Direct investments in the prefunded account?

Does a plan sponsor have control over the fund(s) used for balances in their pre-funded account? Or is a pre-funded account required to use some sort of conservative capital-preservation type fund?

I think you need to provide more details.  If you are talking about an employer prefunding an employer contribution before any allocation conditions are met, the DON'T DO IT.  Period.  If the funds experience a loss, who suffers?  If the funds have an investment gain (even interest), is that an additional contribution when allocated?  If there is money left over because too many people don't meet the allocation conditions, how do you account for the funds (and it clearly can't go back to the employer).

As far as how the funds are invested, they are plan assets.  I would say "prudently" but would reiterate - DON'T DO IT.

I am specifically and only asking about the plan's investment option that a pre-funded contribution sits in and what rules (if any) apply. 

Irrespective of a fund experiencing a loss, irrespective of whether the sponsor does or doesn't want to do anything else.

10 minutes ago, hockptuey said:

I am specifically and only asking about the plan's investment option that a pre-funded contribution sits in and what rules (if any) apply. 

Irrespective of a fund experiencing a loss, irrespective of whether the sponsor does or doesn't want to do anything else.

The problem is, the investment options create many of hte issues I raise.  It's a "fiduciary decision" on investing those assets.

I certainly understand that in most areas of the function of a 401(k) plan, sponsors have the potential to create a myriad of issues. I wasn't asking whether it's a good or bad idea—just what rule exists.

I appreciate you weighing in. A former colleague said a sponsor couldn't attempt to use a prefunded account to see any gains while another colleague told me the fund used is at the sponsor's discretion and I couldn't find anything about the matter online.

1 hour ago, hockptuey said:

I am specifically and only asking about the plan's investment option that a pre-funded contribution sits in and what rules (if any) apply. 

Irrespective of a fund experiencing a loss, irrespective of whether the sponsor does or doesn't want to do anything else.

It's a pooled contribution to the plan until it's allocated to participant accounts so standard prudent fiduciary rules would apply.

There are some rules to follow and consequences to deal with if a plan sponsor is pre-funding a contribution.

First, they cannot pre-fund elective deferrals.  Elective deferrals must come from participants' compensation that when that compensation would otherwise have been paid to participants.  Some employers tried to pre-fund elective deferrals early on when 401(k)s came into existence and the IRS shot it down.

The employer can pre-fund non-elective employer contributions (NECs).  Keep in mind that a defined contribution plan is exactly that - a plan with a specified formula for calculating a participant's contribution.  If the pre-funded NEC has a loss, the employer has to make additional contributions to fully fund the participants' contributions as calculated using the plan contribution formula.  The pre-funded NEC doesn't belong to the participant until it is allocated on an allocation date, and the employer must give each participant the contributions specified by the plan come an allocation date.

Once a contribution is pre-funded and is in the trust, it cannot revert to the employer.  As an asset of the plan, it needs to be treated in a manner consistent with the plan provisions and used for the benefit of participants.  If the pre-funded NEC has a gain, that gain reasonably could be allocated using the same allocation basis that was used to allocate the contributions.  It would be a stretch to use the gain to pay a plan expense that otherwise would be allocated to participants using a different allocation basis.  A plan can say explicitly forfeitures can be used to pay plan expenses, but earnings on pre-funded NECs are not forfeitures.

If there is pre-funded NEC (without considering earnings) that is more than the contributions calculated using the plan contribution formula, then the excess could be used to pay a plan expense if the plan says the employer can reimburse the trust for expenses.  Since the plan should not have unallocated amounts, the excess would have to be allocated to participants which may require a plan amendment if the plan's contribution formula is fixed and there is no discretion available to the plan administrator on the amount of the contribution that is allocated.

A match could be pre-funded, and this would carry all of the baggage that is associated with a pre-funded NEC.

If the excess is not allocated as a contribution to participants or used for a purpose that is authorized by the plan document (like an expense), then there is a good argument that the excess is not deductible.  This also possibly could lead into topics where plans fear to tread like unrelated business income taxes and prohibited transactions.

Bottom line - on the surface, pre-funding seems like a clever way to earn extra income in the plan.  If it worked smoothly, everyone would be doing it.  Many have considered it, very few attempted it, and those who did gave it up after suffering unintended consequences.

I think it can be argued that you can't do it in a self-directed plan - that would be the "rule" that you are looking for. I'd see what the plan says, if anything, about holding funds before they can be allocated to participant accounts.

If you're going to do it anyway, then I'd use a cash equivalent of some kind. It's just not worth the headache of dealing with losses (personally I would take the approach that losses are losses (the pre-funded account is treated as a pooled account), and not made up with additional employer contributions, but then you're back to the issue of whether this can be done at all in a self-directed plan). And not worth the headache of dealing with gains, either, which should be allocated on a pooled basis before being transferred to the self-directed accounts. True confession - we've done it, by sending money to a misnamed forfeiture account, and eventually transferring to self-directed accounts. Any gains were minimal and washed around somehow in the "forfeiture" account, eventually effectively taken as fees when the plan terminated. 

If the plan is pooled, then I don't see a problem, in practical terms.