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Automatic (Enrollment) for the People - Losing Your Discretion

Adam C. Pozek 02/6/23

Ever since creating the ACA, EACA, and QACA as part of the Pension Protection Act of 2006, Congress has acted like automatic enrollment is the greatest thing since sliced bread when it comes to improving workers’ retirement savings (never mind how ridiculous those acronyms sound, especially all together like that).  They have continued down that path with SECURE 2.0 (S2).

Signed into law on December 29, 2022, S2 includes more than 90 new provisions.  Although many are optional, there are a few in there that are mandatory.  One of the mandatory provisions says that all new 401(k) and 403(b) plans established after the date of S2’s enactment are required to include automatic enrollment and automatic escalation…starting in 2025.

There is a bit to unpack here, so we will walk through the who, when, what, and why.  The who, when, and what will be just the facts, and we will share more of our thoughts when we get to the why.


Who (Does This Apply To)?

It’s easier to identify those that are exempt.  There are four general types of businesses that don’t have to worry about this new requirement.  The first two – churches and government entities – are pretty straightforward, but the other two have a few nuances to consider.

Companies with 10 or Fewer Employees

Small businesses that normally employ 10 or fewer employees are exempt from this new mandate.  That is not a permanent exemption, however.  To the extent the company grows to employ more than 10 employees, the requirement kicks in.

Fortunately, there is a one-year transition period, with the auto-enrollment mandate applying for the first year after the year in which the company hits the 10-employee threshold.  So, if the company reaches 10 employees in 2025, they would have to add auto enrollment beginning in 2027, assuming none of the other exemptions apply.

Note, however, that there is no transition away from the mandate for companies that reduce headcount below 10.

Companies in Business Fewer than 3 Years

This one is a bit easier.  If the company (or a predecessor company) was established fewer than 3 years prior, then the auto-enrollment mandate does not apply.  However, once that 3-year grace period has ended, the company must add automatic enrollment unless it qualifies for one of the other exemptions.

All other businesses that setup plans after December 29, 2022, must add automatic enrollment.


When (Does This Take Effect)?

Apart from the exemptions we just discussed, there are two elements to the “When” part of this equation – when the plan is established and when automatic enrollment must be included.

Plan Establishment

Let’s start with what seems like a simple question.  When is a new plan established?  Is it the date the company signs the plan documents?  The effective date shown in the plan document?  While there is some debate, the conventional wisdom is that the initial effective date shown in the plan document is the date to watch.  If after December 29, 2022, the mandate applies; if prior to that, the plan is grandfathered and need not comply with this new requirement.

There is an important point that applies to MEPs and PEPs.  For a company that signs on to one of these as an adopting employer, the establishment date is the effective date of that company’s adoption and not the date the overall MEP or PEP was established.  Interestingly, a strict reading of the law indicates this is true even if a company had a stand-alone plan in place long before December 29, 2022.  In other words, there is no pre-existing plan exception to using the date of the MEP/PEP adoption as the trigger for the automatic enrollment mandate.

Taking that a step further, exiting a MEP/PEP requires the establishment of a new plan and spin-off of the associated participant accounts from the MEP/PEP to the new plan.  You guessed it…since that new plan is established after December 29, 2022, it is subject to the mandate regardless of how long the company was previously part of the MEP/PEP and even if it had a stand-alone plan before that.

Splitting a plan into two to avoid the annual audit requirement?  Yep, the new plan is subject to the mandate, which may then dictate adding auto enrollment to the existing plan to satisfy the nondiscrimination requirements.

Inclusion of Auto Enrollment

The second “when” is when the automatic enrollment features must be added.  This one really is simple – the first plan year that begins after December 31, 2024.  So, for a calendar year plan, we are talking about the plan year that begins on January 1, 2025.

Of course, for plans that don’t want to start out with traditional enrollment and convert come 2025, there is nothing that prevents designing the plan to comply with the new requirements right out of the gate.


What (Provisions Do We Have to Include)?

Beginning in 2025, participants who are not enrolled in the plan must be automatically enrolled at a minimum default rate and gradually increased each year until they hit a maximum default rate.  Let’s take a closer look at each of those components.

Covered Participants

The automatic enrollment and escalation apply to any plan participant that does not have an affirmative election on file.  That includes those who are already participants before the auto enrollment feature is added.  That means any participants not deferring come 2025 must be automatically enrolled unless they made an actual election to defer 0%.

Initial Default Rate

This is the rate used to automatically enroll those who don’t make an election.  Each plan has the ability to set its own initial default rate as long as it is between 3% and 10% of pay.

Automatic Escalation

Each automatically enrolled participants must have his/her deferral rate increased by one percentage point per year until reaching the maximum default rate (see below).  The first escalation takes place on the first day of the plan year, following a participant’s completion of one year of participation.  For example, Simon first enters the plan on July 1, 2023.  He completes his first year of participation on June 30, 2024, so his first escalation would be on January 1, 2025.

Subsequent escalations occur on the first of each subsequent plan year.

Maximum Default Rate

This is the maximum rate to which a participant can be automatically escalated.  As with the initial rate, each plan can set its own maximum as long as it is between 10% and 15% of compensation.

You may have noticed that the bottom end of the maximum range is the same as the top end of the initial range – 10%.  That means a company could set its initial rate at 10% to avoid having to deal with the escalation at all.

Permissible Withdrawals

Certain plans that have voluntarily included automatic enrollment have had the option to offer permissible withdrawals that basically allow new, automatically-enrolled participants to call “do-over” within the first 90 days and get their money out of the plan.  Under S2’s new requirements, plans will be obligated to offer permissible withdrawals.

Default Investment

Last but not least, a QDIA will be mandatory for automatic contributions when a participant does not make an investment election.


Why (Have the Mandate)?

Plenty of studies have shown generally favorable results from automatic enrollment.  It has not worked across the board, and we’ve encountered plenty of situations in which the average deferral rates within a company have decreased after adding auto enrollment.

Going the other direction, as automatic enrollment has improved savings rates, we’ve seen the associated cost of the company match increase prohibitively.  In some of these cases, it has led to a reduction or complete elimination of the match, which then caused participants to opt out of deferring.

Both of those scenarios have been in situations where companies have voluntarily added the auto enrollment.  That begs the question of whether being forced to include automatic enrollment and escalation will cause companies to decide to forego setting up plans in the first place.  While that might be the case in some instances, there is another possibility.

Potentially Counter-Productive

The existing Qualified Automatic Contribution Arrangement (QACA) combines auto enrollment, auto escalation, and safe harbor 401(k) provisions.  In short, the initial default rate must be between 3% and 6% of pay, increase by 1% per year, to a max default rate of 6% to 10%.  Those parameters are similar to (but less than) the those in the new law.

Though very far from being a scientifically conducted analysis, our experience with QACAs has been that companies set the initial default rate as high as they can at 6% (which also happens to be the lowest end of the maximum default rate) to avoid having to deal with the annual escalations.  The relatively high initial rate has generally prompted a large percentage of non-highly compensated employees to opt out of the auto enrollment altogether.

If plan sponsors take a similar approach to this new law and set the initial default rate at 10% to avoid auto escalation, it could drive an even larger percentage of NHCEs to say “no thanks.”  Considering that this is the exact demographic auto enrollment was meant to help, that doesn’t seem like the greatest of outcomes from a policy perspective.

Potentially Detrimental to Non-ERISA 403(b) Plans

Not to be ignored, this new mandate may create a pretty significant unintended consequence for new 403(b) plans.  When the non-profit that sponsors a 403(b) plan limits its involvement to essentially just facilitating the transfer of employee contributions from paycheck to the recordkeeper to be invested, the plan is exempt from many of the regular requirements like filing a Form 5500 each year.  Since designing the automatic enrollment features and establishing a default investment alternative go beyond that “limited involvement” exception, this new rule appears to be a nail in the coffin of the non-ERISA 403(b) plan.  Kind of a raw deal for them.

There you have it – the new automatic enrollment mandate, coming soon to a plan near you.


For more information on all things S2, check out our SECURE 2.0 Resource Page.

Topics: Automatic Enrollment, Legislation, Automatic Escalation, QDIA, Automatic Contribution Arrangement, QACA, Eligible Automatic Contribution Arrangement (EACA), Permissible Withdrawal, Non-Profit Organization, SECURE 2.0


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The views expressed in this blog are those of the authors and do not necessarily represent the views of any other person or organization. All content is provided for informational purposes only and is not intended to be tax or legal advice.