Pension Protection Act Provides Easier ESOP/401(k) Safe Harbor Test

The new automatic enrollment provisions for 401(k) plans in the Pension Protection Act allow companies to meet the 401(k) testing rules if they provide automatic enrollment (that is, employees opt out instead of opting in) that has the following features:

1. There are matching or non-elective employer contributions to the plan of not less than 3% of pay for all participants, regardless of deferrals or a match, or at least a 100% match for the first 1% deferred and a 50% match for the next 5% deferred. The matching percentage test applies to deferrals of non-highly compensated employees.
2. Employees agree to a minimum salary deferral of 3% in the first year, 4% in the second, and 5% in the third.

If these rules are met, the vesting for the employer contributions can be two-year, rather than immediate, as in the existing safe harbor match for contributions to 401(k) plans without automatic enrollment.

There is wide consensus in the retirement planning community that employees are not deferring enough into 401(k) plans, and too many eligible participants do not participate at all. Automatic enrollment generally results in a significant increase in participation and deferrals. The new safe harbor test is effective for plan years after December 31, 2007.

While it may be easier to satisfy the safe harbor tests under the new rules, it is also expected that companies will be less likely to offer company stock as an employee investment choice. Proposed rules on default investments for automatic enrollment plans exempt a fiduciary from liability if the investments meet certain criteria. Employer stock would not be among these available choices, except in the very limited circumstances in which the stock was held by a registered investment company or pooled investment vehicle independent of the company. Employer matches in stock, however, are not covered by this rule.