The Department of Labor has issued the long awaited final regulation implementing the provisions of the Pension Protection Act of 2006 (“PPA”) relating to a qualified default investment alternative (“QDIA”) in individual account plans, such as 401(k) plans. The final regulation shields fiduciaries of individual account plans from some of the liability associated with investing in default investment alternatives, provided the requirements of the QDIA regulation are met. The effective date of the regulation is December 24, 2007, and the new PPA rules apply to contributions made on or after that date.
PPA section 624(a) amended ERISA by adding Section 404(c)(5), under which a participant who has the opportunity to direct the investment of his or her account but does not provide investment directions, is treated as exercising control over his or her account, within the meaning of ERISA section 404(c)(1), with respect to assets that the plan invests in a QDIA.
The final regulation and its preamble respond to a number of issues and questions that had been raised after the DOL issued the proposed version of this regulation in September of 2006. There are a number of questions concerning the application of the regulation that remain open, and the DOL has indicated that it will issue additional guidance in the form of questions and answers. The final regulation also clarifies the application of the statutory preemption provision of new ERISA section 514(e) (also added by the PPA) to state laws that affect automatic enrollment plans.
Scope of Fiduciary Relief
The final regulation provides that, if its requirements are fulfilled, a fiduciary of an individual account plan that allows participants to direct the investment of assets in their accounts is not, in the absence of investment directions, liable for any loss, or by reason of any fiduciary breach, that is the direct and necessary result of investing all or part of a participant’s or beneficiary’s account in any QDIA. The regulation does not relieve fiduciaries from their duties to prudently select and monitor a QDIA or from liability resulting from a failure to satisfy these duties, including liability for any resulting losses.
While plan fiduciaries are not liable for the investment decisions made in connection with the management of a QDIA, any of the fiduciaries directly responsible for managing the assets of a QDIA are not relieved from their fiduciary duties under ERISA or from liability for failing to satisfy these duties.
The regulation does not provide relief from the prohibited transaction provisions of ERISA section 406 or from any liability for violating those provisions.
Plan Fiduciary’s Required Action
In order to for the fiduciary relief under the final QDIA regulation to apply, the following conditions must be met:
- A fiduciary must invest assets on behalf of participants or beneficiaries in a QDIA.
- The participants and beneficiaries whose accounts are invested in a QDIA must have had the opportunity to direct the investment of assets in their accounts but did not do so.
- Participants and beneficiaries must be provided with a specified form of notice at least 30 days in advance of the date of plan eligibility or in advance of the first investment in a QDIA. (A special rule for plans with immediate eligibility is discussed below.) The notice must also be provided within a reasonable period of time (at least 30 days) in advance of each subsequent plan year.
- A fiduciary must provide to participants and beneficiaries the material relating to their investments in a QDIA that is required to be provided under the DOL’s ERISA section 404(c) regulation.
- Participants and beneficiaries whose assets are invested in a QDIA must be able to transfer those assets, in whole or in part, to any other investment alternative available under the plan with a frequency that is the same as is allowed for participants who elected to invest in the QDIA option, but not less frequently than once within a three month period.
- A transfer out of a QDIA resulting from the participant’s election (or a permissible withdrawal under Section 414(w) of the Internal Revenue Code (“Code”)) within 90 days after the first elective contribution or first investment in the QDIA must not be subject to any restrictions, fees or expenses such as surrender charges or redemption fees, but ongoing investment fees and expenses, unrelated to the transfer out or the withdrawal, may be applied.
- The plan must offer a “broad range of investment alternatives” as defined by the DOL’s regulation under ERISA section 404(c).
The final regulation requires that a QDIA notice must be written in a manner calculated to be understood by the average plan participant and, in a change from the proposed regulation, the notice can be provided only in a separate notification, and not as part of the plan’s summary plan description or a summary of material modifications. The notice must contain the following information:
- A description of the circumstances under which assets in the individual account of a participant or beneficiary may be invested in a QDIA, and, if applicable, an explanation of when elective contributions may be made on behalf of a participant, the percentage of such contribution and the right of the participant to elect out of deferrals or change the percentage.
- An explanation of the rights of participants and beneficiaries to direct their account investments.
- A description of the QDIA, including a description of the investment objectives, risk and return characteristics (if applicable) and fees and expenses.
- A description of the right of participants and beneficiaries to direct investment of their QDIA assets to any other investment alternative under the plan, including a description of any fees or restrictions applicable to the transfer.
- An explanation of where participants and beneficiaries can obtain investment information concerning the other investment alternatives under the plan.
Qualified Default Investment Alternatives
The final regulation sets out requirements for a QDIA:
- The investment alternative must not hold or permit the acquisition of employer securities, with two exceptions. The first exception applies to securities held or acquired pursuant to the stated investment objectives of an investment company registered under the Investment Company Act of 1940 or a similar pooled investment vehicle regulated by a state or federal agency which is independent of the plan sponsor. The second exception is for managed accounts when employer securities were acquired as a matching contribution from the employer or plan sponsor or were acquired at the direction of the participant or beneficiary prior to the time the investment management service took over the management of the account, provided that the investment management service has discretionary control over disposition of the employer securities.
- A QDIA must comply with the limitations under the regulation on restrictions and fees that are applicable to the ability of a participant or beneficiary to transfer his or her QDIA investment to any other investment alternative under the plan.
- A QDIA must be an investment company registered under the Investment Company Act of 1940 or a capital preservation product to the extent described below, or be managed by an investment manager as defined in Section 3(38) of ERISA, a trustee of the plan that meets certain Section 3(38) requirements, or the plan sponsor who is a named fiduciary under ERISA.
Permissible QDIA Types of Investment Products
The QDIA must constitute one of the four types of investment products described below.
- A life-cycle or targeted-retirement-date fund product or model portfolio that is diversified and is designed to provide varying degrees of long-term appreciation and capital preservation through a mix of equity and fixed income exposures based on the participant’s age, target retirement date or life expectancy. These products and portfolios change their asset allocations and risk levels over time to become more conservative with increasing age. Asset allocation decisions under this type of alternative are not required to take into account an individual participant’s risk tolerances, other investments or other preferences.
- A balanced fund product or model portfolio that is diversified and is designed to provide longterm appreciation and capital preservation through a mix of equity and fixed income exposures consistent with a target level of risk appropriate to the plan participants as a whole. Asset allocation decisions under this type of alternative are not required to take into account an individual participant’s age, risk tolerances, other investments or other preferences.
- A managed account that is diversified and with respect to which a certain type of fiduciary allocates assets of a participant’s account to achieve varying degrees of long-term appreciation and capital preservation through a mix of equity and fixed income exposures. Using investment alternatives available under the plan, these allocations are based on the participant’s age, target retirement date or life expectancy; the asset allocations and risk levels change over time to become more conservative with increasing age. The asset allocation of a managed account is not required to consider an individual participant’s risk tolerances, other investments or other preferences.
- For not more than 120 days after a participant’s first elective contribution (as determined under Code section 414(w)) an investment product or fund, such as a stable value product or money market fund, designed to preserve principal and provide a reasonable rate of return, consistent with liquidity. Such an investment product must seek to maintain, but does not have to guarantee, a dollar value equal to the amount invested and must be offered by a state or federally regulated financial institution. At the end of the 120 day period, this alternative ceases to be a QDIA and the plan fiduciary must redirect the participant’s investment in such a capital preservation product to another type of QDIA in order to continue to rely on the fiduciary relief provided under the regulation.
The final regulation also provides a grandfathered QDIA treatment for default amounts invested in a stable value fund or product before December 24, 2007, the effective date of the final regulation.
Highlights, Clarifications and Transition Issues
- The preamble and the final regulation state that the fiduciary relief provided by ERISA section 404(c)(5) and the regulation can apply to any participant directed individual account plan that meets the requirements and is not dependent on a plan meeting the requirements of Section 404(c) in general.
- The final regulation states that the standards in the regulation are not the exclusive means by which the ERISA fiduciary rules can be met with respect to the investment of assets in an individual account plan where a participant or beneficiary fails to give investment direction.
- The DOL notes in the preamble that investments in money market funds, stable value products and other capital preservation vehicles may be prudent for some participants or beneficiaries, even though they do not qualify as QDIAs.
- The preamble also clarifies that, while stable value products, money market funds and other capital preservation vehicles may not (subject to the exceptions in the final regulations) be QDIAs in themselves, they can be part of the investment portfolio of a QDIA, such as a balanced fund or target date fund.
- The preamble and the final regulation clarify that the fiduciary relief provided under the regulation is available if a fiduciary selects any of the types of QDIAs available under the regulation as long as the particular QDIA product or service is prudently selected and the requirements of the regulation are met. Thus, a fiduciary is not subject to second guessing as to which of the various types of QDIA is most appropriate for a particular participant or plan population.
- In choosing a balanced fund QDIA, the preamble states that the selecting fiduciary must consider the age of the plan population in determining a target level of risk appropriate for participants of the plan as a whole.
- The preamble states that a fiduciary, in selecting a specific QDIA product or service, must engage in an objective and thorough analysis of competing vendors and products and must consider the applicable investment fees and other expenses.
- The preamble clarifies that the fiduciary relief available under the regulation will apply, as long as the requirements of the regulation have been satisfied, whenever a participant or beneficiary has the opportunity to direct the investment of his or her account but does not do so. Situations where the regulation can apply, in addition to automatic enrollment, include a failure to provide investment direction after the elimination of an investment alternative or change in a service provider, or after a rollover into the plan.
- No relief is available under the regulation where a participant or beneficiary has provided affirmative investment directions concerning the assets invested on his or her behalf.
- The preamble states that if the required notice is not provided at least 30 days in advance of plan eligibility, the fiduciary can still obtain relief for later contributions once the advance notice requirement is met.
- While the final QDIA regulation requires a separate notice for QDIA purposes, the DOL states in the preamble that the QDIA notice can be combined with notices required under the Code for automatic contribution arrangements. On November 15, the Internal Revenue Service issued a sample notice that plan sponsors may use to inform participants about their rights and obligations under automatic contribution arrangements. The sample notice also includes language for QDIA notice purposes.
- For 401(k) plans with immediate eligibility, the final regulation was revised to state that the required notice can be provided on or before the date of plan eligibility, provided that the participant has an opportunity to make a permissible withdrawal under Code section 414(w). That Code section applies to eligible automatic contribution arrangements under the Code and allows for participants to opt out of automatic enrollment and receive a distribution from the plan of their deferral contribution within 90 days after the first elective contribution under the arrangement.
- The preamble states that restrictions and fees are not permitted on transfers or withdrawals out of a QDIA when the election is made during the initial 90 day period, even if the actual transfer or withdrawal takes place after the 90 day period due to administrative or other delays.
- The final regulation provides that, after the 90 day period during which restrictions and fees are not permitted on transfers or withdrawals out of a QDIA, the restrictions and fees on such a transfer or withdrawal must not exceed those applicable to a participant who elected to invest in the QDIA option.
- The preamble states that an investment direction by a participant as to a portion of his or her account may be treated as a decision to retain the remainder of the account as currently invested, so that the entire account balance can be considered as having been directed by the participant.
- The preamble states that plans that wish to use electronic means to satisfy the QDIA notice requirement under the regulation may rely on existing DOL and IRS guidance on electronic disclosures.
- The DOL broadened the notice requirements under the final regulation to include disclosures about any automatic contribution arrangements applicable under a plan so that the form of notice required under the regulation would satisfy both the QDIA requirements and the ERISA section 514(e) notice required for preemption of state laws restricting automatic contribution arrangements, as discussed below.
- Although there are exceptions under the regulation for the holding of employer securities in a managed account QDIA, the preamble states that a managed account will not be a QDIA if it acquires employer securities for an account, except as part of an investment company or similar pooled investment vehicle. A QDIA managed account may reduce the amount of employer securities held in an account.
- If an investment management service does not have investment discretion over employer securities held in a managed account, such as shares acquired as matching contributions that are subject to transferability restrictions, that account will not be a QDIA managed account as to those employer securities.
- In response to comments received, the DOL revised the final regulation to allow plan sponsors who serve as named fiduciaries to directly manage their QDIAs in light of the potential cost savings to participants.
- The final regulation provides that an investment product or model portfolio does not fail to be a target date or balanced fund QDIA solely because it is offered through a variable annuity contract or through common or collective trust funds or pooled investment funds, and that such vehicles can provide annuity purchase rights or other ancillary features.
- The preamble states that a QDIA can have more than one fiduciary responsible for the investment management decisions, such as in a fund of funds arrangement.
- The preamble states that the DOL believes a QDIA should include some level of capital preservation through fixed income investments and that funds that have no fixed income exposure will not qualify as QDIAs.
- The preamble provides guidance on transition issues including the treatment as a QDIA of a current default investment that meets the requirements of the final QDIA regulation, and the transfer of a current non-QDIA default investment into a QDIA. The preamble notes that many plans don’t have the historical information needed to determine which participants were defaulted into the fund that was designated as the current default fund as opposed to those who affirmatively elected to be in that fund. The preamble accordingly states that, with proper notice under the regulation and assuming participants do not elect otherwise, all participants invested in the original default investment vehicle can be transferred into a new QDIA and the plan fiduciaries will receive the protection of the regulation as to all such participants. The same rule, as to fiduciary protection under the regulation after proper notice and no election otherwise, applies to a current default option that qualifies as a QDIA under the final regulation.ERISA Preemption
The PPA added new ERISA section 514(e) which provides that ERISA supersedes any state law which would directly or indirectly prohibit or restrict the inclusion of an “automatic contribution arrangement” in a plan. The PPA defines an “automatic contribution arrangement” as an arrangement under which:
- a participant may elect to have the plan sponsor make payments as contributions under the plan on behalf of the participant, or to the participant directly in cash;
- a participant is treated as having elected to have the plan sponsor make elective contributions in an amount equal to a uniform percentage of compensation provided under the plan until the participant specifically elects not to have elective contributions made (or specifically elects to have them made at a different percentage); and
- contributions are invested in accordance with the DOL QDIA regulation.
The DOL was given authority by the PPA to issue regulations setting standards that automatic contributions arrangements would be required to satisfy in order for the preemption rule to apply, but preemption was not addressed in the proposed QDIA regulations. The final QDIA regulation does cover preemption and takes a broad approach to ERISA preemption as to automatic contribution plans. The final regulation provides that a state law that would prohibit or restrict an automatic contribution arrangement from being included in a plan is superseded regardless of whether the plan meets the PPA definition of an automatic contribution arrangement as set out above. The final regulation also makes clear that the availability of preemption for an automatic contribution arrangement is not restricted to plans that comply with the QDIA rules. The QDIA final regulation further provides that a notice that meets the QDIA requirements also satisfies the notice requirement of ERISA Section 514(e)(3) for preemption purposes, but that this rule is limited to automatic contribution arrangements that meet the PPA definition of an automatic contribution arrangement as set out above.
The PPA provision on QDIAs and the final DOL regulation provide clear rules in an area of long-standing uncertainty as to fiduciary responsibility under ERISA with respect to 401(k) plans. In conjunction with the PPA changes under the Code designed to facilitate the use of automatic enrollment, and the broad preemption of state laws that could hinder automatic contribution plans, the QDIA rules will contribute to greater retirement income security through higher participation rates in 401(k) plans and improved investment results for many participants who do not wish to direct their own plan investments.