Benefits Update: DOL Issues Proposed Regulation for Default Investments

The Department of Labor (“DOL”) issued proposed regulations on September 27, 2006, that are a welcomed relief for plan sponsors who want to implement automatic enrollment programs, but previously refused due to fiduciary concerns related to investment selection.  Upon adoption, the regulations will provide relief to plan fiduciaries who invest assets in a qualified default investment alternative (“QDIA”) on behalf of plan participants who fail to provide investment direction.  Provided certain conditions are met, a participant who does not give investment direction will be treated as exercising control over his or her account with respect to assets invested in a plan’s QDIA.  By treating participants as having exercised control, fiduciaries will generally be protected from liability for any losses that result from investing participant assets in a QDIA.

Previously, plan fiduciaries were potentially liable for a participant’s investment losses unless the participant made an affirmative election or exercised control over the investment of his or her account.  As a result, in the absence of participant investment direction, plan sponsors would provide for investment of participant assets in conservative default funds, such as money markets, stable value or fixed income funds, which seek to preserve capital.  The automatic enrollment provisions under the Pension Protection Act of 2006 (the “Pension Act”), required the DOL to expand the relief available so that fiduciaries would be comfortable selecting default investments with an objective of long-term growth.  The DOL regulations regarding default investments will provide additional protection to plan fiduciaries who implement automatic enrollment, as well as those who maintain voluntary enrollment procedures for their plans.

Fiduciary Relief

The relief expands the protection provided under the Employee Retirement Income Security Act (“ERISA”) Section 404(c), which seeks to limit fiduciary liability when a participant is provided sufficient information to make informed investment decisions, and exercises control over the investments in his or her account.  However, a plan does not have to be a Section 404(c) plan to take advantage of the new QDIA relief.  Accordingly, any plan fiduciary that complies with the notice and investment requirements under the proposed regulations will not be liable for any investment losses associated with assets invested on behalf of plan participants in qualified default investments.  However, plan sponsors continue to be responsible for the prudent selection and monitoring of any QDIAs, and the managers for such investments.

To qualify for the relief afforded under the new ERISA Section 404(c)(5), fiduciaries have to put a few additional procedures in place (or memorialize existing practices) to ensure that:

• any plan assets invested on behalf of participants without their direction are invested in a QDIA;

• participants are given an opportunity to direct their investments;

• participants are furnished a notice at least 30 days prior to the first investment of their assets into a QDIA, and annually thereafter;

• the plan’s terms state that any materials containing information on the QDIA given to the plan are also provided to participants;

• participants have the ability to transfer assets out of the QDIA and into the plan’s other investment options without penalty; and

• the plan provides a “broad range of investment alternatives” that enable participants to achieve a diversified portfolio.

Notice Requirement

As stated above, a notice is required to be delivered to participants on whose behalf assets will be invested in a QDIA within a reasonable period of time of at least 30 days before the first investment, and an annual notice is to be provided at least 30 days before each subsequent plan year.  The notice may be provided in the summary plan description (“SPD”), summary of material modifications (“SMM”) or as a separate notice.  Similar to the requirements for an SPD and SMM, the QDIA notice should be written in a manner that is understandable by the average plan participant, and is to include: 

• a description of the circumstances when assets will be invested in the QDIA,

• a description of the plan’s QDIA, including the investment objective, risk and return characteristics, and expenses,

• a description of participants’ rights to exchange their assets to other options available under the plan, and

• information on where participants may obtain additional investment information.

Qualified Default Investment Alternative

In conjunction with automatic enrollment as described in the Pension Act, plan fiduciaries are afforded fiduciary protection when they invest assets on behalf of participants in a QDIA.  The relief is intended to increase plan participation rates by removing barriers to automatic enrollment, and to enhance the investment performance related to default investments thereby increasing overall retirement savings.  Only qualified default investments will be granted relief, so attention must be given to the qualification requirements outlined below.

• A QDIA generally may not hold employer securities.[1]

• A QDIA may not impose financial penalties or otherwise restrict a participant’s ability to transfer to the plan’s other investment options.

• A QDIA must be:

a mutual fund under the Investment Company Act of 1940; or

professionally managed by an investment manager under the Investment Advisers Act of 1940, a state registered investment adviser, a bank or insurance company, that is exercising discretionary investment authority and has acknowledged in writing that it is a plan fiduciary.

• A QDIA must be diversified so as to minimize the risk of large losses.

• In terms of investment characteristics, the QDIA must be one of three types:

Life-cycle or target-retirement-date fund – that seeks 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 or life expectancy.

Balanced fund – that seeks to provide long-term appreciation and capital preservation through a mix of equity and fixed income exposures consistent with a target level of risk appropriate for participants of the plan as a whole.

Managed account – an investment management service with respect to which a professional manager allocates assets of a participant’s individual account to achieve varying degrees of long-term appreciation and capital preservation through a mix of equity and fixed income exposures.

The Pension Act requires that final regulations governing QDIAs be adopted by February 17, 2007.  Accordingly, comments on the proposed regulations are due on or before November 13, 2006.  The industry buzz is that the final regulations will include substantially similar conditions and requirements as the proposed regulations.  Potter Anderson’s Employee Benefits and Executive Compensation Group will monitor developments in this area and provide any material updates as they develop.  The final regulations will take effect 60 days after adoption and publication in the Federal Register.

Planning Note

Practitioners agree that by outlining an investment “safe harbor” under these regulations, the DOL expects to significantly increase the likelihood that plan sponsors will be motivated to review their current default fund investments, and make any changes necessary to take advantage of the expanded fiduciary relief available under ERISA Section 404(c)(5).  It follows that this recent guidance from the DOL will motivate plan sponsors to carefully reevaluate the use of money market and stable value fund default investments, and make changes based on the applicable employee demographics. 

Please contact Potter Anderson’s Employee Benefits and Executive Compensation Group to assess default fund selection, automatic enrollment, for assistance with plan and SPD amendments related to plan investment options, and required participant notices.

[1]  Except stock held or acquired in a mutual fund or similar pooled investments consistent with the investment objective, and stock acquired by an employer matching contribution or previous participant direction.