Effective December 24, 2007, employers can take advantage of new protections for default investments under qualified retirement plans. As many employers know, Section 404(c) of Employment Retirement Income Security Act of 1974 (ERISA) gives employers fiduciary protection for investment decisions made by employees under qualified plans such as 401(k) plans if the plan meets certain requirements. Among the requirements are the availability of diversified investments for participants, the participants’ ability to change investments at least quarterly and the distribution to the participants of certain information about the investment program.
Although many employers take advantage of Section 404(c), fiduciary protection was not available with respect to participants who failed to make an investment election. Plan fiduciaries were required to make investment elections for those participants and plan fiduciaries who remained responsible for those investments. Congress was concerned that the default investments chosen were often money market funds or stable value funds that protected the participants’ principal but offered little opportunity for growth. In order to encourage a more long-term approach for default investments, Congress added provisions to the tax code and ERISA in the Pension Protection Act of 2006 establishing “qualified default investment alternatives” (QDIAs). Employers who offer QDIAs under their plans can receive fiduciary protection for the choice. The Department of Labor finalized regulations defining a QDIA in November 2007.
Under the final regulations, a QDIA must be one of the following:
- A target-based or age-based retirement fund (so-called life-cycle fund or target retirement fund) incorporating a combination of equities and other investments;
- A fund that takes into account the general ages of the participants and selects an array of investments including equities (a so-called balanced fund);
- An investment or service that uses existing plan investment funds, including equity funds, to create a target retirement date portfolio; or
- For the first 120 days only, a money market or stable value fund.
A QDIA must also meet the following requirements:
- Participants must receive a notice describing the plan investment program and the QDIA at least 30 days in advance of the investment and annually thereafter. If the plan automatically enrolls a participant and permits the participant to withdraw contributions within the first 90 days of automatic enrollment as described in the article in this Update on automatic contribution arrangements (ACAs) “New Automatic 401(k) Contribution Rules Effective in 2008,” the 30-day advance notice requirement is waived. However, participants must receive the notice on their date of plan eligibility. The notice must not be contained in the summary plan description, although it can be combined with the notice required for automatic contribution arrangements discussed in the article, “New Automatic 401(k) Contribution Rules Effective in 2008” The IRS has published a sample combined notice at www.irs.gov/pub/irs-tege/samplenotice.pdf.
- A QDIA cannot impose trading fees or restrictions during the first 90 days of a participant’s investment. This allows participants who default into the fund to change their investments without financial penalty during the first 90 days. It also allows participants to withdraw funds without penalty if the participant is automatically enrolled under the plan as described in the ACA article.
- The plan must offer a range of diversified investments and allow the participant to move from the QDIA at least quarterly and at least as frequently as other investment changes are permitted.
- The plan must give the participants information about the default investment that the plan receives.
The regulations are effective December 24, 2007. Because the 30-day-notice requirement must be met, an employer cannot get retroactive relief. There is, however, grandfathering for stable value funds that were used as default funds before December 24, 2007. In addition, because the QDIA regulations provide a safe harbor, a plan fiduciary can also determine that for its participants, the appropriate default investment is something other than a QDIA (for example, a money market or stable value fund).
Employers should work with their investment advisors and attorneys to determine whether a QDIA is appropriate for their plans. Employers should be particularly aware of the extent to which trading fees and other financial penalties are imposed during the first 90 days of investment. An employer who wishes to use a portfolio of funds otherwise available under the plan may find that some of them impose fees that are inconsistent with QDIA requirements. It is expected that investment companies will develop products that are appropriate as QDIAs, including already available target retirement funds. Employers must evaluate a proposed QDIA under normal fiduciary principles, including a review of the embedded fees to ensure that the QDIA is an appropriate investment vehicle for the plan.