Introduction

Qualified plans generally cannot distribute a benefit prior to normal retirement age without the participant’s consent. However, the law permits a plan to provide for an automatic distribution, or “cash-out,” to a participant who terminates employment with a benefit valued at $5,000 or less.

Many plans provide for these automatic cash-outs to avoid administering the small accounts of those no longer employed by the plan sponsor. Although the participant has the right to rollover the distribution to an IRA or another qualified plan, the perception in Congress, and in the benefits community as well, is that many if not most participants fail to rollover these relatively small amounts. This in turn causes “leakage” in the system — that is, retirement savings are depleted through the distribution of small cash-outs from qualified plans.

In order to help stem this leakage, Congress enacted a requirement that involuntary cash-outs in excess of $1,000 be mandatorily rolled over to an Individual Retirement Account (“IRA”) unless the participant affirmatively elects otherwise. This is part of the Economic Growth and Tax Relief Reconciliation Act of 2001, commonly referred to as EGTRRA.

Recognizing that plan sponsors and the IRA custodian community required more guidance to administer automatic IRA rollovers, Congress provided that the mandatory rollover provision would not be effective until the Department of Labor (“DOL”) issued regulations interpreting and applying the new rule. In response, the DOL recently published its proposed regulations on the automatic rollover provisions after receiving comments on the statutory change from the public. Many of the comments expressed concern about the need for safe harbor standards to protect plan sponsors against claims of fiduciary breach and to give confidence as well to the IRA custody community in accepting such rollovers. It appears that these proposed regulations provide much of the necessary guidance and comfort to be able to administer the automatic rollover provisions.

Of course, plans do not have to provide for mandatory cash-outs of small amounts and plans can also be amended to remove the automatic cash-out rules without violating the Internal Revenue Code (“Code”) prohibitions on reducing or terminating certain rights to benefits. In any event, the regulations are scheduled to be finalized by July with an effective date six months after publication. It is therefore probable that the regulations will be in force by the beginning of 2005 and that plans will then have to comply with the mandatory rollover rules. The following is a brief discussion of the proposed regulations.

Mandatory Rollovers

EGTRRA amended Section 401(a)(31) of the Code, the section which deals with direct transfers of rollover distributions, to include a requirement for a mandatory rollover to an IRA where an amount in excess of $1,000 but no more than $5,000 is to be distributed without the participant’s consent. In such a case, unless the participant makes an affirmative election for a rollover to his or her own IRA or another qualified plan, or elects to take the distribution directly, the Plan must rollover the amount to an individual retirement plan. The plan can be either an individual retirement account or an individual retirement annuity (both referred to in this article as IRAs).

A plan sponsor will only be able to avoid the mandatory rollover rules if the plan does not provide for automatic cash-outs or if the plan’s threshold for automatic cash-outs is less than $1,000. (Cash-outs of amounts of $1,000 or less are not subject to the new rules.) Further, since the rule is limited to the immediate distribution requirements, providing for mandatory distribution at normal retirement age will not implicate the new small cash-out rollover rule.

Safe Harbor for Mandatory Rollovers

The proposed regulation provides for a safe harbor that if satisfied will protect plan fiduciaries from claims of breach of fiduciary duties in complying with the mandatory rollover rules. The DOL indicates that the safe harbor is not the exclusive means of satisfying both fiduciary duties and the rollover rule, but we assume that most fiduciaries will seek to comply with the safe harbor.

There are five components of the safe harbor:

• Compliance with cash-out rules.
  The plan must comply with the rules for determining whether an amount is eligible for a mandatory cash-out — that is, the valuation and other rules for cash-outs under Code section 411(a)(11) must be satisfied. If a distribution of more than $5,000 is inadvertently rolled over to an IRA without the participant’s consent, the safe harbor will not apply. An exception is made for amounts in excess of $5,000 attributable to a prior rollover. These amounts may be cashed out and will be subject to the mandatory rollover rule. It appears that a distribution of less than $1,000 would not be subject to the mandatory rule and in turn the safe harbor would not protect a fiduciary where such an amount is transferred by the plan to an IRA without the participant’s consent.
• Plans to which amounts may be rolled over.
  The rollover vehicle must be an IRA; it cannot be a qualified plan.
• Permissible investments.
  The IRA must invest the rolled over amounts in investments designed to preserve principal while providing for a “reasonable” rate of return, presumably based on the expected returns for an investment which emphasizes preservation of principal.

  The investment need not be guaranteed but must seek to maintain a “stable value.” Specifically mentioned in the DOL’s preamble to the proposed regulation are money market funds, savings accounts, certificates of deposit and certain stable value products. Liquidity is required, we assume, because a participant must be allowed to remove IRA assets at any time, and this would appear to preclude GIC contracts that are not benefit sensitive.

  Any entity allowed under the IRA rules to hold IRA assets may receive a rollover under the safe harbor. But only products offered by banks, credit unions, licensed insurance companies and registered mutual funds may be used for the IRA investments.

• Fees that may be charged.
  There are two components of this part of the regulation. First, the IRA fees must not exceed the fees charged by the institution for comparable IRAs established for rollover distributions. This should allow an institution to charge proportionately more for mandatory rollover accounts where it has a tiered fee schedule based on the size of the IRA.

  The second requirement is potentially more troubling. The fees must not exceed the amount of the earnings on the account at any given time, except for any start up charges. This limitation can cause a loss of fees in a given case where the earnings due to the small size of the IRA and current interest rates are quite low. The IRA community will undoubtedly weigh in on this point in hopes that the DOL modifies this part of the safe harbor before it becomes final.

• Notice requirements.
  Participants must be given information, in either a summary plan description or material modification, describing the types of investments that will compose the IRA and how fees will be charged and allocated under the IRA. Apparently, the proposed regulation does not require the amount or rate of the fees to be disclosed in these documents, presumably because the fees will change from time to time and from institution to institution. The participants also must be informed of the person to contact to obtain more information about the investment of the mandatory rollover, including specific fee and provider information.

Protections and Implementation

Most importantly, the regulation clearly states that the plan fiduciary will not be responsible for either the selection of the IRA custodian or the products in which the amounts are invested, so long as the safe harbor is satisfied. An exception is provided if the rollover constitutes a prohibited transaction, for example, where the fiduciary receives something of value for using a particular institution or product. Contemporaneously with the publication of the proposed regulation, the DOL has issued a proposed class exemption which would allow plan sponsors to use their own IRA custodial services and products for mandatory rollovers from their plans.

With the safe harbor, there do not seem to be significant obstacles to continuing mandatory cash-outs and satisfying the safe harbor rules. It can actually make it easier for plan sponsors to cash-out small amounts, for example where a participant cannot be located or refuses to acknowledge receipt of distribution information. Now the sponsor will be able to rollover these amounts into an IRA and be rid of the small account, with assurances that there will not be liability for the transfer.

We have assumed that IRA custodians will respond by accepting these rollover amounts without the signature of the participant. In the past, most custodians have been reluctant to do so. Hopefully affected agencies, such as the SEC and the banking regulatory agencies, will establish guidelines so that institutions may accept these amounts with assurance of compliance with applicable regulations.

Implementation will require plan amendments to reflect the mandatory rollover rules, if the plan is to provide for mandatory cash-outs of small amounts. Some plans may already have been amended under EGTRRA in such a way as to anticipate adoption of the regulations which would trigger the new rollover rule. Any plans which seek to satisfy the rules will have to provide, in any event, notice provisions about the new rules and will have to revise rollover forms to describe and accommodate the new rules.

Effective Date

The mandatory rollover rules are to become effective six months after publication of the final regulations. As previously indicated, the DOL has said it is targeting June for finalization and if this time table is adhered to, the rules will go into effect as of 2005.