Adding a negative election feature to a 401(k) can increase plan participation and help companies pass nondiscrimination testing. But first some important legal and administrative questions must be answered.
Three years ago, when Promus Co. split its business into two separate entities, Harrah's Entertainment and Promus Hotel Corp., the holding company for Embassy Suites and Hampton Inn, Promus Hotel began running into problems with its 401(k) discrimination tests. Not enough rank-and-file employees were participating, and senior managers were forced to take back contributions they had made to the plan.
It is still unclear how negative elections are affected by state laws that prohibit payroll deductions without an employee's written permission.
After reading about McDonald's Corp.'s successful use of negative elections for increasing plan participation, Kelly Jenkins, vice president for compensation, benefits and human resource information systems at Promus Hotel, decided to investigate. After researching the legal issues and holding focus group meetings with employees who reacted enthusiastically to the idea, Jenkins decided negative elections could be the answer to the company's discrimination test problems. A negative election feature was added to the plan in December 1996, and in January 1998 the first default contributions were ready to be made.
Last December, however, Promus merged with Doubletree Corp., and before the withdrawals could be made, new management squelched the whole idea. The reason? Cost. With 40,000 employees instead of Promus' previous 10,000, combined with a generous match, the negative election feature simply would have cost the company too much.
Promus Hotel's brush with a negative election highlights the promises and pitfalls of this relatively new, often-misunderstood plan feature. As a result of an IRS ruling this summer spelling out the conditions under which negative elections could be added to a plan and President Clinton's public statements backing the idea, negative elections are likely to become center stage in many plan sponsors' discussions.
What exactly is a negative election? It's a feature in which individuals are automatically enrolled in their company's 401(k) plan as soon as they are eligible at a predetermined contribution rate with a predetermined investment allocation. Employees can opt out of the plan by making an affirmative decision not to participate. As the IRS ruled this summer, individuals must be told they have that option, they must be given ample time before they are enrolled in the plan so they can exercise that option, and the mechanism for doing so must be simple. (A copy of the IRS decision is available at www.irs.ustreas.gov/prod/ind_info/bullet.html. The ruling is included in Internal Revenue Bulletin 1998-25.)
The main impetus behind companies' interest in negative elections is trouble passing discrimination tests — non-highly compensated employees are not participating at levels adequate to allow executives and other highly compensated employees to make maximum contributions. Companies that face these problems usually have large numbers of lower-paid employees, often with high turnover. Bringing more employees into the plan, even if they are coming in with fairly low amounts of money, helps balance the plan's contribution rates between highly and non-highly paid employees.
In addition, employers who are attracted to negative elections often believe that employee inertia rather than a conscious decision on the part of employees is behind their non-involvement in the company's 401(k). "We figured, why not have that inertia work for us?" said Jenkins.
Negative Election in Action
One company that has been happy with the results of its negative election feature, added in early 1997, is Borden Inc. The company's plan currently has a participation rate of over 90 percent, according to Vicki Fortman, vice president for compensation and benefits. "We instituted a negative election in order to encourage employees to save and to help us pass discrimination tests," she said. "We've accomplished both objectives."
But, before considering a negative election feature, plan sponsors need to be aware of several key issues including outstanding legal questions, design and administrative questions, and communications issues. Moreover, before any of those concerns are addressed, plan sponsors should honestly assess the attractiveness of their 401(k) plan. Several consultants said they are reluctant to encourage the use of negative elections in plans where there is no company match. Unless employees can see an immediate benefit from participation, warned Deborah Novotny, vice president at T. Rowe Price Retirement Plan Services in Baltimore, they're likely to back out of such plans as quickly as they are signed up.
It is critical that an employer know its employee base and conduct focus tests to make sure that a negative election feature will not be met with hostility.
The IRS ruling has gone a long way toward solving many of the legal questions surrounding negative elections. However, it is still unclear how negative elections are affected by state laws that prohibit payroll deductions without an employee's written permission. Such deductions are considered an illegal garnishment of pay.
The fact that McDonald's instituted its negative election feature several years ago and has not run into visible legal problems indicates that plan sponsors should not be too concerned about this issue, said consultants. Moreover, some legal experts believe that the Employee Retirement Income Security Act of 1974 (ERISA) holds precedence over these state laws. "In most cases, we feel ERISA will preempt," said Richard Koski, principal at Buck Consultants in Secaucus, N.J. Still, states have not issued any ironclad assurances, and companies would be well advised to get an attorney to consult with states in which they do business, he said.
Employers also have to be careful how they treat employees who are paid minimum wage. "There are questions about whether you can reduce someone's pay below the minimum wage," noted Dennis Coleman, principal at PwC Kwasha/HR Solutions in Ft. Lee, N.J.
Plan sponsors also need to be aware that the Department of Labor (DOL) will not give 404(c) protection to plan sponsors for the assets that go into the plan as a result of the negative election feature. That liability concern may be enough to put off many plan sponsors who might otherwise consider this feature, said Novotny.
Koski argues, however, that with the IRS having passed judgment on negative elections — with input from the DOL — and with President Clinton speaking out in favor of this feature, "you have to be fairly comfortable that the legal issues won't be a big problem."
Among the key administrative and design issues that need addressing is the percentage rate at which employee contributions will be set. On one hand, plan sponsors do not want to make withdrawals onerous, but on the other, they want the contributions to have a meaningful impact on the plan's assets and the employee's statement. Typically, plan sponsors target a rate in the low single-digit range — about 2 percent to 3 percent of pay.
Still another question is what to do about the default investment option. Given that the employer is making this decision for the employee, it is critical that the decision be made carefully. Most plan sponsors bring in representatives from their treasury departments to help with this decision. While the first inclination might be to put the money in a super-safe money-market account or liquid guaranteed investment contract (GIC) account, this may not be the best decision given the long-term nature of the investment, noted Brian C. Ternoey, principal at William M. Mercer Investment Consulting Inc., Princeton, N.J. By the same token, making company stock a default option could be considered very risky.
The most common default investment choice is a balanced option — a fund or account that invests in both stocks and bonds. Lifestyle funds also are a good choice, said consultants.
Another administrative issue is how to deal with beneficiary selections, said Koski. If an employee is married, the spouse is the default beneficiary. If the employee is not married, the default beneficiary can be either the person designated in the group life insurance policy, a family relation or ultimately an estate. Most plan sponsors choose among the first two options as many individuals do not have estates, noted Koski.
As the Promus Hotel situation highlighted, cost is another key concern. If a company provides a generous match as Promus did — a 100 percent match on the first 6 percent contributed — a negative election can be an expensive proposition. "Frankly, it's a hard thing to sell," said Jenkins. The irony is that "you can see your best hopes realized, but you'll take a financial hit," she said.
Plan sponsors also need to be aware that if they institute a negative election feature, they'll be giving themselves more administrative work. "You're running a lot more people through the system than if you never signed them up," said Ternoey. Given that the kinds of companies that most often consider negative elections do so because they have a substantial number of transient workers, this is an important point to remember. At the same time, however, as long as a plan sponsor's recordkeeping systems are up-to-date and efficient, this additional input should not be too burdensome, Ternoey noted.
Plan sponsors considering such a feature need to be aware that a negative election requires a substantial amount of communication. Particularly critical is how plan sponsors handle the notification required by the IRS, especially when negative election features are being rolled out to existing employees, said Koski. This communication should include exactly how and when the feature will go into effect, what percentage will be deducted from the employee's pay and how the money will be invested. Plan sponsors should make sure that the individuals receiving this notification realize that they are a particular subset of the employee population, said Koski. "You need really good proof that people got disclosure," he said.
Moreover, employees should be given at least 60 to 90 days notice before the election goes into effect, he said. Be particularly careful with employees who have balances but who are not currently contributing. Usually, these participants are not contributing for a reason and "you have to understand that," said Koski.
There are other potential communications pitfalls, as a story on CNNfn's Web site this past September highlighted. Titled "Forced Into a 401(k)," the story focused on the coercive nature of negative elections and the self-interest driving plan sponsors' interest in the feature — the desire to increase executives' contribution rates. Nowhere in the story was it mentioned that the IRS has mandated that participants have ample warning and an easy mechanism for opting out of the plan. The story also erroneously reported that no companies had "surfaced" yet that had instituted such a feature — McDonald's notwithstanding.
Indeed, consultants warn that some employees may balk at appearing to have no choice about being put in a plan. It is critical that an employer know its employee base and conduct focus tests to make sure that a negative election feature will not be met with hostility, said Promus Hotel's Jenkins. In all the focus tests conducted by Promus Hotel, employees have reacted positively to the idea, she noted.
"A clear and consistent communications program is key," said Coleman. Because of the directive nature of negative elections, plan participants need to understand exactly what's happening. "You want them on board," he said.
There are alternatives to negative elections that are less directive. PwC Kwasha's Coleman is a fan of simplified enrollments whereby all new hires are asked to sign a form saying they agree to have a certain percentage of their pay contributed to a default investment option. The fact that the individual has actually signed something gives Coleman more comfort in regards to plan sponsors' fiduciary liability.
The new 401(k) Safe Harbor Plan, which can be implemented beginning in 1999, also may cut the need for negative enrollments, since plans that go under the safe harbor will not have to undergo discrimination testing, noted Dawn Bennett, CIMA, senior vice president for investments at Legg Mason Wood Walker Inc. in Washington, D.C. A plan is eligible for the safe harbor as long as the employer matches 100 percent of the first 3 percent of pay saved plus 50 percent of the next 2 percent, or as long as the employer kicks in a 3 percent across-the-board contribution.
"A negative election is not a panacea," said Bennett. Yet, like others, she believes that more companies will seriously consider this option in the future. After all, "it's a benefit to plan participants," she noted. "It helps provide for their retirement."