Regulations Require Changes To Default Investments

(Published November 8, 2007)

Plan sponsors may have to invest employees' 401(k) contributions themselves when employees elect to participate in the plan and designate an amount to be withheld, but fail to make investment choices; when employees roll over assets from another employer's plan and likewise fail to give investment direction; when employees are automatically enrolled into the plan; and when the plan changes investment options, but employees fail to make new designations. Normally, fiduciaries are liable if these default investments don't pan out. Final regulations relieve fiduciaries from liability for default investments when certain notice and investment standards are met. Bad news: Two common default investments — stable-value funds and money-market funds — generally don't garner protection from fiduciary liability under the final regs.

Qualified Default Investment Alternatives  

Fiduciaries receive relief when plans invest in qualified default investment alternatives (QDIAs). Key: Fiduciaries must still exercise prudence when choosing QDIAs. The default investment must include a mixture of equities and fixed income. Investment in employer securities is basically forbidden, except for securities held in a mutual fund, for example, or securities used to make employer matching contributions.

QDIAs may be offered through variable annuity contracts or other pooled accounts. The regs don't specify investment products. Instead, they describe three investment mechanisms:

• products with a mix of investments that take into account employees' ages or retirement dates (e.g., life-cycle or target-date funds);

• investment services that allocate contributions among existing plan options to provide an asset mix that accounts for employees' ages or retirement dates (e.g., managed accounts);

• products with a mix of investments that take into account the characteristics of the group of employees as a whole, rather than individual employees (e.g., balanced funds).

With three exceptions, stable-value funds, money markets, and other capital preservation vehicles don't qualify as QDIAs. Exception #1: These investment vehicles can be part of a fund of funds that are QDIAs. Exception #2: Employees who are auto-enrolled may be invested in one of these vehicles for the first 120 days. Exception #3: Plans whose default investments were in one of these vehicles prior to these regs may keep current investments there; no new default investments may be made, however.

The regs clarify that once employees exercise any control over any portion of their QDIA, they are considered to have exercised control over their entire QDIA. In that case, fiduciaries no longer need the protection of these regs, but can rely on the regular provisions of ERISA that immunize fiduciaries from liability for employees' investment decisions.

In addition, employees placed in QDIAs must be provided with investment materials and given the same opportunities to diversify their accounts as employees who make affirmative elections (this must be at least quarterly, but could be as often as daily).

Notice Requirements  

Two notices are required. An initial notice must be provided at least 30 days in advance of the date of plan eligibility or the first default investment. This notice also satisfies the employer's obligation to notify auto-enrolled employees. An annual notice, at least 30 days before the next plan year begins, is also required. Notices may be provided electronically, provided the electronic method meets current government standards. Content requirements for these notices include the following.

• Notices must describe the circumstances under which employees' contributions may be invested in QDIAs. If applicable, notices must state the requirements that apply to auto-enrolled plans, including an explanation of the circumstances under which pre-tax contributions will be made on employees' behalf, the percentage of contributions, and employees' rights to opt out and receive pay, instead.

• Notices must explain that employees have a right to exercise control over their plan assets.

• Notices must detail the QDIAs, including the investment objectives, risk and return characteristics, and related fees and expenses.

• Notices must specify that employees have the right to invest their assets in any plan option, including an explanation of restrictions, fees, or expenses.

• Notices must inform employees where they can obtain information concerning other investment options.

Limitations Regarding Fees  

Employees in QDIAs can't be charged any fees for the first 90 days; this gives them time to make investment decisions or, in the case of auto-enrolled employees, to opt out and receive pay. Exception: Fees that are charged on an ongoing basis for the operation of the investment itself (e.g., investment management fees, distribution and/or service fees, administrative fees for legal or accounting services, or transfer agent expenses) may be charged. At the end of the 90-day period, employees in QDIAs may be subject to the same fees that employees electing to participate are.

The regs become effective December 24, 2007. Click here to read the regs.

Related Topic(s): Benefits