporate malfeasance. Only about aquarter of the Baby Boomers held thisview.

These differences appear to foster arather unfavorable view of 401(k) plansin younger workers. Millennials werenearly 20% more likely than BabyBoomers to say 401(k) plans are “thebenefit of yesterday.” Their participationrates reflect this view. According to thereport, a third of Millennials who are eligible to participate in their employers’plans do not — versus just 16% of BabyBoomers.

Of equal or greater concern to manyemployers, 67% of Millennials reportedthat their employer’s 401(k) plan has

little or no effect on whether they wouldstay with their current employer oraccept another job (see graph).

May Others Plan Their Future

What can employers do to make their401(k) plans more effective as a recruit-ment and retention tool for youngeremployees? The report points to severalways to make 401(k) plans more relevantto Millennials:

■ Tailor education and communicationprograms to specific life stages,

■ Keep educational materials simple and focused on one topic,

■ Target educational materials and communications to one specific result,such as increasing participation orincreasing deferrals,

■ Measure results to see if the plan ismeeting employee needs, and

■ Try new and different messages aboutwhy saving for retirement is importantand “outside the box” methods fordelivering those messages.

Employers also may want to consideradding automatic enrollment and offering lifestyle funds to appeal toMillennials’ higher respect for authority,their preference for clear rules andguidelines, and their aversion to risk.

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Effect of 401(k) plan on decision whether to stay with current employer*

Millennials

Baby Boomers

No

ne

On

ly a

lit

tle

So

me

Gre

at

44%34%

23%20%

20%29%

7%14%

*Workplace Report on Retirement Planning, CIGNA Retirement & Investment Services, 2004

Stay or Go?

■ Unclaimed Benefits. The PensionBenefit Guaranty Corporation (PBGC)reports that it is holding $75 million inunclaimed pension benefits for 26,000individuals. The benefits are from terminated defined benefit plans andrange from $1 up to $264,548. Theaverage benefit is approximately $3,675.Individuals can use the PBGC’s PensionSearch Directory (www.pbgc.gov/search)to track down lost pensions.

■ Fiduciary Education. Employers thatsponsor retirement plans can learn moreabout their fiduciary obligations atwww.dol.gov/ebsa. The site, sponsored bythe U.S. Department of Labor (DOL),includes educational materials on topicssuch as selecting a plan auditor. TheDOL is also holding seminars across thecountry as part of its campaign to edu-cate plan fiduciaries about their respon-sibilities.

Recent Developments In Benefit Plans■ Prohibited Transaction. In a recent

case, the Tax Court held that Z, presidentand sole shareholder of a corporationthat sponsored a profit sharing plan (ofwhich Z was sole trustee), had to payexcise taxes on loans made by the plan toZ and a company owned by Z becausethey were prohibited transactions. Theloans were not made in the best interestsof the plan and its participants (RalphZacky, TC Memo. 2004-130).

Choosing Default Investments for Your Plan

SITUATION: The default investment for Employer’s tax-qualified retirementsavings plan is a money market fund.Employer chose the fund several yearsago because of its low risk. Now, a mem-ber of the plan’s investment committee is wondering whether a balanced fundmight be a better choice.

QUESTION: Does it make sense for aretirement savings plan to have a highlyconservative default investment?

ANSWER: Employer should look at this issue closely. Employer has a fiduciaryresponsibility to invest prudently onbehalf of employees who have not giveninvestment instructions. Employer shouldn’t select a “safe” default investmentwithout carefully analyzing other options.

DISCUSSION: Plans that give employeesthe opportunity to direct their investments

investments substantially outperform the default.

Both arguments have merit. Practicallyspeaking, then, what should an employerdo? No matter which path an employertakes, one point is clear: There needs tobe a selection process and it needs to bewell documented. It’s a mistake to choosea default option with little review andrarely, if ever, look at it again.

As employers work through the selectionprocess, they should keep in mind that“prudent” investing isn’t necessarily“safe” investing. A plan fiduciary isallowed to take investment risks as longas those risks are in keeping with theplan’s objectives. Questions to ask:

■ Should a plan have different defaultinvestments for young, mid-career,and older employees?

■ Should a plan ever have a fund thatinvests in stocks as its default?

■ How often should an employer reviewthe plan’s default investment?

■ What review criteria should an employer use?

These are just some of the questions wecan help employers answer. If you wouldlike to discuss your plan’s default invest-ment, please let us know.

typically have a default investment. Theplan invests contributions in the defaultwhen employees haven’t made their owninvestment selections.

Many employers simply assume that ahighly conservative default investment is appropriate. After all, a more riskydefault investment could leave theemployer exposed if the investment experiences losses and employees whose accounts are invested in thedefault option complain.

On the other hand, the long-term returns from money market funds,stable value funds, and other similarlyconservative choices are likely to be rela-tively low. Employees whose accounts areinvested in a plan’s conservative defaultinvestment for many years could end up feeling shortchanged if riskier plan

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©Copyright 2004 by NPI