Guest Article

(From the November 5, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

A Closer Look at the DOL's Final Regulations on QDIAs

The Department of Labor's Employee Benefits Security Administration (EBSA) has published final regulations on "qualified default investment alternatives" (QDIAs). 72 FR 60452 (October 24, 2007). The QDIA rules are the result of one of several provisions in the Pension Protection Act (PPA) of 2006 (P.L. 109-280) intended to encourage sponsors of 401(k) and other individual account plans to implement automatic enrollment arrangements. The goal of automatic enrollment is to increase plan participation -- and thus retirement savings -- by forcing employees to opt-out of plans rather than opting in.

Background on PPA Provisions Relating to Automatic Enrollment

One of the significant impediments to automatic enrollment for some 401(k) plan sponsors has been concern about potential fiduciary liability arising from making investment decisions on behalf of automatic enrollees. The PPA addressed this by establishing a default investment election safe harbor, effective for plan years beginning after December 31, 2006.

Specifically, the PPA amended ERISA § 404(c) to provide that automatic enrollees will be treated as exercising control over their investments if the default investment election is consistent with Department of Labor (DOL) regulations. This means fiduciaries will not be responsible for any losses associated with investing automatic enrollees' contributions in accordance with the DOL's guidance.

Another obstacle to automatic enrollment arrangements had been state wage garnishment laws. Some plan sponsors worried these laws would preclude automatic enrollment of employees in certain states. In response, the PPA amended ERISA to specifically preempt any state laws that otherwise would prevent a plan from implementing an "automatic contribution arrangement." ERISA § 514(e).

In addition to clearing these legal barriers to automatic enrollment, the PPA addressed a possible administrative barrier to such arrangements. The administrative barrier related to plan sponsors' concerns about automatic enrollees opting out of the plan after a short period of time, leaving behind small accounts to be administered.

To address this concern, the PPA created IRC § 414(w) to permit -- but not require -- plans to let automatic enrollees withdraw "erroneous automatic contributions" within 90 days of their first elective contribution. These corrective distributions are treated as compensation, rather than as plan distributions. As a result, otherwise applicable withdrawal restrictions and the 10 percent penalty tax on early withdrawals do not apply. Also, these "erroneous automatic contributions" do not count for nondiscrimination testing purposes.

Finally, the PPA created new incentives for employers to add automatic enrollment features to their 401(k) plans. Specifically, plans with automatic enrollment features that meet certain requirements -- so-called "qualified automatic enrollment features" -- are treated as satisfying the ADP and ACP nondiscrimination tests. Also, the top-heavy rules do not apply to plans consisting solely of contributions made pursuant to qualified automatic enrollment features.

An automatic enrollment feature is "qualified" only if it satisfies certain requirements relating to (1) automatic deferrals, (2) employer contributions, and (3) notices to employees. Specifically, plans must set their default deferral percentages for automatic enrollees at no less than three percent in the first year, four percent in the second year, five percent in the third year, and six percent in the fourth year and beyond, up to a maximum of ten percent. The default deferral percentages must apply universally to all eligible employees, meaning everyone eligible to participate in the arrangement except for those who became eligible before the automatic enrollment feature became "qualified."

Overview of DOL's Final Regulations on Default Investments

With respect to the fiduciary relief for default investments for automatic enrollees and other participants or beneficiaries who do not make affirmative investment elections, the safe harbor is available only if each of six specific requirements is satisfied.

The final regulations provide additional details about several of these requirements, as discussed below.

What Is a QDIA?

In order for an investment alternative to be a QDIA it generally must be a mutual fund or a pooled-investment fund managed by a registered investment adviser. Additionally, a QDIA must be one of the following:

The final regulations offer stable value products and funds as a fifth type of QDIA, but only with respect to assets invested before December 24, 2007 -- the effective date of the regulation. This grandfather provision is designed to accommodate those plans that adopted stable value products as default investment options before the PPA was enacted or the final regulations were issued.

Finally, QDIA's generally may not hold or permit the acquisition of employer securities. However, this restriction does not apply to QDIAs that are mutual funds or similar pooled investment vehicles regulated by a state or federal agency, so long as the investment is consistent with the product's stated investment objectives and is made independent of the plan sponsor or any of its affiliates.

What Are the Notice Requirements?

The safe harbor is conditioned upon a specific notice being provided to participants or beneficiaries before their assets are first invested in a QDIA and 30 days before each subsequent plan year. The initial notice must be provided at least 30 days before the participant becomes eligible to participate in the plan, or at least 30 days before the participant's or beneficiary's assets are first invested in a QDIA. If the participant has the opportunity to make a permissible withdrawal under IRC § 414(w), the initial notice can be provided any time on or before the date of plan eligibility.

The notice must be written in a manner calculated to be understood by the average plan participant, and must include the following information.

The proposed regulations would have allowed these notices to be incorporated into a summary plan description (SPD) or summary of material modification (SMM). EBSA decided not to make this option available under the final regulations due to concerns the information would be lost in the SPD or SMM. Thus, a separate notice must be used. However, the preamble to the final regulations also states the notice can be distributed with other plan documents.

The preamble to the final regulations states these notices can be distributed via electronic means. Until other guidance is issued, plans can follow either the Department of Labor's or the IRS's existing regulations on using electronic media.

Divesting and Re-investing QDIA Holdings

If a participant's or beneficiary's account is invested in a QDIA by default, the regulations require that he or she be given the same opportunity to divest and re-invest such holdings as any other participant or beneficiary who affirmatively elected to invest in a QDIA. At a minimum the participant or beneficiary must be permitted to exercise this option on a quarterly basis.

The regulations also limit the fees and other restrictions that can be imposed on these QDIA divestments occurring within 90 days of the participant's first elective contribution or first default investment in the QDIA. During this period, the transaction may not be subject to "any restrictions, fees or expenses (including surrender charges, liquidation or exchange fees, redemption fees and similar expenses charged in connection with the liquidation of, or transfer from, the investment)." This prohibition does not apply to "fees and expenses that are charged on an ongoing basis for the operation of the investment itself (such as investment management fees, distribution and/or service fees, '12b-1' fees, or legal, accounting, transfer agent and similar administrative expenses), and are not imposed, or do not vary, based on a participant's or beneficiary's decision to withdraw, sell or transfer assets out of the [QDIA]." These same rules apply to permitted withdrawals pursuant to IRC § 414(w).

Once this 90 day period has ended those with default investments in QDIAs can be subject to the same restrictions, fees or expenses that would apply to any other participant or beneficiary who affirmatively elected to invest in a QDIA.

Additional Points to Consider

As noted, ERISA § 404(c)(5) and the final regulations provide fiduciary relief for losses resulting from investing a participant's or beneficiary's account in a QDIA. Additionally, the relief extends to the fiduciary's choice of the type of QDIA to offer. However, as with all other investment options a plan makes available, ERISA's general fiduciary duties continue to apply to the selection and monitoring of the investment product that is used as the QDIA.

Even though this special fiduciary protection is codified within ERISA § 404(c), its applicability is not contingent upon the plan being a "404(c) plan." ERISA § 404(c) provides broader protections to 401(k) and other individual account plan fiduciaries for losses resulting from participants or beneficiaries "exercising control" over their accounts. However, this relief is available only to fiduciaries of plans that satisfy the extensive regulatory requirements for "404(c) plans." The relief provided by ERISA § 404(c)(5) is available to 401(k) and individual account plans regardless of whether they qualify as 404(c) plans.

Finally, even though ERISA § 404(c)(5) was created with automatic enrollment arrangements in mind, it applies to other situations in which default investment allocations may be made. The preamble to the final regulations provides the following examples of these "other" situations: "The failure of a participant or beneficiary to provide investment direction following the elimination of an investment alternative or a change in service provider, the failure of a participant or beneficiary to provide investment instruction following a rollover from another plan, and any other failure of a participant to provide investment instruction."

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2007, Deloitte.