On October 24, 2007, the Department of Labor issued the final regulations implementing the default investment amendments made to the Employee Retirement Income Security Act of 1974 ("ERISA") by the Pension Protection Act of 2006. This regulation provides a safe harbor for fiduciaries of participant-directed individual account plans (such as a 401(k) plan) investing participant assets in the absence of participant investment direction. If plan assets are invested in Qualified Default Investment Alternatives ("QDIAs") as defined in the regulation, then the participant is deemed to have exercised control over the assets in his or her account and the plan fiduciary will not be liable for any loss, or by reason of any breach, that occurs as a result of such investments. This regulation becomes effective December 24, 2007.
Call to Action
The final regulations directly impact sponsors of 401(k) plans and other participant directed individual account plans and therefore requires immediate action. Apart from the exceptions discussed in more detail below, plan sponsors that use a capital preservation product as the plan's default investment alternative (such as a stable value fund or money market fund) must choose an alternative product that fits the QDIA criteria by December 24, 2007, to take advantage of the regulation's safe harbor.
Plan sponsors may be able to continue using capital preservation products in the following two circumstances:
- Short-Term Exception. Under the short-term exception, investments in capital preservation products (both money market funds and stable value funds) will be treated as QDIAs for 120 days following a participant's first elective contribution to the plan. After this 120-day period, the assets are required to default into one of the other QDIA products. To get the relief afforded by the regulation, the plan fiduciary must redirect the participant's investment to another QDIA prior to the expiration of the 120-day period.
- Grandfather Exception. Under the grandfather exception, plans that provided for automatic enrollment and default investments into stable value funds prior to December 24, 2007 will be grandfathered in and treated as QDIAs. This exception applies only to stable value funds and not other capital preservation products. In addition, the rule does not provide relief for future contributions to stable value funds. The regulation is very clear that this exception is limited to pre-effective date contributions and applies only to stable value funds, not money market funds.
Going forward, plan sponsors should review their plans and evaluate whether the default investment product will qualify as a QDIA. If the investment does not qualify, plan sponsors should choose an alternative product before December 24, 2007. Remember that when selecting a QDIA, plan fiduciaries should select the QDIA on a prudent and objective basis, balancing the quality of service and fees and continue to monitor the fund and manager performance on an on-going basis. In addition, if plan fiduciaries wish to transfer assets from existing default investment alternatives into QDIAs, these decisions cannot be based solely on the desire to take advantage of the safe harbor provisions. Plan fiduciaries should take into account the financial consequences of withdrawal to the plan's participants and beneficiaries, such as market value adjustments or similar penalties and make a decision in compliance with ERISA's prudence and exclusive purpose requirements.
Plan fiduciaries may continue to use money market funds, stable value funds and other capital preservation products for participants' preliminary investments but should develop a mechanism for transferring assets into a QDIA within 120 days after the initial contribution if they wish to take advantage of the safe harbor provision. Notice (as described above) should be provided by November 24, 2007 to all new employees who become eligible to participate in the plan and to all employees who have previously defaulted into capital preservation products. Notice does not need to be given to employees who have affirmatively elected their investments. Employers may also want to give notice to all participants regardless of whether or not the participant or beneficiary was defaulted or elected into the investment vehicle to the extent that any contributions might be defaulted in the future. This way plan fiduciaries will obtain relief with respect to both existing and new default investments that constitute QDIAs. Changes may also need to be made to the plan documents, summary plan descriptions and prospectuses to reflect these changes.
QDIA Safe Harbor Relief
For a plan sponsor to fit within the new safe harbor, the following criteria must be met:
- The default investment fund must be a QDIA. A QDIA must be managed by either (i) an investment manager, plan trustee or plan sponsor/fiduciary or (ii) an investment company registered under the Investment Company Act of 1940. QDIAs may not invest participant contributions directly in employer securities.
- Plan participants and beneficiaries must have been given the opportunity to direct the investment of his or her account and have failed to make an election.
- Plan participants and beneficiaries must be provided a notice that meets the requirements set forth below.
- Any material provided to the plan with respect to the QDIA, such as prospectuses and other notices, must also be furnished to participants and beneficiaries.
- Participants and beneficiaries must have opportunity to direct investments out of a QDIA with the same frequency available for other plan investments but no less than quarterly.
- QDIAs may not impose financial penalties or otherwise restrict ability of participants and beneficiaries to transfer investments from QDIAs to any other investment alternative available under the plan. There is a prohibition against transfer, surrender or withdrawal fees for 90 days following a participant's first elective contribution in a QDIA. After the first 90-day period, the QDIA can charge transfer or withdrawal fees as long as they are the same fees charged to anyone else in the fund.
- A QDIA can charge "ongoing fees" for investment management and "administrative fees."
- The plan must offer a broad range of investment alternatives, in accordance with the ERISA Section 404(c) requirement of having at least three funds with different risk and return characteristics.
- Timing of Notice. Notice must be given to participants and beneficiaries at least 30 days in advance of plan eligibility or their first investment, and on an annual basis at least 30 days in advance of each subsequent plan year for all participants and beneficiaries on whose behalf default investments may be made. There is an exception to this 30-day notice under which participants can be notified concurrently with enrollment if their plan provides them with the opportunity to opt out within 90 days without incurring a withdrawal tax.
- Content of Notice. The IRS published a sample default investment notice on November 15, 2007. A copy of the sample notice is available on the IRS’s Web site, http://www.irs.gov/pub/irs-tege/sample_notice.pdf. The notice must be written in a manner calculated to be "understood by the average plan participant" and may not be provided in the summary plan description (SPD). The notice must include:
- a description of the circumstances under which assets will be invested in a QDIA;
- a description of investment objectives of the QDIA including risk and return characteristics, fees and expenses;
- an explanation of the right of participants and beneficiaries to direct investment of the assets out of the QDIA to any other investment option under the plan; and
- an explanation of where participants and beneficiaries can obtain information on the other investment options under the plan.
3. Effective Date. For existing default funds and QDIAs, compliance with the notice requirements may be achieved by providing notice in accordance with the regulation prior to December 24, 2007.