Order Code RS21954
October 14, 2004
CRS Report for Congress
Received through the CRS Web
Automatic Enrollment in Section 401(k) Plans
Patrick Purcell
Specialist in Social Legislation
Domestic Social Policy Division
Summary
Historically, most employers that have sponsored retirement savings plans under
§401(k) of the Internal Revenue Code (IRC) have required employees to decide whether
to enroll in the plan. The Internal Revenue Service (IRS) has issued rulings to inform
employers that it is permissible under current law to enroll employees in these plans
automatically, provided that the employee is notified in advance and is permitted to
leave the plan if he or she chooses to do so. Automatic enrollment, in which a
percentage of the employee’s salary is placed in an individual account without requiring
the worker to take any action, has been shown to increase worker participation in
§401(k) plans and similar salary reduction retirement savings plans. As of 2003,
automatic enrollment had been adopted by an estimated 8% of §401(k) plans. About 1%
of plans with fewer than 50 participants and 24% of plans with 5,000 or more
participants had adopted automatic enrollment by 2003. This report will be updated as
legislative developments warrant.
Types of Retirement Plans. About half of all workers in the United States
participate in an employer-sponsored retirement plan, a figure that has remained relatively
stable for the past quarter-century. Over the last 20 years, however, there has been a shift
in coverage from traditional pensions, also called defined benefit plans, to defined
contribution plans such as those authorized under §401(k) of the Internal Revenue Code
(IRC). According to the Bureau of Labor Statistics, only 20% of workers in the private
sector participated in a defined benefit plan in 2003, while 40% participated in a defined
contribution plan. About 11% of private-sector workers were in both types of plan at their
current job in 2003. Defined benefit (DB) plans typically are funded entirely by the
employer, and they are required by law to offer the retiree the option to receive his or her
benefit in the form of a guaranteed life-long annuity.1 Defined contribution (DC) plans
consist of individual accounts in which workers can accumulate savings for retirement.
Prior to enactment of the Revenue Act of 1978 (P.L. 95-600), DC plans also were
typically funded exclusively by employer contributions. This law added §401(k) to the
1 A DB plan also can offer to pay the worker his or her accrued benefit as a single lump-sum
payment, but the employee must be offered the option of an annuity.
Congressional Research Service ˜ The Library of Congress
CRS-2
IRC, allowing employees to make pre-tax contributions to employer-sponsored retirement
savings plans.
In 2004, workers can defer taxes on up to $13,000 of wage or salary income that is
directed to an employer-sponsored retirement plan established under §401(k).2 The
maximum annual salary deferral will increase to $14,000 in 2005 and to $15,000 in 2006,
after which it will be indexed to the Consumer Price Index.3 Employers also can
contribute to §401(k) plans. The maximum allowable contribution to a §401(k) plan —
including both employer and employee contributions — is $41,000 in 2004.
Enrollment Practices. In a traditional defined benefit plan, employees typically
do not need to enroll in the plan to accrue benefits. Workers automatically earn benefits
under a DB plan, provided that they are in a covered group of workers and work the
required number of hours per year.4 In contrast, most employers who sponsor §401(k)
plans require employees to enroll in these plans voluntarily. One reason for this
difference is that DB plans in the private sector usually are funded entirely by the
employer, while most DC plans (and all §401(k) plans) require the employee to contribute
to the plan. Employers who require employees to enroll voluntarily in §401(k) plans do
so for several reasons: (1) participants in most DC plans must decide how much to
contribute (up to the legal limit or a lower limit established by the plan sponsor); (2)
participants in many DC plans must decide how to invest their contributions; and (3)
several states have laws that require employers to secure a worker’s permission before
making any payroll deductions other than those required by law, such as income tax
withholding and the Social Security and Medicare payroll taxes.
Because enrollment in most §401(k) plans is voluntary, not all workers whose
employers offer a plan choose to participate. The Bureau of Labor Statistics reports that
in 2003, 51% of workers in the private sector were employed at establishments that
offered a defined contribution plan, but just 40% of employees at private establishments
participated in a plan. Consequently, the participation rate among employees whose
employer offered a DC plan was 78%. In contrast, the BLS reports that 20% of workers
in the private sector were employed at establishments that offered defined benefit plans
and 20% participated in those plans, yielding a participation rate in these plans of 100%.
IRS Rulings. Employers who sponsor §401(k) plans often promote participation
in the plan among their employees by providing them with information on the importance
of saving for retirement and the tax savings that result from participating. One way to
achieve high rates of plan participation is to enroll employees automatically. Rather than
the default option being that the employee will not be included in the plan unless he or she
actively enrolls, the default under automatic enrollment is that some of the employee’s
pay will be deducted and directed into a retirement account unless he or she instructs the
employer not to do so. The IRS has issued several rulings in recent years to clarify for
employers that they are permitted to enroll employees in §401(k) and §403(b) plans
2 The same limits also apply to §403(b) annuities and §457 deferred compensation arrangements.
3 Workers age 50 or older can make an additional contribution of $3,000 in 2004, $4,000 in
2005, and $5,000 in 2006. This amount will be indexed to inflation in years after 2006.
4 Employers can, if they choose, exclude employees who work fewer than 1,000 hours per year.
CRS-3
automatically through payroll deduction, provided that the employee is notified in
advance and has the option to drop out of the plan. Unless the employee elects otherwise,
he or she is presumed to be participating, and an amount set by the employer (such as 3%
of pay) is deducted from the employee’s (pre-tax) pay and contributed to the §401(k) plan.
In 1998, the Internal Revenue Service (IRS) issued a ruling clarifying that automatic
enrollment in §401(k) plans is permissible for newly hired employees (Revenue Ruling
98-30). The IRS issued a second ruling in 2000 stating that automatic enrollment also is
permissible for current employees who have not already enrolled in the plan (Revenue
Ruling 2000-8).5 In 2004, the IRS published a general information letter in response to
a public inquiry that clarified two previously ambiguous points. The letter stated that (1)
the amount deducted from the employee’s pay and contributed to the plan can be any
amount that is permissible under the plan up to the annual contribution limits under IRC
§402(g), and (2) the plan can automatically increase the employee’s contribution over
time, such as after each pay raise. Again, the IRS emphasized that employees must be
fully informed of these plan provisions and they must have the option to change the
amount of their contribution or to stop contributing to the plan altogether.
Plan Participation. The IRS has promoted automatic enrollment through these
official announcements mainly to increase participation among moderate- and
lower-income workers. The IRS has noted that “the rate of participation in elective
retirement savings plans tends to be lowest among these workers.”6 Evidence from
surveys and case studies suggests that automatic enrollment results in higher rates of
participation in §401(k) plans. In 2001, the Profit Sharing/401(k) Council of America
(PSCA) surveyed 25 companies that had adopted automatic enrollment. Nine provided
information on participation rates before and after the implementation of automatic
enrollment. The average participation rate at these companies increased from 68% three
months before automatic enrollment was implemented to 77% at the time of the survey.
Studying the effect of automatic enrollment at three companies that adopted it between
1997 and 1998, economists James Choi, David Laibson, and Brigitte Madrian found that
participation increased to between 86% and 96% after automatic enrollment took effect.
After three years of service, the participation rate among employees hired under automatic
enrollment was 30 percentage points higher than among employees hired before automatic
enrollment was implemented.7
According to the PSCA, 8% of §401(k) and profit-sharing plans used automatic
enrollment in 2003. Automatic enrollment was more common in large plans than in small
plans. It had been adopted by 1% of §401(k) plans with fewer than 50 participants and
by 24% of plans with 5,000 or more participants. In a survey of mainly large firms, the
benefits consulting firm Hewitt Associates found that 14% used automatic enrollment in
5 Revenue Ruling 2000-35 states that automatic enrollment is permitted in 403(b) plans for
employees of public schools, other educational and charitable organizations. Revenue Ruling
2000-33 states that automatic enrollment is permitted in 457(b) plans for state and local
government employees. Announcement 2000-60 states that automatic enrollment is permitted
in IRS-approved prototype 401(k) plans (standardized plans used largely by small businesses.)
6 Press release, Internal Revenue Service, July 18, 2000.
7 James J. Choi, David Laibson, and Brigitte C. Madrian, “Plan Design and 401(k) Savings
Outcomes,” National Tax Journal, vol. 52(2), June 2004, pp. 275-298.
CRS-4
2003, up from 7% in 1999 but the same percentage as in 2001 and 2002. The Vanguard
Group reports that 10% of the 2,000 companies whose §401(k) plans it manages now
enroll employees automatically.
Policy Issues. Automatic enrollment has been shown to increase participation
rates in §401(k) plans among eligible employees. There are, however, two other
important decisions that participants in a §401(k) plan must make, or that must be made
for them: how much to contribute to the plan and how to invest those contributions. Plan
sponsors who have adopted automatic enrollment generally have been conservative in
setting the contribution amount and in choosing investments for employees who have
been enrolled automatically. The PSCA reports that the most common contribution rate
for employees who are enrolled in a plan automatically is 3% of pay. These contributions
are typically invested in a money market fund or a stable value fund.8 Many plan sponsors
are reluctant to set the default contribution rate for automatic enrollment higher than 3%
of pay because that rate was used in examples of permissible automatic enrollment
practices published by the IRS. Employers also tend to choose conservative investments
— those with little risk of capital loss, such as money market funds and stable value
funds — due to concerns about their liability as plan fiduciaries if the investments they
have chosen decline in value. Financial analysts generally agree that a contribution equal
to 3% of pay is too small, and that the rate of return on money market funds and stable
value funds is too low for most workers to build an adequate retirement fund over the
course of their careers.9
The low default contribution rates and conservative default investment funds typical
in plans that have automatic enrollment would not be of concern to plan sponsors and
policy-makers if participants later took an active role in managing their contribution
amounts and investment choices. Unfortunately, many participants in retirement plans
behave passively, and for them the default choices often become permanent. This is a
concern not only for workers who would not otherwise have enrolled in the plan, but also
for participants who would have elected voluntarily to participate in the plan and who —
if not for the plan’s default contribution rate and default investment funds — would have
chosen a higher contribution rate and more appropriate investments for their retirement
accounts.
Researchers have found that there is a substantial amount of inertia among
participants in §401(k) plans with respect to managing their accounts.10 A relatively small
percentage take great interest in managing their retirement funds, regularly increasing
their contributions and re-balancing their accounts. Many plan participants, however,
8 Stable value funds typically invest in bonds and achieve rates of return 2 to 3 percentage points
higher than money market funds. Most include guaranteed investment contracts (GICs). A GIC
is a contract between an insurance company and an employer that sponsors a retirement plan.
The insurance company invests the money and guarantees the investors a rate of return. It keeps
any returns above the guaranteed rate.
9 Many employers also provide matching contributions, but even a 100% match on an employee
contribution of 3% — resulting in a 6% total contribution — is too low for most workers’ needs.
10 See James Choi, David Laibson, Brigitte Madrian, and Andrew Metrick, “Defined Contribution
Pensions: Plan Rules, Participant Decisions, and the Path of Least Resistance,” Working Paper
2002-3, Pension Research Council, University of Pennsylvania, Nov. 2001.
CRS-5
seem to accept the default contribution percentages and investment choices associated
with automatic enrollment as implicit investment advice, or as an endorsement by their
employer that these are somehow the “right” choices for them.
In order to clarify its interpretation of federal law with respect to contribution rates
under automatic enrollment, the IRS issued a general information letter on March 17,
2004, stating that the automatic contribution level may be more (or less) than the 3% that
it had used in previously published examples of acceptable practices under automatic
enrollment. If the employer offers matching contributions, for example, the automatic
contribution rate can be higher or lower than the percentage that is matched by employer
contributions. The letter also stated that the automatic contribution percentage can be
increased (or decreased) over time under a specified schedule — one based on years of
service, for example. The employer must describe the details of the change in the
required notice to employees of their right to select another contribution rate. The IRS
letter also stated that increases in the automatic contribution percentage can be triggered
by future increases in an employee’s pay or by bonuses. Again, the required employee
notice must describe exactly how this would affect participating employees.
The rulings and letters issued by the IRS may encourage more firms to adopt
automatic enrollment, and to couple it with automatic increases in the contribution rate
until the employee reaches some agreed-upon maximum contribution level. Analysts
point out, however, that employers who adopt automatic enrollment should be sure to put
the participant’s contributions into appropriate investment funds as he or she gets older.
Life-cycle funds, for example, progressively invest more in bonds and less in stocks as
the employee approaches retirement age, lessening the chance of large capital losses.
Employees also should be reminded continually that they have the right to change their
contribution amount or to choose alternative investment funds.
One successful model of automatic enrollment coupled with progressive increases
in the employee contribution rate was developed by economists Richard Thaler of the
University of Chicago and Shlomo Benartzi of UCLA. Called Save More Tomorrow
(SMarT), it asks workers to contribute a portion of their future raises into their §401(k)
plan. This way, workers can raise their future contribution rate without experiencing a
drop in take-home pay. In a case study of the SMarT plan, Thaler and Benartzi found that
most workers (78%) who were asked to participate agreed to do so and most who joined
(80%) continued with scheduled increases through at least the fourth pay raise. (Even
those who eventually dropped out continued to contribute a higher percentage of pay than
they were contributing before the program began). Those who participated raised their
average contribution rate from 3.5% of pay to 13.6% of pay over a 40-month period.11
Legislative Proposals. Although both automatic enrollment and automatic
increases in employee contributions are permissible under federal law, only about 8% of
§401(k) plans have adopted automatic enrollment, and even fewer automatically increase
employees’ contributions over time. Some financial analysts have suggested that
Congress could promote wider adoption of automatic enrollment through legislation. For
example, because some state laws bar employers from deducting amounts from
11 See Richard H. Thaler and Shlomo Benartzi, “Save More Tomorrow™: Using Behavioral
Economics to Increase Employee Saving,” Journal of Political Economy, vol. 112(1) Feb. 2004.
CRS-6
employees’ paychecks without their prior approval, it has been proposed that Congress
could clarify that automatic enrollment is permissible, notwithstanding such state laws.
Another proposal would amend the IRS nondiscrimination rules to apply less stringent
tests to plans that include automatic enrollment and that set an adequate minimum
contribution rate.12 Amendments to the Employee Retirement Income Security Act
(ERISA) could ease employers’ concerns of fiduciary liability for investment losses if
they choose a default investment that includes stocks and bonds. Some observers have
suggested that if the federal government were to apply automatic enrollment to the Thrift
Savings Plan for federal employees, employers would see this as a strong endorsement
by Congress of the concept of automatic enrollment in §401(k) plans.
Bills in the 108th Congress. In the 108th Congress, H.R. 1776 (Portman/Cardin)
and S. 9 (Daschle) include provisions intended to encourage sponsors of 401(k) plans to
adopt automatic enrollment. H.R. 1776 would amend ERISA §404(c) to provide that a
qualified plan that adopts automatic enrollment has the same protection from liability for
investment losses as is provided by law to all plans in which the employee exercises
control over the investment of plan assets. H.R. 1776 also would amend ERISA §514(b)
to provide that the federal law permitting automatic payroll deductions for §401(k) plans
supersedes any state laws that might prohibit this practice. On July 18, 2003, H.R. 1776
was ordered to be reported by voice vote from the Committee on Ways and Means.
S. 9 provides that a plan meets the requirement prohibiting discrimination in favor
of highly-compensated employees if it automatically deducts from pay, and contributes
to the plan, an amount not less than 3% of pay, and if (1) the contributions are made on
behalf of at least 70% of nonhighly-compensated employees, (2) the employer makes
matching contributions on behalf of each nonhighly-compensated employee equal to 50%
of the elective contributions of the employee up to 5% of pay, (3) it meets the vesting
standards, and has the limits on early withdrawals, that are applicable to §401(k) plans,
and (4) all eligible employees are notified of their right to elect not to have elective
contributions made on their behalf and have a reasonable period of time before the first
elective contribution is made to make this election. By meeting these requirements, the
plan also would be deemed to have met the requirements under IRC §401(m) that relate
to the nondiscrimination test for matching contributions and employee contributions. S.
9 also would provide that a qualifying automatic-enrollment plan will not be considered
a “top-heavy” plan under IRC §416(d).13 S. 9 was referred to the Committee on Finance.
12 The IRC prohibits plans from discriminating in favor of highly-compensated employees with
respect to contributions or benefits. Plans are tested for discrimination by a mathematical formula
that measures contributions for highly-compensated employees relative to other employees.
13 A “top heavy” plan is one in which the account values of the “key employees” exceed 60% of
the total of the accounts of all employees under the plan. A “key employee” is defined as anyone
who in any of the preceding four plan years was (1) an officer of the company having an annual
salary greater than $130,000, (2) a 5% owner of the employer, or (3) a 1% owner of the employer
having annual compensation from the employer of more than $150,000. Top-heavy plans are
subject to minimum benefits for, and faster vesting of, non-key employees.