Investment direction as an allocation condition

An individual-account retirement plan allows § 401(k) contributions, provides matching contributions, and allows (but does not mandate) a non-elective contribution.

The plan provides that an election to make an elective deferral (whether non-Roth or Roth) that does not include a proper investment direction is invalid.

But if a participant never made elective deferrals, she might not have made an investment direction.

Rather than set a default investment, the plan’s sponsor would prefer to provide that a proper investment direction is a condition for a participant to share in a non-elective contribution.

This would not be an exercise of a fiduciary’s discretion; rather, the plan’s sponsor would express the provision in the plan’s governing document.

In this employer’s circumstances, excluding a few people from a non-elective contribution would not result in a failure under Internal Revenue Code § 410(b) or § 401(a)(4).

Is there some other tax-qualification condition a plan might not meet because of this provision?

Is there an ERISA mandate a plan might not meet because of this provision?

6 minutes ago, Peter Gulia said:

Rather than set a default investment, the plan’s sponsor would prefer to provide that a proper investment direction is a condition for a participant to share in a non-elective contribution.

I'm curious what they're trying to accomplish here. Do they have a specific "few people" in mind who wouldn't be getting a contribution?

The first thing that comes to mind -- by no means is this a complete answer -- is whether this amounts to making eligibility for the non-elective contribution dependent on a deferral election. Of course it's technically possible for somebody in this plan to make an investment election without electing to defer, but I think in practice you're going to end up with people who figure "if I don't plan to defer, what's the point?" and don't realize they're cutting themselves out of a non-elective contribution by doing so (or claim as much later). I don't know if just having them sign a paper saying that they understand is sufficient.

It seems hard to believe participants are going to knowingly give up free money just because they don't want to spend a few seconds randomly picking from a list of funds and signing their name, so it sounds like they're thinking they can get out of contributing to people who haven't taken the time to "opt in", which kind of defeats the purpose of a non-elective contribution (at least in spirit). Maybe there's another possibility I'm not seeing!

59 minutes ago, Peter Gulia said:

The plan provides that an election to make an elective deferral (whether non-Roth or Roth) that does not include a proper investment direction is invalid.

The Plan provides or wants to provide?  IRS approved?  Or is it something on a form?

As for excluding someone from non-electives, the premise is so vindictive and silly, given the easy availability of default investments, that it's hard to take it seriously.  I'd say that it's not permitted as a condition for excluding someone from a non-elective contribution but I don't necessarily know why.  I know, or think, that in theory you could exclude everyone wearing white shoes on such-and-such a day but that doesn't mean I'd do it.  I suppose if everyone is in their own group you could do it in practice but otherwise writing it into the document is fraught with peril (or just "fraught" in 2019 lexicon) - as of the last day of the year, or some other day?  - how does it tie in with other allocation conditions, such as 500 hours or last day?

Thank you, duckthing and Bird, for helping me think about this.

That an election to make an elective deferral must include a proper investment direction has been in the plan’s document for years, and the IRS issued a favorable determination on it.  (Adding an investment-direction condition for a non-elective contribution would be new.)

So far, there has been no participant who “g[a]ve up free money” by not making an investment direction when she became entitled to a nonelective contribution. 

But the employer is aware of the possibility that someone might not make an investment direction, and wants to prepare for that situation.  The employer does not seek to be vindictive or unfairly harsh.  But it also doesn’t want to allow a participant to escape responsibility for directing investment.  And with the employer volunteering “free money” it has no other obligation to provide, it feels asking for an investment direction is not an unreasonable condition.

Again, thank you for helping me think about cautions I should point out to the plan’s sponsor. 

It is on the Trustee to invest the funds prudently if the participant can't or won't make an investment election. I do not believe you can condition a contribution on the participant providing investment direction.

The DOL has set up provisions for default investments with just this situation in mind for Trustees who would like to limit or reduce their exposure to investing the funds on behalf of the participant. I don't think the Trustee can refuse the funds for a participant who does not provide direction and I don't think "must provide investment direction" will be seen as a reasonable business classification by the IRS for receiving an allocation.

But if you want to submit a plan with that condition for a DL to the IRS, I guess you could try.

I would be worried about the contingent benefit rule of 401(k)(4)(A). The CODA is not qualified "if any other benefit is conditioned (directly or indirectly) on the employee electing" to defer. The investment direction is so closely tied to the deferral election that I would not feel comfortable allowing this.

What is the deadline for making the investment election?  If it can be made after the end of the plan year of the contribution, they will at some point have Section 415 issues.  I'm thinking of :

Quote

1.415(c)-1(b)(6) Timing rules—(i) In general—(A) Date of allocation. For purposes of this paragraph (b), an annual addition is credited to the account of a participant for a particular limitation year if it is allocated to the participant's account under the terms of the plan as of any date within that limitation year. Similarly, an annual addition that is made pursuant to a corrective amendment that complies with the requirements of §1.401(a)(4)-11(g) is credited to the account of a participant for a particular limitation year if it is allocated to the participant's account under the terms of the corrective amendment as of any date within that limitation year. However, if the allocation of an annual addition is dependent upon the satisfaction of a condition (such as continued employment or the occurrence of an event) that has not been satisfied by the date as of which the annual addition is allocated under the terms of the plan, then the annual addition is considered allocated for purposes of this paragraph (b) as of the date the condition is satisfied.

However, I think this falls under the category of "just because you can do it doesn't mean you should".  Pick a QDIA that satisfies the rules, provide the proper notices and forget about this ________________.

4 hours ago, Peter Gulia said:

An individual-account retirement plan allows § 401(k) contributions, provides matching contributions, and allows (but does not mandate) a non-elective contribution.

 

The plan provides that an election to make an elective deferral (whether non-Roth or Roth) that does not include a proper investment direction is invalid.

 

But if a participant never made elective deferrals, she might not have made an investment direction.

 

Rather than set a default investment, the plan’s sponsor would prefer to provide that a proper investment direction is a condition for a participant to share in a non-elective contribution.

 

This would not be an exercise of a fiduciary’s discretion; rather, the plan’s sponsor would express the provision in the plan’s governing document.

 

In this employer’s circumstances, excluding a few people from a non-elective contribution would not result in a failure under Internal Revenue Code § 410(b) or § 401(a)(4).

 

Is there some other tax-qualification condition a plan might not meet because of this provision?

 

Is there an ERISA mandate a plan might not meet because of this provision?

Peter, someone needs to take a firm stance with the client and tell them that what they are doing is just plain stupid; yes, I think there is a problem with not having a default but I'm between business trips (heading out to Cincinnati for the ASPPA Regional to speak Monday and just returned from 5 day in FL a few hours ago) so I just don't have time to find the chapter and verse that says you have a problem with no default.  I believe the failure of the fiduciary to select a default investment (when they have already selected the menu of choices otherwise available) is a fiduciary violation and if a participant made an election but did not choose an investment, I think he will have an enforceable claim against the fiduciary.  

What exactly is the language the says the deferral election is invalid if no choice of investment is made? Is it in the actual plan document (I don't think you answered that question).  And by the way, a favorable determination letter does not make this language OK: it is a fiduciary issue which is not in the purview of the IRS.

Thank you, all, for helping me think about this.

The sponsor hasn’t yet decided anything and is keenly aware its idea is unusual and seems harsh.  That’s why the sponsor seeks advice.  I expect the advice will include observations about how participants would perceive the provision, how EBSA and IRS might see it, what a court would decide, and how challengers or defenders might evaluate whether it’s worthwhile to assert one’s view.

I recognize that whether an administrator could follow a provision or must disobey it as contrary to ERISA’s title I involves unsettled law and challenging questions.

That an election to make an elective contribution must include a proper investment direction is in the plan’s governing document.  Adding an investment-direction condition for a nonelective contribution would be new.

There has been, so far, no participant who failed to direct investment promptly after she became entitled to a nonelective contribution.

But the sponsor perceives a possibility that someone might not make an investment direction, and wants to prepare for that situation.  The sponsor does not seek to be unfairly harsh.  But it also doesn’t want a participant to escape responsibility for directing investment.  And with the sponsor volunteering “free money” it has no other obligation to provide, it feels asking a recipient to direct investment of her account is not an unreasonable condition.

The sponsor includes nonelective contributions because the sponsor wants to provide something for those who chose not to make elective contributions.  The sponsor does not seek to exclude particular people.

The purpose of an investment-direction allocation condition would be to make sure a participant’s refusal to direct investment does not burden the administrator or allow a participant to avoid responsibility.  While the administrator recognizes its responsibility prudently to select a broad range of investment alternatives, the sponsor prefers that the administrator not be burdened with a responsibility to choose the investment mix for a participant’s individual account (even if that could be done simply through an asset-allocation fund such as a balanced fund or a target-year fund).  Further, the sponsor believes an adult should not avoid decision-making responsibility.

I’ll warn the sponsor about the risk that the IRS might assert a nonelective contribution was conditioned because the condition for an investment direction might be an indirectly implied condition about an election to make or not to make elective contributions.

Thank you for the observation about § 415 limitation years.  For the participants who might be affected, the contribution is not so big that a delay into another year would matter.

Again, thank you, all, for helping me think about cautions to point out to the sponsor.

And before any of us too hastily sees only harshness in the sponsor’s idea, consider that the sponsor could resolve, instead, to provide no nonelective contribution.

Peter, if the employer compensates those who self-exclude by refusing to provide investment direction with a cash bonus, you could have nonqualified CODA. Otherwise, as long as the allocation passes 401(a)(4) without these folks, would not seem to violate the Code. Also, since part of plan document would not appear to be an ERISA 510 problem.

Luke Bailey, thank you for your further observations.

(There's no risk that the employer would replace the non-allocation of a nonelective contribution with money wages.)

On 11/9/2019 at 1:54 PM, Peter Gulia said:

 

But the sponsor perceives a possibility that someone might not make an investment direction, and wants to prepare for that situation.  The sponsor does not seek to be unfairly harsh.  But it also doesn’t want a participant to escape responsibility for directing investment.  And with the sponsor volunteering “free money” it has no other obligation to provide, it feels asking a recipient to direct investment of her account is not an unreasonable condition.

 

 

The purpose of an investment-direction allocation condition would be to make sure a participant’s refusal to direct investment does not burden the administrator or allow a participant to avoid responsibility.  While the administrator recognizes its responsibility prudently to select a broad range of investment alternatives, the sponsor prefers that the administrator not be burdened with a responsibility to choose the investment mix for a participant’s individual account (even if that could be done simply through an asset-allocation fund such as a balanced fund or a target-year fund).  Further, the sponsor believes an adult should not avoid decision-making responsibility.

 

 

Well, it's all well and good that the employer "doesn't want a participant to escape responsibility for directing an investment" but I just don't think they have that option!  I don't believe a participant can be forced to make investment choices; that's why I think a default is REQUIRED and then has to meet the fiduciary rules.  I don't believe a sponsor can decide otherwise.  And I think they have it wrong when they say "the sponsor prefers that the administrator not be burdened with a responsibility to choose the investment mix for a participant’s individual account (even if that could be done simply through an asset-allocation fund such as a balanced fund or a target-year fund)" because that assumes they have that option; I don't think they do.  If they have a plan and a participant doesn't choose, then the default (which has already been chosen) applies and there is no "burden" because it is automatic.  The "burden" (if there is one) is only when establishing what the default is, and a good advisor will walk them through that, and it should be no more burden than the choice they had to make as to what would be provided in the option menu.

I'm hoping that I will have time to find the specifics that mandate a default election.

Peter Gulia:  I didn't read all the posts, so I apologize if this has been stated.  Possibly a  "definite allocation formula" issue?

jpod, thank you for a new (or perhaps newly stated) point about whether an allocation condition might fail to meet 26 C.F.R. § 1.401-1(b)(1)(ii)’s condition that a profit-sharing plan “must provide a definite predetermined formula for allocating the contributions made to the plan among the participants[.]”

Larry Starr, thank you for your further observations.

Peter, I think for definitely determinable an algorithm is as good as a formula, and you've got one. If no investment election, then not employer contribution.

Maybe the most salient point with the employer, who is presumably rational, would be that this is really unusual. My clients often ask me what is "market." Not this.

12 hours ago, Luke Bailey said:

Peter, I think for definitely determinable an algorithm is as good as a formula, and you've got one. If no investment election, then not employer contribution.

Sort of.  As I noted above, as of what date?  Presumably the last day of the year, or earlier...I don't think it would be possible to "measure" this as of some later date, such as the date the contribution is made after the end of the year.  Would have to be spelled out in the document...I wouldn't volunteer to try to write that language.

I was just throwing it out there, but after re-thinking it perhaps it could be viewed as nothing more than an eligibility condition that does not violate 410(a).  I have to agree with the consensus that this is an absolutely terrible idea given that the DOL's QDIA rules should provide about as much protection as anyone could hope to have.      

One consideration - is this a daily valued plan on a recordkeeping platform?  Nearly all of them require the employer to choose a default fund as part of the initial set up of the plan on the recordkeeper's platform.  I would check with the recordkeeper to see if they are showing a default fund for the plan.  The financial advisor may well have set that up when the paperwork was completed.  If so, I don't think the employer can take the position that the participant has to make an investment election in order to receive the profit sharing contribution, because a smart participant is going to argue that they don't have to make such an election, there is already a default fund in place.

Although this makes me wonder how the employer is currently enforcing the provision that the participant must have made an investment direction in order for the deferrals to be valid.  Maybe they aren't on an investment platform(?)

Luke Bailey, Bird, jpod, AKconsult, thank you for your further observations.

I don't know which of the three paths the sponsor will take, but we sure had an interesting BenefitsLink discussion.

Let me try on the devil's advocate hat for a moment.  Are we talking about something that is written into the plan document?  I assume the answer is yes,  per the OP and that some language is necessary in the plan to support this plan sponsor's desires.

It appears that there is one section of the regs that somewhat supports a more draconian interpretation. I don't have time to look up the details, but isn't there a section of the 401(k) or 410(b) regs that allows for a one-time election to permanently opt-out of all qualified plans? Is the plan sponsor willing to support this even less favorable course of action as punishment for failure to provide investment direction?  That is, to treat a failure to provide investment direction as an affirmative act to permanently step aside from all qualified benefits?  

How would the plan administrator demonstrate that a participant didn't provide proper investment instructions?  I'm envisioning a claim several years down the road after the plan has changed recordkeepers.  Would there be a record of the participant being notified of the deficiency and the consequences if left uncorrected?  I kind of like the idea; it forces participant engagement.  It seems like the risk of not administering this properly may be greater than any risk that could be associated with QDIA selection and I'd have to have a lot of confidence in the employer's ability to facilitate this to even begin to consider this sort of provision. 

I'd also wonder about whether the sponsor could unintentionally hinder a participant's ability to select investments. For example, maybe there is a single employee who speaks only Spanish - the deferral form is available in Spanish, but fund materials might only be available in English.  

1 hour ago, Mike Preston said:

Let me try on the devil's advocate hat for a moment.  Are we talking about something that is written into the plan document?  I assume the answer is yes,  per the OP and that some language is necessary in the plan to support this plan sponsor's desires.

It appears that there is one section of the regs that somewhat supports a more draconian interpretation. I don't have time to look up the details, but isn't there a section of the 401(k) or 410(b) regs that allows for a one-time election to permanently opt-out of all qualified plans? Is the plan sponsor willing to support this even less favorable course of action as punishment for failure to provide investment direction?  That is, to treat a failure to provide investment direction as an affirmative act to permanently step aside from all qualified benefits?  

Mike, that's the nonqualified CODA issue I mentioned in my post. For it to be a problem, the employer would have to have an agreement with the employee to make up some or all of the foregone plan contribution as current W-2 cash.

1 hour ago, Mike Preston said:

Let me try on the devil's advocate hat for a moment.  Are we talking about something that is written into the plan document?  I assume the answer is yes,  per the OP and that some language is necessary in the plan to support this plan sponsor's desires.

It appears that there is one section of the regs that somewhat supports a more draconian interpretation. I don't have time to look up the details, but isn't there a section of the 401(k) or 410(b) regs that allows for a one-time election to permanently opt-out of all qualified plans? Is the plan sponsor willing to support this even less favorable course of action as punishment for failure to provide investment direction?  That is, to treat a failure to provide investment direction as an affirmative act to permanently step aside from all qualified benefits?  

I just don't see how the failure to select a investment could ever rise to the level of an affirmative, one time election to permanently opt out of all the employer plans.  That's a big stretch to me, and not one that I would want to have to justify.

1 hour ago, Larry Starr said:

I just don't see how the failure to select a investment could ever rise to the level of an affirmative, one time election to permanently opt out of all the employer plans.  That's a big stretch to me, and not one that I would want to have to justify.

Me, neither.  But this plan sponsor wants to punish those who don't want to absolve the investment fiduciaries of their normal fiduciary responsibilities.  We surmise that punishments like caning are carrying things a bit too far.  But where does the Plan Sponsor draw the line?

The sponsor did not imagine a one-time election or anything else that would set an allocation condition for anything more than one nonelective contribution at a time.

Again, I don't know what the sponsor will decide, and I might never know.  (The sponsor is not my client.)

3 hours ago, Peter Gulia said:

The sponsor did not imagine a one-time election or anything else that would set an allocation condition for anything more than one nonelective contribution at a time.

Again, I don't know what the sponsor will decide, and I might never know.  (The sponsor is not my client.)

Hence, laying waste to the only path available under the IRC and ERISA to punish a participant.  Anything else smells very much like an ERISA 510(a) violation.  I wonder if the sponsor would give up on their own personal idea of what is right or wrong if they were made aware of the potential penalties for an ERISA 510(a) violation?  Hardly seems worthwhile when potentially facing jail time. 

22 hours ago, Mike Preston said:

Me, neither.  But this plan sponsor wants to punish those who don't want to absolve the investment fiduciaries of their normal fiduciary responsibilities.  We surmise that punishments like caning are carrying things a bit too far.  But where does the Plan Sponsor draw the line?

I would prefer caning (of the participants; that's not a personal preference!).

17 hours ago, Larry Starr said:

I would prefer caning (of the participants; that's not a personal preference!).

I guess I'm too soft nowadays, I draw the line at tarred and feathered