A new pension act provides some real opportunities for additional retirement planning.  As its name indicates, the Pension Protection Act of 2006 targets the nation’s retirement savings.  However, this extensive piece of legislation covers other areas as well, from college savings to charitable giving.

Some of the bill’s major provisions are aimed at large employers, the ones offering traditional defined benefit pension plans.  Such plans generally will need more funding by employers, although these are special breaks for airline companies.  So-called “cash balance” plans, which have been controversial, received some clarification in the bill.

In addition, several provisions of the new law are particularly important to smaller employers and individual taxpayers. 

Automatic-Enrollment 401(k) Plans Get a Green Light

In recent years (401(k) and 403(b) plans have become widespread.  These defined contributions plans allow workers to defer part of their income (and the tax on that income) until retirement. Along the way, the tax on any investment earnings also is deferred.

Many workers, though, decline to participate in these plans, or participate at minimal levels.  In response, some employers have implemented “automatic enrollment” 401(k) and 403(b)s, sometimes known as negative-election plans.

Raising participation

Employees are automatically signed up for these plans.  Unless they opt out, a certain percentage of their pay is placed into their accounts on a regular basis.  Because of inertia, few workers actually choose to be removed from these plans so participation rates wind up reaching much higher levels.

There have been some clouds over automatic-enrollment plans, though.  Some state laws prohibit employers from setting aside employees’ earnings without written consent, for example.

These concerns have been overridden by the new law, which expressly permits automatic enrollment in 401(k) and 403(b) plans.  Although this portion of the new law won’t officially take effect until 2008, there is nothing to prevent employers from acting sooner.  Now that Congress is on record as favoring automatic-enrollment plans, there may be little risk in moving ahead.

Help for the highly-paid

What’s more, business owners should be aware that this area of the new law is more than a warm-hearted movement to encourage workers to save for their own retirement.  Salary-deferral plans such as 401(k)s are subject to non discrimination rules:  in order for highly-compensated employees to maximize their own personal contributions, there must be adequate contributions from rank-and-file workers.  Implementing an automatic enrollment 401(k) plan may help owner-employees and other key executives enjoy maximum tax deferral that otherwise might not be available.

Running on autopilot

If you’re attracted by the idea of an automatic-enrollment 401(k) plan, you should know how they work.  As mentioned, all eligible employees are automatically placed in the plan.  Unless they sign a form stating that they don’t want to be in the plan, they’re enrolled.  Each year, all participating employees are given an opportunity to drop out of the plan. 

Several other details must be determined:

Amount of salary deferral.

Typically, these plans set a 3% level.  Thus, an employee earning $30,000 will have $900 (3% of $30,000) withheld from his paychecks over the year and deposited to his 401(k) account.  A higher or lower level of salary deferral can be chosen, up to each year’s 401(k) limits.

 Employer match.  As a further incentive to stay in rather than opt out, many employers provide matching contributions.  Typically a 25% or 50% match is provided, up to 6% of the employee’s salary.  Thus, if the employee described above contributes $900 to his 401(k) the employer will add another $225 or $450 to the employee’s account.

Employers might require three to six years of employment before these matching contributions are fully vested.  Such conditions can reduce employee turnover, always a key concern.  Moreover if some employees do leave and forfeit matching contributions, these forfeitures can stay in the 401(k) plan and reduce future company outlays.

Automatic increases.  If an employee begins with a 3% contribution the first year, the default contribution might go to 4% in Year Two, 5% in Year Three, etc.  The new law makes it easier for companies to automatically escalate the percentage of an employee’s salary that is directed to the plan.  Such an autopilot approach may make a 401(k) plan less intimidating to employees and thereby reduce negative elections.  Also, as employees see their nest eggs grow, they may be more willing to participate at higher levels.

Automatic investing.  Automatic enrollment 401(k) plans generally have a default investment option.  However, if all the money goes into a money market fund, the long-term results may be disappointing.

Therefore, the default investment plan might be a diversified mix of equities and fixed-income holdings, chosen by a financial advisor.  Again, employees may be more inclined to participate in an automatic-enrollment 401(k) if a professionally-designed investment portfolio is readily available. 

The new and the old

New employees can be educated about an automatic-enrollment (401)k plan while they’re being told about company benefits such as insurance.  Existing employees can be informed during their year-end review of benefits, when health plans are chosen and cafeteria plan selections are being made (open season).

With the right package and the right presentation, an automatic enrollment (401)k plan can provide greater tax-deferral for highly-compensated executives while other workers enjoy retirement savings they might have passed up.