Section 401(a)(35) of the Internal Revenue Code of 1986, as amended (the "Code"), and Section 204(j) of the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), were added by Section 901 of the Pension Protection Act of 2006 (the "Act") and provide that defined contribution plans must provide certain participants, beneficiaries and alternate payees ("applicable individuals") the right to divest employer securities in their accounts and reinvest such amounts in other investment options. Notice 2006-107 was issued by the Internal Revenue Service on December 1, 2006, to provide guidance on these diversification requirements.

IRS Notice 2006-107


Section 401(a)(35) of the Code and Section 204(j) of ERISA impose diversification requirements on certain defined contribution plans that hold "publicly traded employer securities." For this purpose, "publicly traded employer securities" means employer securities which are readily tradable on an established securities market. Under Section 401(a)(35) of the Code, defined contribution plans must permit applicable individuals the right to divest employer securities in their accounts and reinvest such amounts in other diversified investment options. In addition, Section 101(m) of ERISA, as added by the Act, requires plans to provide applicable individuals with a notice which describes these diversification rights and provides information on the importance of diversifying the investments in their accounts.


For purposes of Section 401(a)(35) of the Code, if a plan holds employer securities that are not publicly traded, the employer securities are generally treated as publicly traded employer securities anyway if any employer corporation, or any member of the controlled group of corporations that includes the employer, has issued a class of stock that is a publicly traded employer security. (For this purpose, employer corporation means any corporation that is an employer maintaining the plan and a controlled group of corporations has the meaning given under Section 1563(a) of the Code, except that 50 percent is substituted for 80 percent.)1 Notice 2006-107 clarifies that the diversification requirements of Section 401(a)(35) of the Code do not apply with respect to any securities held by either an investment company registered under the Investment Company Act of 1940 (e.g., a mutual fund) or a similar diversified pooled investment vehicle. In addition, Section 401(a)(35) of the Code does not apply to ESOPs that do not permit elective deferrals, employee after-tax contributions or matching contributions.

Diversification of Employee Contributions

A plan is required to permit all applicable individuals with the right to divest the portion of their accounts attributable to elective deferrals (i.e., pre-tax contributions) and employee contributions (i.e., after-tax contributions and rollover contributions).

Diversification of Employer Contributions

With respect to employer contributions (e.g., employer matching contributions), diversification rights must be made available to each applicable individual who is either (i) a participant who has completed at least three years of service, (ii) an alternate payee who has an account under the plan with respect to a participant who has completed at least three years of service, or (iii) a beneficiary of a deceased participant. For this purpose, the date on which a participant completes three years of service occurs immediately after the end of the third vesting computation period provided for under the plan. However, for a plan that uses the elapsed time method of crediting service for vesting purposes (or for a plan that provides for immediate vesting without using a vesting computation period), three years of service is completed on the third anniversary of the participant's date of hire.

Investment Options

The investment options offered for purposes of divestiture of employer securities must include no less than three investment options, other than employer securities. Each such investment option must be diversified and have materially different risk and return characteristics. For this purpose, investment alternatives that satisfy the requirements set forth in Section 2550.404c-1(b)(3) of the Department of Labor Regulations are treated as being diversified and having materially different risk and return characteristics.2

Restrictions / Conditions on Diversification

A plan may limit the time for divestment and reinvestment to periodic, reasonable opportunities occurring no less frequently than quarterly. In general, restrictions on the divestment of employer securities are not permitted if such restrictions are not imposed on other investment options. The following are examples of restrictions in plans that are prohibited:

  • Applicable individuals are provided the right to divest employer securities on a periodic basis (e.g., quarterly), but the plan permits divestiture of all other investment options on a daily basis.
  • A plan provides that an individual who divests his or her account of employer securities receives less favorable treatment (e.g., a lower rate of matching contributions) than a participant whose account remains invested in employer securities.

The following are examples of restrictions that are permitted:

  • Limitations on the extent to which an individual's account balance can be invested in employer securities (e.g., no more than ten percent may be invested in employer securities).
  • Restrictions imposed by reason of compliance with securities laws or a restriction that is reasonably designed to ensure compliance with such laws.
  • Fees on other investment options under the plan merely because fees are not imposed with respect to investment of employer securities. Diversification rights with respect to employer securities may be restricted for up to 90 days following an initial public offering of the employer's stock.
  • Freezing employer securities as an investment option (i.e., amounts invested in the plan may no longer be transferred into a class of employer securities and new deferrals may not be permitted to be invested in that class of employer securities).

A plan provision that restricts a participant from reinvesting his or her account balance back into the class of employer securities that he or she previously diversified is a restriction that is prohibited by Section 401(a)(35) of the Code. Thus, it is unclear from Notice 2006-107 whether the IRS' intent was to effectively restrict employers from completely eliminating employer securities as an investment option (i.e., once an employee divests his or her interest from an employer security, he or she must always have the ability to transfer such amounts back into the investment option, even if the option has been frozen to any new investment) or whether employers are simply limited from restricting participants from reinvesting for a "period of time." The possible effect of this rule may be that plan sponsors may not be able to fully freeze an employer security investment option since participants must be able to transfer their account balances back to such investment option.

Transition rules

Continuation of Existing Restrictions or Conditions

To the extent that a plan restricts diversification rights with respect to employer securities pursuant to a plan provision in effect on December 18, 2006, such plan will not violate Section 401(a)(35) of the Code if such restriction is no longer imposed after March 31, 2007.

Grandfathered Investments

Plans are permitted to continue, through December 31, 2007, as in effect in such plan on December 18, 2006, (i) to impose a restriction on investments in employer securities that does not apply to a stable value fund, and (ii) to permit divestitures on a periodic basis, but allow more frequent divestitures of an investment that is not a generally available investment (e.g., an investment limited to a fixed class of participants).

Employer Securities Acquired Before January 1, 2007

With respect to employer securities acquired in a plan year before January 1, 2007, the diversification requirements with respect to employer contributions only apply to the applicable percentage of the number of shares of those securities. The applicable percentage is 33 percent for the first plan year after the diversification rules take effect; 66 percent in the second plan year; and 100 percent for all subsequent plan years. This transition rule does not apply to a participant who, before the first plan year beginning after December 31, 2005, had attained age 55 and completed at least three years of service. Some plans may find the administration of this three-year transition to be cumbersome and may alternatively wish to permit diversification of 100 percent of employer contributions as of January 1, 2007.

Notice Requirement

The Act also added Section 101(m) to ERISA which requires plans to notify applicable individuals of their diversification rights and describe the importance of diversifying the investment of retirement accounts. Section 101(m) of ERISA is effective for plan years beginning after December 31, 2006 and requires that the notice required thereunder be provided to participants no later than 30 days before the first date on which the individuals are eligible to exercise their diversification rights. Therefore, plans with a calendar year plan year would have been required to provide the notice by December 2, 2006. Notice 2006-107, however, provides that the Department of Labor (the "DOL") has advised the Internal Revenue Service (the "IRS") that plans with plan years beginning on or after January 1, 2007, but before February 1, 2007, were not required to furnish notices to participants before January 1, 2007. Plans are encouraged to furnish notice on the earliest possible date. The DOL has since provided additional relief for plans to provide this notice to participants for plans already in compliance with the divestiture rules as of January 1, 2007. Under the relief provided by the DOL, eligible plans are generally not required to provide this notice until 45 days after March 31, 2007.3

Notice 2006-107 provides a model notice for purposes of Section 101(m) of ERISA. The model may be adapted to reflect particular plan provisions. For example, since the model notice provides that participants have a "new right" to diversify their employer stock plan sponsors with plans that already permit the diversification of investments in company stock, employers may wish to revise the model notice to avoid confusion among plan participants. Notices to participants should explain that the notice is required due to changes in the law and can serve to remind participants of the diversification rights permitted by the plan.


Notice 2006-107 provides welcome clarification with respect to the Act's newly enacted diversification requirements. In this regard, plan sponsors should take the opportunity to review their plan documents to ensure that they are in compliance with the new diversification requirements and, if applicable, prepare notices to participants and beneficiaries regarding the diversification requirements. Of course, White & Case would be pleased to assist you in this regard.