Many employers look for ways to increase participation among non-highly compensated employees ("NHCEs") in their 401(k) plans. One method which began to emerge in the 1980’s was the use of "negative elections" or "automatic enrollment." In 1998, in Revenue Ruling 98-30, the Internal Revenue Service ("IRS") approved an arrangement where each employee automatically participated in the salary deferral arrangement at some specified level. In the ruling, the deferral was set at 3% of compensation. The ruling required that the employee must be given notice of his right to receive the deferred amount in cash and also be given an opportunity to elect to receive cash rather than a contribution to the plan. In addition, an annual notice must be given outlining the current amount of deferral and the procedures to change the amount including the ability to stop all deferrals.

Two concerns which arise in the use of this method of increasing participation are potential increased fiduciary liability and state law issues. Many 401(k) plans permit participants to direct the investment of their accounts. Plan sponsors and other fiduciaries use ERISA section 404(c) to limit liability for imprudent investment choices made by the participant. In the negative election context, where a participant makes no deferral or investment election, an investment choice would have to be made for the participant in the form of a default fund. The act of choosing such a fund could place additional liability on the fiduciary responsible for that choice.

The second concern deals with state laws regulating the circumstances under which an employer may withhold funds from an employee’s wages. Some states require written consent from the employee before any withholding is permitted. The Department of Labor has indicated that these laws are preempted, but this is an issue that should be carefully examined.

With that as background, recent actions in this area may be examined. In February of this year, the IRS issued Revenue Ruling 2000-8 which amplified and superseded Revenue Ruling 98-30. The ruling makes it clear that a plan can apply negative elections to newly hired employees as in the prior ruling. It goes on to permit a plan to be amended to provide that not only newly hired employees but also current employees who are not deferring at the set level may be subject to withholding at the plan mandated level. For example, a plan could be amended to provide for an automatic deferral of 3%. All participants who were deferring below that level would have 3% withheld unless they elect otherwise. Of course, the earlier requirements of giving notice and providing an opportunity to elect out still apply.

Later this year, the IRS issued two rulings which expanded the permitted uses of negative elections. Revenue Ruling 2000-33 deals with a county which maintains a Section 457 eligible deferred compensation plan. The county wished to add an automatic deferral of 2% for all current and new employees not deferring at that level. The ruling found that such an arrangement would not cause the plan to fail to qualify under Section 457. In much the same way, Revenue Ruling 2000-35 applies the concept to Section 403(b) tax sheltered annuity plans. Contributions made under a negative election scenario will not fail to be considered as being made under a salary reduction agreement. These rulings permit governmental units and certain non-profit entities to use the automatic method of deferral.

In a final expansion and expression of approval of this concept, the IRS issued Announcement 2000-60. That announcement reminded prototype plan sponsors and employers who adopt prototype plans that those plans may provide for the use of negative elections or automatic enrollment. This clearly indicates that the use of this concept has been fully accepted by the IRS.

The use of negative elections is an effort to increase participation in 401(k) plans. It is a now accepted method and some surveys have indicated that there is a significant increase in overall participation in plans which utilize this technique.