In Part I of this article, we focused on the various types of automatic contribution arrangements that an employer may adopt to encourage wider employee participation in its retirement plans, as well as employer incentives for adopting these arrangements. In this Part II of the article, we will explore the method of investing these automatic contributions in the absence of participant investment instructions, while obtaining fiduciary relief to protect plan sponsors (and other plan fiduciaries) from liability for losses suffered by the plan accounts invested in the default funds.
The Pension Protection Act of 2006 (the "PPA") added new ERISA Section 404(c)(5), which enables plan fiduciaries to limit their liability for the investment of participant accounts when participants fail to provide investment instructions. On October 24, 2007, the US Department of Labor (the "DOL") released final regulations that provide some liability relief to fiduciaries that select qualifying default investments in the absence of participant investment instructions ("qualified default investment alternatives" or "QDIAs"). On April 29, 2008, the DOL issued additional guidance that corrects some provisions of the final QDIA regulations and clarifies other provisions.
1. What is a QDIA?
Some 401(k) plans (as well as 457(b) and 403(b) arrangements) may have an automatic enrollment feature (also referred to as an "automatic contribution arrangement" or an "ACA"). If a plan has an ACA, the default elective deferral for those employees who enter the plan without affirmatively opting to participate is an elective contribution at a pre-determined level. Since the participant will have failed to have made an affirmative election to contribute to the plan, such participant probably will not have elected how the automatic contributions should be invested. In such a case, the plan sponsor must determine a default investment for those contributions. However, default investments raise fiduciary and liability concerns. Provided that the requirements of a QDIA are met, a participant would be treated as exercising control with respect to the contributions and earnings thereon, thereby relieving the fiduciary from the investment risk to the extent the fiduciary prudently selects and monitors the QDIA.
2. What are the fiduciary concerns regarding default investments?
Among other concerns prior to the enactment of the PPA, many plan sponsors were worried that they could be held responsible for investment losses suffered by plan accounts invested in the default funds and were reluctant to adopt ACAs. Plan fiduciaries were unable to receive any protection under ERISA Section 404(c), which only relieves fiduciaries from responsibility for participant investment decisions if the participant actually exercises control. Without Section 404(c) protection, fiduciaries are left personally at risk for losses suffered by participants for the default investment if it was determined that the default investment was imprudent. When Congress sought to encourage ACAs as a way to boost retirement savings, the fiduciary liability concerns were one of the problems that had to be resolved. The PPA alleviates this concern by amending ERISA Section 404(c) to add Section 404(c)(5). If the requirements of Section 404(c)(5) are met, a participant would be treated as exercising control with respect to the automatic contributions and earnings thereon.
Note that it is not clear that every situation in which specific investments were not expressly designated necessarily leads to a QDIA-type situation. The preamble to the final Section 404(c) regulations released in 1992 states that a "participant will be considered to have given affirmative instruction where the participant or beneficiary signs an instruction form specifying how assets in his account will be invested if he has exercised independent control within the meaning of [the applicable regulations] with respect to such signature." Thus, with proper drafting, a participant's execution and submission of a form could effect an affirmative election of a particular investment (in which case the QDIA regime might not apply) even without the participant's filling in a blank, making a checkmark or other selection. (This approach would not be possible in the case of automatic contribution plans and other plans in which no forms of any kind are submitted by participants or beneficiaries.)
3. What is the nature of the fiduciary relief provided by the PPA?
Plan sponsors are relieved from any liability for the decision to place assets in the default investment, provided the plan sponsor permits participants to direct the investment of assets in their accounts and satisfies all other requirements to obtain fiduciary relief (as discussed in Q&A-4 below). However, there is no relief from the fiduciary duties associated with selecting the QDIA. There is also no relief from the obligation to monitor the QDIA's performance and to change the QDIA investment if that performance is inadequate. If the QDIA is managed by plan fiduciaries, as opposed to being invested in a mutual fund or some other investment that is managed by non-fiduciaries, the plan fiduciaries will remain fully responsible for the prudent performance of that investment. Note, however, if the plan fiduciaries do not manage the QDIA, that the plan fiduciaries will not be responsible for investment decisions made by the entity managing the QDIA.
4. What are the conditions for obtaining fiduciary relief under ERISA Section 404(c)(5)?
ERISA Section 404(c)(5) fiduciary relief is conditioned upon the satisfaction of six requirements: (1) assets invested on behalf of the participants must be invested in a QDIA
(2) the participant on whose behalf assets are being invested in a QDIA must have been given the opportunity to direct the investment of assets in his or her account, but failed to do so
(3) the participant must be furnished with a notice regarding the QDIA
(4) a fiduciary must provide to a participant any material relating to the participant's investment in a QDIA (e.g., prospectuses, proxy voting materials)
(5) a participant must be given the ability to change the investment consistent with the opportunity given to other plan investors, but at least quarterly
(6) the plan must offer a "broad range of investment alternatives."
5. What are the types of investments that qualify for QDIA status?
The PPA requires the DOL to provide guidance on designating default investments that "include a mix of asset classes consistent with capital preservation or long-term capital appreciation, or a blend of both." In general, the DOL precludes a QDIA from holding or acquiring employer securities. The DOL's list of qualifying investments consists of three categories: long-term QDIAs, short-term QDIAs and grandfathered QDIAs.
(a) What are the long-term QDIAs?
Long-term QDIAs consist of three choices:
(1) "Life cycle" or "targeted-retirement-date" portfolios — investment fund products or model portfolios that provide a changing mix of assets based on a participant's age, target retirement date or life expectancy. The DOL does not require a participant's risk tolerance or individual preferences to be taken into account.
(2) "Balanced" funds — investment fund products or model portfolios that provide a mix of equity and fixed income assets that are appropriate for participants of the plan as a whole. The DOL does not require a participant's age to be taken into account if the focus is on the demographics of the participant population as a whole.
(3) "Managed accounts" — investment management services that provide a changing mix of assets based on a participant's age, target retirement date or life expectancy. The DOL does not require a participant's risk tolerance or individual preferences to be taken into account.
Notably, the appropriate target level of risk under the life cycle and managed account options is determined by a participant's age, target retirement or life expectancy; while under the balanced option, the appropriate target level of risk is determined with respect to participants in the plan as a whole.
(b) What are the "short-term QDIAs"?
"Short-term QDIAs" are capital preservation investments that seek to maintain a dollar value that is equal to the amount invested, provide a reasonable rate of return and are offered by a state or federally regulated financial institution. The short-term QDIA is a default into a capital preservation investment for not more than 120 days after the date of the first elective contribution for the defaulted participant. After the 120-day period, the plan sponsor must transfer the participant's account to one of the three long-term QDIAs in order to continue to satisfy the fiduciary safe harbor.
(c) What is a "grandfathered QDIA"?
A grandfathered QDIA is an asset invested in stable value investment products or funds before December 24, 2007. Such investment products or funds invest primarily in investment products that are backed by state or federally regulated financial institutions, which are designed to preserve principal, provide a rate of return generally consistent with intermediate investment grade bonds and provide liquidity for withdrawals by participants (including transfers to other investment alternatives). However, the plan sponsor must invest contributions made after December 23, 2007 for these participants in one of the three long-term QDIAs in order to continue to satisfy the fiduciary safe harbor. Thus, in many cases, the grandfathered alternative may be of little or no practical use.
6. What happens if participants are given the opportunity to change investments and fail to do so?
To obtain fiduciary relief under ERISA Section 404(c)(5), participants must have been given an opportunity to provide investment directions and failed to have done so. If the participant affirmatively provides investment instructions, then the QDIA fiduciary relief is no longer available. Instead, plan fiduciaries may receive protection under ERISA Section 404(c), which relieves fiduciaries from responsibility for participant investment decisions if the participant actually exercises control.
7.What are the notice requirements regarding QDIAs?
Written notice, containing information outlined in the DOL regulations, must be timely furnished to the participants in order to obtain the benefit of fiduciary relief.
(a) What information needs to be contained in the notice?
The notice must include the following items:
- a description of the circumstances in which assets will be invested in the QDIA
- if applicable, an explanation of the circumstances in which automatic contributions will be made on behalf of a participant, the percentage of such contributions and the participant's right to change or cancel such contributions
- an explanation of the right of participants to direct the investment of the assets in their accounts to any other investment alternative under the plan, including a description of any applicable restrictions, fees or expenses in connection with such transfer
- an explanation of where to obtain additional investment information
(b) When does notice need to be given?
Plan sponsors must furnish participants with an initial notice and annual notices.
- The initial notice must be given to eligible participants at least 30 days before the date of plan eligibility (or at least 30 days before any first investment in the QDIA). In the case of an eligible automatic contribution arrangement, in which the participant is given the opportunity to withdraw the automatic contributions within a 90-day window (an "EACA", as discussed in the prior article), the initial notice may be provided on or before the date of plan eligibility.
- Annual notice must be given to participants within a reasonable period of time of at least 30 days in advance of each subsequent year.
(c) Can the automatic contribution arrangement notice be combined with the QDIA notice in a single disclosure?
Yes. As discussed in Part I of this article, the eligible automatic contributions arrangements ("EACAs") and qualified automatic contribution arrangements ("QACAs") also contain notice requirement rules imposed by the tax regulations. In its April 2008 guidance, the DOL allows plan sponsors to combine the separate notice disclosures in a single disclosure document. For plan sponsors that wish to combine these notices, the DOL coordinated with the US Department of the Treasury (the "Treasury") and the Internal Revenue Service (the "IRS") to provide a sample notice that may be used to help a plan sponsor satisfy the content requirements of these notices. Although the timing provisions for these notices are not identical, plan sponsors can easily satisfy the QDIA regulations and the tax regulations if a notice is provided at least 30 days (and not more than 90 days) before the participant's eligibility date or the beginning of each year.
(d) Are plan sponsors permitted to use an electronic means of satisfying their notice requirements?
Yes. Plan sponsors that wish to use electronic means to satisfy their notice requirements may rely on either guidance issued by the DOL or guidance issued by the Treasury and the IRS.
8. What materials must be furnished to a participant relating to his or her investment in a QDIA?
In order to provide an opportunity for a participant to exercise control over assets in his or her individual account, a fiduciary identified by a plan must provide the participant with a copy of the most recent prospectus of the investment and any materials provided to the plan relating to the exercise of voting, tender or similar rights (to the extent that such rights are passed through to participants). In addition, the fiduciary identified by the plan must either directly or upon request provide the latest information available regarding the designated investment alternative, which generally includes: the annual operating expenses (e.g., investment management fees, administrative fees, transaction costs); copies of any prospectuses, financial statements and reports, to the extent such information is provided to the plan; a list of the assets comprising the portfolio; information concerning the value of shares or units, as well as the past and current investment performance and the value of the shares or units held in the participant's account.
9. Must participants in a QDIA be given the ability to change the investment?
Yes. Participants must have the opportunity to reinvest in other assets at least as frequently as participants who affirmatively elected to invest in the QDIA. At a minimum that opportunity has to be presented at least quarterly.
The DOL's April 2008 guidance provides that if a participant elects a transfer or a permissible withdrawal during the 90-day period, beginning on the date of the participant's first investment in the QDIA, that transfer or withdrawal cannot be subject to any restrictions, fees, or expenses such as surrender charges, exchange fees or redemption fees. This "no financial penalty" rule does not restrict the application of fees and expenses such as investment management fees and "12b-1" fees that are charged on an ongoing basis.
10. How does a plan satisfy the requirement to offer a "broad range of investment alternatives"?
A plan must provide a participant an opportunity to choose, from a broad range of investment alternatives, the manner in which some or all of the assets in his or her account are invested. In general, a plan offers a broad range of investment alternatives if the available investment alternatives (i) are sufficient to provide the participant with a reasonable opportunity to choose from at least three investment alternatives, each of which is diversified; (ii) have materially different risk and return characteristics; (iii) in the aggregate, enable the participant to achieve a portfolio with aggregate risk and return characteristics at any point within the range normally appropriate for the participant and (iv) when combined with investments in other alternatives, tends to minimize through diversification, the overall risk of a participant's portfolio.
11. Is compliance with the QDIA regulations the exclusive means to obtain fiduciary protection?
No. The standards set forth in the QDIA regulations are not intended to be the exclusive means by which a fiduciary might satisfy responsibilities with respect to the investment of assets in the individual account of a participant. Accordingly, a fiduciary may select a non-QDIA default investment, provided that such investment choice is prudent, as determined in accordance with the standards of care set forth under ERISA Section 404(a). Notably, on July 23, 2008, the DOL issued proposed regulations that apply to the general prudence rules of ERISA Section 404(a).