(From the December 11, 2006 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)
IRS Guidance on New Employer Stock Diversification Requirements
The IRS recently issued Notice 2006-107 to provide transitional guidance on the PPA's new diversification requirements for individual account plans that offer the plan sponsor's publicly traded stock as an investment option. The notice clarifies certain issues relating to the diversification requirements and provides limited transition relief relating to some of these requirements. Additionally, Notice 2006-107 provides that plans do not have to provide a notice of diversification rights to participants before January 1, 2007.
The PPA added IRC § 401(a)(35) and ERISA § 204(j) to guarantee participants in certain defined contribution plans the right to divest their holdings in the plan sponsor's publicly traded stock. Additionally, the PPA added a new ERISA § 101(m) to require these plans to give participants notice of their diversification rights and information about the importance of diversifying investments. These diversification and notice requirements generally are effective for plan years beginning after December 31, 2006. The IRS and Treasury plan to issue regulations under IRC § 401(a)(35) sometime in the future. In the interim, Notice 2006-107 provides transitional guidance and a model disclosure notice plans can use to satisfy ERISA § 101(m).
The PPA provides a special transition rule for employer securities acquired in plan years beginning before January 1, 2007. For those shares the diversification rules will be phased in over a three-year period. Additionally, if a plan holds more than one class of employer securities, the transition rule applies separately with respect to each class. However, the transition rule does not apply with respect to a participant who, before the first plan year beginning after December 31, 2005, had attained age 55 and completed at least three years of service.
Overview of Diversification Requirements
Basically, IRC § 401(a)(35) requires defined contribution plans (other than certain ESOPs) that hold publicly traded employer securities to permit participants to divest employer stock holdings attributable to elective deferrals and employee contributions at any time, and to divest employer stock holdings attributable to elective deferrals after completing three years of service. Participants must be able to exercise their diversification rights at least quarterly. According to Notice 2006-107, a participant completes three years of service immediately after the end of the plan's third vesting computation period pursuant to IRC § 411(a)(5). If the plan uses the elapsed time method for crediting service for vesting purposes, or provides for immediate vesting, then a participant completes three years of service on the third anniversary of his or her date of hire.
In order to satisfy the diversification requirements, a plan must have at least three other investment options -- other than employer securities -- for participants. Each of these three options must be diversified and have materially different risk and return characteristics. Also, plans generally may not impose restrictions or conditions with respect to the investment or employer securities that are not imposed on other plan investment options. According to the notice, restrictions or conditions on employer securities include:
Thus, the notice identifies the following as "prohibited restrictions or conditions":
Permitted Restrictions or Conditions
Certain restrictions or conditions are allowed, so long as they do not take into account a prior exercise of rights to divest employer securities. Examples include plan-imposed limits on the extent to which individuals can invest their accounts in employer securities and provisions closing an employer securities investment fund to new investments. However, a provision preventing participants from reinvesting in employer securities for a period of time after exercising their diversification rights is prohibited because it takes into account the participant's prior exercise of diversification rights.
Additionally, the PPA permits restrictions required by, or reasonably designed to comply with, securities laws. For example, the notice provides plans may limit divestiture rights for participants subject to the Securities Exchange Act of 1934 to a period (such as 3 to 12 days) following publication of the plan sponsor's quarterly earnings statements in order to ensure compliance Securities Exchange Commission (SEC) Rule 10b-5. Also, plans may restrict the application of otherwise applicable diversification rights for up to 90 days following an initial public offering of the plan sponsor's stock. And plans may impose fees on other investment options that do not apply to the employer stock investment option.
Transition Rules Relating to Prohibited Restrictions or Conditions
As noted, the new diversification requirements generally apply to plan years beginning after December 31, 2006. However, Notice 2006-107 provides special transition relief with respect to certain rules. Specifically, the notice states a plan can continue to impose restrictions on diversifying employer securities that are in effect on December 18, 2006, until March 30, 2007. But these restrictions may not continue to be imposed on or after March 31, 2007 unless they are otherwise consistent with the diversification requirements.
Additionally, the notice provides plans do not violate the new diversification requirements merely because, as in effect on December 18, 2006, they (1) do not impose an otherwise applicable restriction on a stable value fund, or (2) allow participants the right to divest employer securities on a periodic basis, but permit divestiture of another investment that is not generally available (e.g., an investment that is only available to a fixed class of investments) on a more frequent basis. This transition relief is available only through December 31, 2007.
As discussed, the PPA also created a new ERISA § 101(m) to require plans to give participants notice of their diversification rights. This notice must be provided no more than 30 days before the first date the participant is eligible to exercise his or her diversification rights. In addition to setting forth the participant's diversification rights, the notice must describe the importance of diversifying the investment of retirement account assets.
Like the new diversification requirements, the diversification notice requirement is effective for plan years beginning after December 31, 2006. However, Notice 2006-107 states the Department of Labor has advised the IRS that ERISA § 101(m) does not require plans to furnish the diversification notice before January 1, 2007. Thus, calendar year plans can furnish the diversification notice to participants on January 1, 2007 without violating the 30-day requirement discussed above. However, the Department of Labor is encouraging plans to furnish the diversification notice on the "earliest possible date."
In order to facilitate compliance with the diversification notice requirement, the PPA directs the Treasury Department to prescribe a model diversification notice. Notice 2006-107 includes a model notice, which is reproduced below. However plans may have to adapt the notice to their particular provisions. For example, changes to the model notice are needed if the plan has more than one class of employer securities, the plan provides the same diversification rights for participants regardless of whether they have three years of service, some of the plan's investment options are closed, the plan receives participant elections electronically, or the plan is taking advantage of the three-year transition rule for employer securities acquired in plan years beginning before January 1, 2007.
Model Notice is below:
Notice of Your Rights Concerning
This notice informs you of an important change in Federal law that provides specific rights concerning investments in employer securities (company stock). Because you may now or in the future have investments in company stock under the [insert name of plan], you should take the time to read this notice carefully.
Your Rights Concerning Employer Securities
For plan years beginning after December 31, 2006, the Plan must allow you to elect to move any portion of your account that is invested in company stock from that investment into other investment alternatives under the Plan. This right extends to all of the company stock held under the Plan, except that it does not apply to your account balance attributable to [identify any accounts to which the rights apply only after three years of service] until you have three years of service. [Insert description of any advance notice requirement before a diversification election becomes effective.] You may contact the person identified below for specific information regarding this new right, including how to make this election. In deciding whether to exercise this right, you will want to give careful consideration to the information below that describes the importance of diversification. All of the investment options under the Plan are available to you if you decide to diversify out of company stock.
The Importance of Diversifying Your Retirement Savings
To help achieve long-term retirement security, you should give careful consideration to the benefits of a well-balanced and diversified investment portfolio. Spreading your assets among different types of investments can help you achieve a favorable rate of return, while minimizing your overall risk of losing money. This is because market or other economic conditions that cause one category of assets, or one particular security, to perform very well often cause another asset category, or another particular security, to perform poorly. If you invest more than 20% of your retirement savings in any one company or industry, your savings may not be properly diversified. Although diversification is not a guarantee against loss, it is an effective strategy to help you manage investment risk.
In deciding how to invest your retirement savings, you should take into account all of your assets, including any retirement savings outside of the Plan. No single approach is right for everyone because, among other factors, individuals have different financial goals, different time horizons for meeting their goals, and different tolerances for risk. Therefore, you should carefully consider the rights described in this notice and how these rights affect the amount of money that you invest in company stock through the Plan.
It is also important to periodically review your investment portfolio, your investment objectives, and the investment options under the Plan to help ensure that your retirement savings will meet your retirement goals.
For More Information
If you have any questions about your rights under this new law, including how to make this election, contact [enter name and contact information].
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