In this second of a four-part series providing an overview of some key provisions of the Setting Every Community Up for Retirement Enhancement (“SECURE”) Act of 2019, I summarize the Act’s liberalization of the 401(k) plan nondiscrimination testing safe harbors and the Act’s effort to make it easier for employers to offer annuity payments as a distribution option under 401(k) plans. I also discuss why the changes made by the Act do not go nearly far enough to remove the legal and regulatory barriers that discourage 401(k) plans from offering annuity payments.
Easing of 401(k) Safe Harbor Requirements
An employer can avoid the Internal Revenue Service (“IRS”) nondiscrimination test applicable to elective contributions to a 401(k) plan by satisfying safe harbor requirements that include making a matching contribution or a matching contribution to the plan.
The SECURE Act increases employer flexibility in using these safe harbors, in several respects.
First, the Act modifies the prior law limitation that an employer seeking to avail itself of the nonelective contribution safe harbor was generally required to have included the nonelective contribution provision in their 401(k) plan before the beginning of the year. Employers will now be able to adopt an amendment adding the provision at any time up until the 30th day before the end of the plan year. The Act also eliminates the requirement of providing a detailed notice to plan participants for nonelective safe harbor contributions. Employers that make matching safe harbor contributions to a 401(k) plan will continue to be required to provide a notice in accordance with IRS rules.
One of the existing safe harbor alternatives is an automatic enrollment feature, where employees are automatically enrolled in the plan, at increasing annual percentages of compensation, unless the employee elects a lesser or greater percentage, coupled with an employer matching contribution. Prior to passage of the SECURE Act, the Tax Code required a minimum automatic enrollment percentage of 3% in the first year of participation, 4% in the second year, 5% in the third year, and 6% in the fourth year, with a cap on the maximum permissible safe harbor automatic enrollment percentage of 10%. The SECURE Act increases the cap from 10% to 15%. The SECURE Act’s legislative history expresses the view that concerns about a “relatively high reduction in take-home pay” attributable to too high an automatic enrollment rate in the initial year of participation “are lessened with respect to automatic increases in default rates for years after default contributions have begun” and that the 10% cap may have the effect of unnecessarily limiting the amount that is contributed and thereby negatively impacting retirement savings.
It is the author’s understanding—anecdotally—that the increase in the cap was of particular interest to a number of high-tech companies with workforces composed of young, highly paid employees who are not inclined to affirmatively elect to participate in the company’s 401(k) plan, but who also do not bother to elect out of automatic enrollment in the plan or annual percentage increases in their contributions.
The changes to the safe harbor rules are effective for plan years beginning after December 31, 2019.
Encouraging Annuity Payouts from 401(k) Plans
As employers have moved away from traditional pension plans, in favor of 401(k) plans, policymakers have become increasingly concerned that employees find themselves in the position of having to manage the investment of their retirement savings and that they are ill prepared to take on this responsibility.
As a partial solution to this problem, some have advocated that employers should be encouraged to include payments under an annuity contract for the life of the participant, as a distribution option under 401(k) plans, with the objective of providing a stream of income to plan participants following their retirement. In furtherance of this objective, effective immediately, the SECURE Act creates some protection from claims for the fiduciaries of a 401(k) plan who select the life insurance company from which a plan purchases the annuity contracts. Importantly, there are a number of things that the Act does not do.
- Although the Act creates a safe harbor that a plan fiduciary may rely upon in evaluating the financial integrity of an insurance company, it leaves open the steps that fiduciaries must take, in satisfying their duties to plan participants, in determining whether the fees charged and actuarial assumptions used by an insurance company to convert a 401(k) plan account balance into an annuity are appropriate.
- There are a number of complex, statutorily-imposed obligations applicable to the distribution of a 401(k) plan account in the form of an annuity, including election and information dissemination requirements, and, in the case of a married participant, the right of a spouse to receive a survivor benefit unless the spouse consents to a form of distribution that does not have a survivor benefit. Failure to satisfy these obligations may cause a plan to lose its tax qualification, which has been a driving force in the historical trend by employers to eliminate annuities from their 401(k) plans.
The arcane structure of the spousal rights provisions applicable to retirement plans that distribute benefits via annuity payments has generated its fair share of litigation. A prime example is a case decided by the United States Court of Appeals for the Ninth Circuit, which held that a spouse’s annuity survivor benefit rights attach at the time benefits begin and cannot be undone by an intervening divorce that occurs before survivor benefits are payable. Although the life insurance company that issued the annuity contract would likely be a named party in the litigation, the plan that distributed the contract and the employer maintaining the plan might also find that their agreement with the insurance company obligates them to participate in the lawsuit as well.
 Carmona v. Carmona, 603 F.3d 1041 (2010). A fun fact is that the lawsuit was brought by the plan participant’s ninth wife, to whom he was married when he died, contesting the survivor benefit rights of the participant’s eighth wife.