Automatic IRA Legislation
September 2010
Aon Consulting
© 2010 – Aon Corporation
Brief Description: The Senate and House have both introduced proposals requiring
employers not maintaining pension plans to establish payroll deduction IRA programs
that employees are defaulted into. Here we look at the policymaker attitudes behind the
proposals and examine key issues for large plan sponsors.
Introduction
In August, the Senate and House introduced legislation that would require certain employers to establish "auto IRA" programs. Both bills are titled the "Automatic IRA Act of 2010." The Senate bill is sponsored by Senator Bingaman (D-NM), the House bill by Congressman Neal (D-MA).
Below we discuss (1) the strategy behind automatic IRA policy initiatives, (2) key issues for larger plan sponsors, and (3) the specific House and Senate proposals.
Background
Auto IRA proposals essentially require employers who are not maintaining pension plans to establish payroll deduction IRA programs into which employees are defaulted.
Auto IRA legislation is most easily understood as an attempt to expand coverage – to bring more workers into retirement savings programs. Democrats have generally supported auto IRAs; proponents are searching for a Republican co-sponsor.
Auto IRA legislation was one of five retirement initiatives President Obama outlined as a candidate in 2008. The legislation reflects two fundamental retirement policy assumptions. First, that account-based retirement programs are the future. Second, that the best way to get workers to contribute to retirement accounts is to use auto-enrollment, which is widely used by many 401(k) plans.
Auto IRA legislation is really half of a two-part initiative. The other half is an expansion of the Saver's Credit. Generally, the Saver's Credit provides a tax credit to certain persons making contributions to 401(k) plans, IRAs, and certain other retirement savings programs. The current Saver's Credit is not very robust. Its income limits are very low, and it is non-refundable, so persons who pay no taxes get no credit. Expanding the Saver's Credit – to make it refundable and dramatically increase the income limits – was another of candidate Obama's retirement savings proposals and was included in the administration's 2009 budget. Congressman Pomeroy (D-ND) introduced legislation expanding the Saver's Credit in 2009. While Democrats are pushing these two pieces of legislation, both parties are for broadening coverage. However, the legislation presents three big problems.
1) Cost concerns – The Saver's Credit will have a significant price tag if it is made refundable and income limits are increased.
2) Mediation concerns – All auto IRA proposals require employers to mediate the establishment of retirement accounts. This will necessarily involve some administrative burden and, perhaps, some legal risk.
3) Administrative challenges – Accounts will typically be small and transitory – participants will appear, disappear, and reappear. Thus the program will not necessarily be appealing to a lot of financial institutions.
Issues for Sponsors
Plan sponsors have some concerns with this legislation. First, which employers will have to set up auto IRA programs? Critically, to what extent will larger employers who sponsor qualified plans still have to provide auto IRA programs for non-covered employee groups? Second, how great will an employer’s administrative burden be for maintaining an auto IRA program? Finally, what compliance risk – such as fiduciary exposure and penalties – will there be for employers?
Current Proposals
With that background, let's review the House and Senate proposals.
Which Employers Are Covered?
Generally, under both bills, an auto IRA arrangement must be provided when the employer does not maintain a qualified plan (e.g., a qualified defined benefit or 401(k) plan) or certain other retirement savings arrangements. Frozen plans and discretionary plans under which contributions have not been made for two years do not count for this purpose. Very small employers and certain government and church entities are also excluded from coverage.
Employees who do not meet certain age and service requirements or those covered by collective bargaining agreements may be excluded both from this coverage analysis and from auto IRAs. For larger employers who already sponsor plans, the question is: to what extent must auto IRA arrangements be provided to employees who are not covered by their plan? The House and Senate proposals differ on this point.
Under the Senate bill, unless otherwise excludible, an auto IRA arrangement must be provided to "employees of a subsidiary, division, or other major business unit of the employer [who] are not generally eligible to participate in any such qualified plan or arrangement."
The House bill includes similar language, but limits its application to subsidiaries, divisions, and major business units in which "there are 50 or more ineligible employees … constituting at least 10% of the employees of the employer (other than excludable employees)." We think that 10% is a pretty big number and will give a pass to a lot of sponsors who would have to provide auto IRAs to non-covered employees under the Senate bill.
The 10% provision is a key issue for large plan sponsors. They will want to follow it closely.
What Must the Auto IRA Arrangement Provide?
Generally, the auto IRA arrangement must cover each non-excludible employee. It must allow the employee to elect to make a contribution to an individual retirement plan (e.g., an IRA) or purchase a "qualified retirement bond" (essentially, a direct U.S. Treasury investment), in either case by payroll deduction.
Here's the "auto" part: If no election is made, the employee will be treated as having elected to contribute 3% of pay. The Secretary of Treasury is given authority to vary the 3% amount (between 2%-6% under the House bill and between 2%-4% under the Senate bill) and to provide for increases in the automatic amount for employees "under an automatic IRA arrangement for 2 or more consecutive years."
There are administrative requirements with respect to elections (most importantly, the election not to have a contribution made), notice, and termination.
Tax Treatment
Auto IRA contributions are generally treated like other IRA contributions. The Senate bill provides that if the employee makes no explicit election, the contribution is treated as a Roth IRA contribution. The House bill takes the opposite approach, treating it like a traditional IRA. As a general matter, because of the way Congressional Budget Office scoring works (see the discussion in our article Roth 401(k)s, Roth IRAs and 2010 Roth Conversions), Roth treatment significantly reduces the cost of this legislation.
Investment of Contributions and Default Investments
Policymakers continue to be challenged with how to select IRA providers, especially when neither the employer nor the employee has made an affirmative election.
Under the House bill, the employer may decide whether to offer an IRA, a retirement bond, or both and to determine which vehicle will be the default investment. If the employer makes no such election, the default investment is a retirement bond. If the employee makes no election (and therefore has effectively been defaulted into the program), contributions to an IRA may only be invested in 1) a principal
preservation vehicle, 2) a target date fund, or 3) a balanced fund.
Under the Senate bill, unless the employee elects otherwise, IRA contributions must be invested in a principal preservation vehicle if the employee's balance is less than the deductible limit for traditional IRAs (currently $5,000). If the balance is greater than this limit, contributions must be invested in "[a] broadly diversified class of assets or fund, as specified in … regulations, that is substantially similar to target date, life cycle, balanced or similar funds, as so specified."
The Senate bill may generate a significant amount of rulemaking around what types of investments may be offered. Among other things, auto IRA investment options must be "based on low-cost investment options" and "avoid undue complexity." The regulations must include provisions for "clear and uniform methods for reporting the fees imposed with respect to the investment options provided … and … a prohibition on charging additional fees solely on the basis that the balance in an automatic IRA is small." The House bill simply provides that the auto IRA arrangement may not "charge unreasonable additional fees solely on the basis that the balance in an automatic IRA is small."
Policymaker proposals on how auto IRAs may be invested are of interest to sponsors primarily to the extent that they present administrative burdens or compliance risk. Otherwise, they are mostly of concern to investment services providers. Policymakers are concerned with fees and investment risk (with a bias towards lower fee and lower risk investments). They also need to ensure that investment alternatives are available in the market.
We expect the investment provisions of the auto IRA proposals to be subject to much discussion, with perhaps more alternative approaches considered.
Enforcement
Where there is a failure to comply with auto IRA requirements, both bills provide for an excise tax or $100 per calendar year per employee and for exceptions where the employer exercises "reasonable diligence" and cures any failures.
Compliance Burden and Risk
The biggest burdens this legislation will impose on large plan sponsors are likely to be that of
communicating the program, administering the program, and making a payroll transfer to the designated provider or the Secretary of Treasury. As anyone who has administered a 401(k) plan knows, these are not simple tasks. Errors, and time required to identify and correct them, are inevitable. One helpful provision of both proposals is that, under each, the employer is allowed to limit participation to only one IRA provider (or to the retirement bond program).
With respect to employers’ compliance risk, both the House and Senate bill provide for an approved list of IRA providers (approved by the Secretary of Treasury) and a retirement bond alternative. If one of these approaches is taken, there is a general exemption from ERISA coverage and ERISA fiduciary exposure. While these provisions are subject to revision, it appears that both bills' sponsors are committed to accommodating sponsor concerns about risk.
Outlook
It seems unlikely that, with a significant election near, Congress will pass an auto IRA measure. The fate of this legislation next year will depend on who is running the next Congress and whether its proponents can come up with a way to finance it. In the current environment, the biggest obstacle to passage is cost. Aon will continue to follow this initiative.
Contact Information
Drew McCorkleSenior Vice President Aon Investment Consulting +1.404.240.6149
