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About 20 years ago it was hoped that defined contribution 401(k) plans would help provide an adequate retirement for employees in the face of the decline in traditional defined balance plans. While the plans have become incredibly popular, and in fact are becoming the dominant savings vehicle for most current workers, they have failed to live up to their expectations of providing an adequate vehicle for retirement savings. One of the most highly touted features of these plans was that they would provide freedom of choice for employees. It was up to the employee to decide to participate, at what level, and how to invest their monies. This did not work out as foreseen. Either through inertia, disincentives or ignorance, many workers were not capable of managing their own retirement funds within 401(k)s. Beginning in 2008, we should begin to see some major changes in the process. Employers have new incentives to offer automatic enrollment 401(k) plans that will relieve many of the burdens of personal choice from their employees. An automatic 401(k) plan is an employer-sponsored defined contribution retirement plan where the employee does not have to enroll in the plan to participate. Instead, he’s automatically enrolled in the plan after some qualifying events, unless he affirmatively opts out. This is the opposite of the traditional 401(k) plan, in which the employee had to choose to participate in the plan. This change was made possible by the Pension Protection Act of 2006. While these automatic enrollment plans have been allowed since 1998, they have not been very popular due to potential fiduciary liability for plan sponsors. The problem was how much liability sponsors could face if they picked poor investments for their employees’ retirement funds. The Pension Protection Act of 2006 took many burdens off of employers by giving them guidance as to fiduciary standards for 404(c) compliance and eliminated many of the problems in establishing an automatic 401(k) plan. Traditional 401(k) plans have often had disappointing participation rates for sponsors and less than impressive investment experiences for participants. Younger, job changing workers often could not see the advantages of deferring immediate consumption for a 40-year distant retirement. This resulted in a large amount of eligible employees failing to enroll in their plan. In fact, the participation level for defined contribution plans has remained stagnant at about 50 percent for the past decade. People simply aren’t saving enough money for their future retirement needs. Even many workers who were enrolled in the plans often failed to maximize their contributions, or their investment returns. Workers, left to their own devices, often made poor investment decisions, failed to diversify holdings, and neglected to periodically rebalance their portfolios. It is believed that the changes in the Pension Protection Act of 2006 will encourage more employers to provide automatic enrollment plans and fix many of these drawbacks of traditional 401(k) plans. Automatic enrollment plans will now have several default options that should significantly improve the average employee’s retirement savings. First, all employees are automatically enrolled in these plans when they first become eligible. They will have to affirmatively opt out of these plans if they do not want to participate. It is believed that this simple change will lead to participation rates of between 85 and 95 percent and greatly reduce future retirement shortfalls. Second, these automatic plans will start by deferring 3 percent of the employee’s salary the first year and increasing by 1 percent per year until they are deferring 6 percent of their salary. This will take care of the second problem of employees not deferring enough money at early ages to provide an adequate retirement. Thirdly, these plans will have new investment rules about automatic investment options that more closely follow modern portfolio theory. The Department of Labor has new guidelines for what will pass as a qualified default investment alternative (QDIA) for these new plans. Before these changes were in place employers did not want the burden of fiduciary responsibility by deciding for their employees where their money should be invested so it was usually left in cash. Very importantly, the changes in the Pension Protection Act grant employers fiduciary protection under 404(c) as long as they follow the guidelines regarding QDIA investments. The first alternative is a lifecycle fund or target date fund. The second is an equity-income fund. The third alternative is to put investments into professionally managed accounts, and the fourth alternative is a stable value fund. The stable value fund, which is very similar to a money market, is only allowed to hold monies for the first 120 days. They recognize that cash makes a very poor long-term investment as past results have proven. After the first 120 days the funds must be invested in one of the first three long-term investment options. This investment feature is one of the prime benefits of these plans to employees. If they don’t make a choice as to investments, a roughly appropriate election will be made on their behalf. While these investment alternatives might not be optimal for any individual employee, they are vastly superior to letting retirement savings sit in cash over long periods of time. This was designed so that employees saving for retirement would, by default, put their monies in asset classes that have high-expected long-term growth rates. This does not affect the ability of informed investors to make their own choices. Participants still have the freedom in plans to make changes as they see fit. This is simply a new, improved default option for those participants who never put their monies to work. Finally, the employee is not the only one to receive benefits under the new automatic enrollment plans. Employers will have significant advantages in electing to implement this type of plan. Probably the biggest advantage is the new fiduciary protection afforded under 404(c) rules. If the participant in a plan fails to make an affirmative election, the plan sponsor now has protection as long as the investments are one of the qualified default investment alternatives (QDIA). The Labor Department finally acknowledged that as long as there is proper diversification and professional management in the investment process, the fluctuations of the market are not a responsibility of the plan sponsor. These new rules make it much easier to pass antidiscrimination testing and allow employers to maximize their contributions. In the past, under the old rules, this was a particularly onerous problem for small and midsized businesses. Often the owners of these businesses would start a 401(k) plan in order to provide for their own, as well as their employees’, retirement. Often, after spending large amounts of time and money, the testing showed the plan to be top-heavy and the sponsors/business owners could not maximize their personal benefits. The main reason plans would fail the antidiscrimination testing was not having enough employees enrolled in the plan. The new automatic enrollment plans are a simple way to solve this problem. Beginning in 2000, any automatic roller plan that matches dollar for dollar the first 1 percent of compensation deferred and 50 percent of the elective deferrals of the next 5 percent of compensation qualifies as a safe harbor plan for testing purposes. In addition to encouraging employees to save more for retirement and being easier to pass the nondiscrimination testing automatic enrollment, 401(k) help plan sponsors demonstrate a commitment to their employees. They’re useful in boosting employee morale as well as reducing employee turnover. The general consensus is that over the next decade these automatic enrollment plans will become the norm for all defined contribution plans. Instead of requiring employees to make complicated individual retirement decisions, employers will use the default option of, unless the employee opts out, making preset contributions, into preset investments on their behalf. This better, simpler, 401(k) plan should fix many of the problems found in original 401(k) plans and vastly enhance the ability of the average employee to save for more secure future. William Z. Suplee IV is the president of Structured Asset Management Inc. in Paoli, Pa., and an adjunct professor of investments at the American College in Bryn Mawr, Pa. He may be reached at 610-648-0700 or [email protected].

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