Order Code RS21954
Updated August 9, 2006
CRS Report for Congress
Received through the CRS Web
Automatic Enrollment in 401(k) Plans
Patrick Purcell
Specialist in Social Legislation
Domestic Social Policy Division
Summary
Most employers that sponsor retirement savings plans under §401(k) of the Internal
Revenue Code (IRC) require 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. In 2004, automatic enrollment had been adopted by
an estimated 11% of §401(k) plans. About 1% of plans with fewer than 50 participants
and 31% of plans with 5,000 or more participants had automatic enrollment in 2004.
H.R.4, the Pension Protection Act, includes provisions to promote automatic enrollment.
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 past 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 21% of workers in the private
sector participated in a defined benefit plan in 2005, whereas 42% participated in a
defined contribution plan. About 11% of private-sector workers were in both types of
plan at their current job in 2005. 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 IRC, allowing employees to make pre-tax contributions to employer-sponsored
retirement savings plans.
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

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In 2006, workers can defer taxes on up to $15,000 of wage or salary income that is
directed to an employer-sponsored retirement plan established under §401(k).2 After
2006, the maximum annual deferral will be indexed to the Consumer Price Index.3
Employers also can contribute to §401(k) plans. Section 415(c) of the Internal Revenue
Code defines the maximum allowable contribution to a §401(k) plan, including both
employer and employee contributions. The maximum contribution is $44,000 in 2006.
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, whereas 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 2005, 53% of workers in the private sector were employed at establishments that
offered a defined contribution plan, but just 42% of employees at private establishments
participated in a plan. Consequently, the participation rate among employees whose
employer offered a DC plan was 79%. In contrast, the BLS reports that 22% of workers
in the private sector were employed at establishments that offered defined benefit plans
and 21% participated in those plans, yielding a participation rate in these plans of 95.5%.
IRS Rulings. Employers who sponsor §401(k) plans often promote participation
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 Internal Revenue Service (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 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
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 $5,000 in 2006. This amount
will be indexed to inflation in years after 2006.
4 Employers can, if they choose, exclude employees with less than one year of service or who
work fewer than 1,000 hours per year.

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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 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 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, 11% of §401(k) and profit-sharing plans used automatic
enrollment in 2004. 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 31% of plans with 5,000 or more participants. In a survey of mainly large firms, the
benefits consulting firm Hewitt Associates found that 24% 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.

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2005, up from 14% in 2003. Deloitte Consulting recently reported that 23% of the 830
plan sponsors it surveyed in 2005 and 2006 had instituted automatic enrollment.
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. Both the PSCA and Deloitte Consulting report 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 stable value fund, money market
fund, or target retirement date 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 Life-cycle funds
and target retirement date funds allocate contributions among investments based on
generally agreed upon principles of diversification. They are more likely then money
market funds or stable value funds to result in adequate retirement savings over a lifetime.
Low default contribution rates and conservative default investment funds typical in
plans that have automatic enrollment would be of less concern to policy-makers if
participants 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 a guaranteed investment contract (GIC) with an
insurance company. 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. Common match rates are 50% of the first
6% of pay that the employee defers or 100% of the first 3% of salary the employee defers.
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.

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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.
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
The Pension Protection Act. H.R. 4 of the 109th Congress, The Pension
Protection Act, was passed by the House on July 28, 2006, and by the Senate on August
3, 2006. Section 624 of the bill would amend ERISA §404(c) to extend to default
investments under automatic enrollment plans the same protections that participant-
directed investments receive, thus relieving employers of fiduciary liability for investment
losses. Section 902 of the bill provides that beginning in 2008, §401(k) plans with
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.

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automatic enrollment that satisfy certain requirements will be deemed to meet the
nondiscrimination requirements of the Internal Revenue Code.12 It also provides that
plans consisting solely of contributions made through automatic enrollment will not be
subject to the top-heavy rules.13 To be deemed as satisfying the nondiscrimination rules,
a plan with automatic enrollment must meet requirements with respect to (1) automatic
deferral of pay; (2) matching or nonelective contributions; and (3) notice to employees.
The bill provides that a plan may limit eligibility for automatic enrollment to
employees who were not eligible for the plan prior to the date it began automatic
enrollment. The plan must provide that, unless an eligible employee elects otherwise, the
employee will defer a percentage of pay not to exceed 10%, but at least equal to 3% of
pay for the first year; 4% during the second year; 5% during the third year; and 6% during
the fourth year and thereafter. The percentage must be applied uniformly to all eligible
employees. The employer also must either make (1) a matching contribution on behalf
of each nonhighly compensated employee equal to 100% of the first 1% of pay the
employee defers and 50% of the next 5% of pay the employee defers, or (2) a nonelective
contribution equal to at least 3% of pay on behalf of each eligible nonhighly compensated
employee. If the employer makes matching contributions, the match rate for a highly
compensated employee cannot be greater than the match rate with respect to the same rate
of deferral of a nonhighly compensated employee. Also, if the plan makes matching
contributions, it must assure that matching contributions are not provided for elective
deferrals in excess of 6% of pay, and that the match rate does not increase as the rate of
an employee’s elective deferrals increases. Plans with automatic enrollment must provide
that employees with at least two years of service are 100% vested in employer
contributions. (Employees are always 100% vested in their own contributions.)
Each employee eligible to participate in the plan must receive notice of his or her
right to elect not to have automatic deferrals made on the employee’s behalf or to elect
to defer a different amount. The employee must be informed how contributions made
under the automatic enrollment arrangement will be invested in the absence of any
investment election by the employee. Erroneous automatic deferrals may be distributed
from the plan within 90 days after the date of the first deferral. The 10% early withdrawal
tax will not apply to distributions of erroneous automatic deferrals. In addition, the excise
tax on excess contributions will not apply if the excess contribution, and any income
attributable to the contribution, is distributed within six months after the close of the plan
year. The bill also would preempt any state law that would directly or indirectly prohibit
or restrict the inclusion in a plan of an automatic contribution arrangement.
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) a 5% owner of the employer, (2) a 1% owner
of the employer having annual compensation from the employer of more than $150,000, or (3)
an officer of the company having an annual salary greater than $140,000. Top-heavy plans are
subject to minimum benefits and faster vesting of benefits for non-key employees.

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