NEGATIVE ELECTIONS FOR 401(K) PLAN SALARY DEFERRALS
By Cynthia L. Shupe
The Internal Revenue Service officially sanctioned the use of negative elections in Revenue Ruling 98-30, holding that negative elections (essentially automatic 401(k) plan salary deferrals) are permitted under Code ß 401(k). In essence, negative elections function to automatically enroll eligible employees in 401(k) plans at a preset percentage of pay, without any affirmative action by employees.
In contrast, the Department of Labor has indicated that a participant will not be considered to have exercised control for purposes of ERISA ß404(c) fiduciary protections if a participant is simply told how automatic deferrals will be invested under a 401(k) plan and the participant does not affirmatively provide investment instructions to plan fiduciaries.
Finally, relative uncertainty continues about the degree to which ERISA will pre-empt the state withholding laws which use various statutory structures to preclude employers from withholding amounts from employeesí pay without prior written employee consent. These requirements vary from state to state, and in some cases include criminal penalties.
Here are the some key factors for employers to consider in deciding whether and how to institute automatic 401(k) deferrals through "negative elections":
1. Why Do Negative Elections At All?
Careful consideration should be given to the motivations for using negative elections. Is the plan consistently failing yearly discrimination tests or is enrollment simply below desired levels? (In President Clintonís address promoting negative elections, he indicated that the overall 401(k) plan participant rate without negative elections was 67%.)
If a plan is consistently passing discrimination testing and the primary desire is simply to encourage employees to make greater use of a good benefit, the first step should be to analyze what other enrollment incentives are in place (for example, matching contributions). If a plan has a matching contribution and enrollment is still not reaching desired levels, the current enrollment process ought to be reviewed to determine whether some aspect of that process is discouraging enrollment (for example, employees are reluctant to use telephone features).
2. What Should the Automatic Percentage Be?
If plan fiduciaries elect to pursue negative elections, a fixed percentage for the elections must be selected. The typical choice is 3% or 4%. Consideration should be given to how the selected percentage fits into the overall plan design, particularly matching contribution levels, or current testing results. If the percentage necessary to pass discrimination testing is greater than fiduciaries think appropriate to impose on employees as an automatic election, a review of overall plan design may be more appropriate than negative elections.
3. What Must Employees Be Told?
Rev. Rul. 98-30 requires employees to be notified that plan enrollment and payroll deductions are automatic, including the fixed percentage of payroll withholding. Employees must receive this notice with sufficient time period after the notice, and before the first pay check from which deferrals would be withheld, to elect out of the automatic deferrals or to change the level of automatic deferrals. This requirement may present some timing challenges for immediate enrollment plans, particularly those that use computer and telephone systems where there may be some delay in the assignment and activation of PIN numbers. The message is clear, however, that employees must be have a realistic opportunity to prevent any money from going into the plan if they so desire.
4. How Often Must Employees Be Permitted to Change Automatic Elections?
Rev. Rul 98-30 further provides that employees must be permitted to revoke or change any automatic election and must be provided with notice of the timing and procedures for doing so. The Ruling appears to recognize that a procedure which allows for the processing of change or revocations in conjunction with the timing of other payroll changes is reasonable. A procedure that only permits revocations or changes periodically during the course of a plan year would not satisfy the terms of the Ruling.
5. How Should Automatic Deferrals Be Invested?
Plan fiduciaries will need to determine where automatic deferrals will be invested and recognize that in light of the Department of Laborís position, they will be taking on added fiduciary responsibility to these participants. This responsibility can be moderated by communication materials designed to remind and encourage these participants to regularly review and consider their investment choices. Nevertheless, the default investment elections associated with automatic deferrals inevitably will increase the potential for exposure to claims of breach of fiduciary duty from automatic election participants who fail to review the default investment election for their automatic deferrals until something goes wrong.
The best defense to such claims will be (1) for plan fiduciaries to carefully select the default option, recognizing that neither a simple money market nor the most conservation option is likely to be viewed as an appropriate fiduciary investment choice (ie. a fiduciaryís investment responsibility is not limited to preservation of capital) and (2) for plan fiduciaries to have a consistent record of communications reminding participants about the investment of their automatic deferrals and their ability and the mechanics to make changes in investment elections.
6. How Should State Withholding Laws Be Addressed?
The laws of most states provide that, unless required by certain court orders or by law, any withholding from an employeeís pay without the employeeís written consent is void. For example, under Arizona law, an employer may not withhold from any employeeís wages unless the employer is required or empowered to do so by state or federal law, the employer has prior written authorization from the employee, or there is a reasonable good faith dispute as to the amount of wages due. ARS ß 23-352. If an employer violates this provision, the employee may recover three times the unpaid wages in a civil action. ARS ß23-355. Some states have criminal penalties for withholding from employeeís wages without the employeeís prior written consent.
The United States Department of Labor is being urged through a number of channels to issue either an Advisory Opinion or general guidelines holding that ERISA pre-empts all of these states laws to the extent that they preclude or impede automatic 401(k) deferral elections. The authority for such DOL action arises under ERISA ß514 which provides that ERISA supersedes "any and all State laws insofar as they may now or hereafter relate to any employee benefit plan" which is subject to ERISA.
Until the DOL takes formal action, and particularly for employers with employees in more than one state, we recommend having employees sign an acknowledgment of the automatic deductions from pay along with general employment forms (such as withholding elections) signed at the time of employment. We recommend that the acknowledgement signed include the notices required by the IRS Ruling, an acknowledgement of the default investment option, and the procedures for changing investment options. We do not recommend instituting negative elections for current employees who do not sign such an acknowledgement.
7. What Steps Must Be Taken to Implement Automatic Deferrals?
The plan document and summary plan description, as well as elections forms, telephone scripts and other employee communications will need to be reviewed, amended, and revamped.
8. What Follow-Up Is Recommended?
The plan which the IRS reviewed in Rev. Rul. 98-30 provided participants with an annual statement of their existing deferral percentage and a reminder of their rights to and the mechanics of changing deferral elections. Although this step was not included as an element in the Serviceís approval of negative elections, it would wise to consider it in annual communications to show consistent reminders to participants of their ability to change automatic deferrals.
9. What Records Should Be Kept?
Since both compliance with the initial notice parameters set forth in Rev. Rul 98-30 and any defense against participant claims concerning default investment elections hinge upon clear and consistent employee communications, it would be wise to consider methods to verify that employees have received notices and disclosures. This will most clearly accomplished if information about the mechanics of the automatic deferrals and the default investment choice is included in the form which we recommend employers obtain from employees at the time of employment in order to satisfy any state withholding laws. Keeping copies of communication materials and records of the dates dissemination is also a useful practice.