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Leading The Horses To Water: 401(k) Plan Re-enrollment and “Backsweeps”
Thursday, September 17, 2015

It’s not hard to find stories in the business and popular press these days about the impending “retirement crisis” in the United States created by the demise of the defined benefit plan, the increased reliance by employees on 401(k) plans as their primary source of retirement income (other than Social Security), and the inadequate level of retirement readiness of most Americans.

The last point is generally viewed as the result of certain shortcomings among American workers participating in 401(k) plans: they wait too long to start saving; they don’t save enough when they start (and often leave matching employer contributions on the table); they don’t invest their savings effectively; and when they change jobs, they take their money and spend it rather than keeping it in a tax-favored retirement savings account (the so-called “leakage” problem, which we will discuss in a future post).

While perfect solutions to these problems have yet to be developed, one approach on the savings and investment front that has gained traction in the last ten years—particularly following the Pension Protection Act of 2006 (PPA ’06)—is the “lead the horses to water” approach. That is, automatically enrolling employees in a defined contribution plan and then defaulting those who do not otherwise make an affirmative investment election into an appropriate investment fund, subject to opt-out. This approach relies on the incredibly strong power of inertia to keep employees in these choices, and data has shown that employees largely stay in the investment fund into which they were defaulted.

The most popular of these techniques has been auto-enrollment of new hires, in which contributions for new hires are automatically defaulted into a qualified default investment alternative (QDIA), typically one of a suite of target-date funds. A number of plans have also added auto-escalation as a feature, in which auto-enrolled employees have their contributions increased annually (typically by 1% a year) up to a specified maximum, subject to opt-out.

Employers have been slower to warm up to applying similar techniques for their existing workforce. For example, an employer that is auto-enrolling new hires at 5% a year likely has some material number of current employees contributing either zero or less than 5%, which raises the question—why not just enroll those employees at 5%, subject to opt out? (This is typically called a “backsweep.”) As part of that process (or separately), why not take all of the existing participants’ account balances and invest them in the plan’s QDIA unless they make a different affirmative investment election? (This is typically called a “re-enrollment.”) If it’s optimal for new hires to be contributing at least 5% (and to have their contributions auto-escalated in the future), and if it’s optimal for the majority of employees to be invested in a QDIA instead of trying to manage their own investments, why not lead those horses to water?

There are a number of issues and concerns that plan sponsors and plan fiduciaries raise about backsweeps and re-enrollment—for example, concerns about additional costs associated with a substantial increase in required matching employer contributions (since, typically, the default level is set high enough to allow for a full match) and about whether current employees might be more likely to react negatively than new hires to being defaulted (though our anecdotal experience with clients is that there is typically very little pushback). Like any other material plan design choice, the decision to do a backsweep of current employees and/or to re-enroll participants in a QDIA involves a combination of finance, human resources, employee communications, and other concerns. However, concerns about legal risk should not be an impediment to these actions. Various “safe-harbor” provisions of ERISA enacted as part of PPA ’06 affirm the legality of both backsweeps and re-enrollments, as long as specified required steps are taken to comply with those safe-harbor provisions (such as providing affected participants with at least 30 days’ written notice before implementing the changes, with an explanation of their ability to opt out).

In the only court challenge to such actions to date, Bidwell v. University Medical Center, Inc., 685 F.3d 613 (6th Cir. 2012), the Sixth Circuit Court of Appeals held that the QDIA safe harbor protected plan fiduciaries that defaulted participants to the QDIA in a re-enrollment. In Bidwell, the defaulted participants were previously in a stable-value fund as a result of an affirmative investment choice, but were re-enrolled into target-date funds just before a significant drop in the stock markets. As a result, the participants’ accounts suffered material losses. Nevertheless, the court held that because the company and the plan fiduciaries had appropriately followed the PPA ’06 safe-harbor requirements, they were not liable to make the participants whole for any of their losses.

In summary, plan sponsors concerned about their employees’ retirement readiness that would like to be more proactive should not be deterred by potential legal risk. The default safe-harbor provisions enacted as part of PPA ’06, used appropriately, provide a plan sponsor with a number of effective tools (like re-enrollment and backsweeps) that they can use to help not only lead the horses to water, but let them drink.

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