ERISA Advisory–Labor Department Releases Final QDIA Rule

Overview of the Final QDIA Rule

On October 23, the U.S. Department of Labor issued its long-awaited final rule on qualified default investment alternatives for participant-directed individual account plans, 29 C.F.R. § 2550.404c-5.  The rule implements provisions of the Pension Protection Act of 2006 (“PPA”) that are designed to make it easier for employers to automatically enroll employees in their 401(k) and other defined-contribution plans.  The final rule was published in the Federal Register on October 24, 2007, and will be effective December 24, 2007.

Under prior law, many employers were reluctant to adopt automatic enrollment arrangements because of concerns about the applicability of state wage withholding laws and potential exposure to legal liability for market fluctuations when investing assets of participants who are automatically enrolled.  The PPA includes a safe harbor that protects fiduciaries against liability where the assets of participants who fail to provide investment direction are invested in accordance with regulations to be issued by the Department of Labor.  The final rule released on October 23 implements this PPA safe harbor by conditioning a fiduciary’s protection from liability on compliance with the following requirements:

• Assets must be invested in a qualified default investment alternative (QDIA), discussed further below;
• Participants and beneficiaries must have been given the opportunity to provide investment direction, but failed to do so;
• The plan must furnish participants and beneficiaries with notice before the first investment in a QDIA and annually thereafter, generally 30 days in advance;
• Materials provided to the plan for the QDIA must be furnished to participants and beneficiaries;
• Participants and beneficiaries must have the opportunity to direct investments out of a QDIA as frequently as from other plan investments, but at least every three months;
• The rule limits the fees that can be imposed on participants who opt out of participation or who decide to direct their investments elsewhere; and
• The plan must offer a “broad range of investment alternatives” as defined in the Department’s regulation under section 404(c) of ERISA.

Provided that these requirements are satisfied, relief will be accorded without regard to which type of QDIA the fiduciary selects.  The rule lists four general categories of investments that constitute QDIAs:

• A product with a mix of investments that takes into account the individual’s age or retirement date, e.g., life-cycle or targeted-retirement-date fund;
• An investment service that allocates contributions among existing plan options to provide an asset mix that takes into account the individual’s age or retirement date, e.g., a professionally-managed account;
• A product with a mix of investments that takes into account the characteristics of the group of employees as a whole, e.g., a balanced fund; and
• A capital preservation product, but only for the first 120 days of participation.

Two additional conditions must be satisfied for a default investment to qualify as a QDIA.  First, the default investment must be a registered investment company or managed by an investment manager, plan trustee, or plan sponsor who is a named fiduciary.  Second, the default investment cannot invest participant contributions in employer securities, with two limited exceptions. 

Notably, the rule also provides safe harbor relief for plan sponsors who adopted stable value products as their default investment before the PPA’s passage.  The final rule, however, does not provide relief for future contributions to stable value products.

Changes from the Proposed Rule

The Department of Labor received a host of comments on the proposed regulation, which was published on September 27, 2006.  In response to these comments, the Department made a number of changes in the final rule, which are summarized briefly below.

A.                Notice

The final rule altered the notice requirements of the proposed regulation by permitting less than 30 days’ notice in some circumstances, requiring a separate QDIA notice, and altering the required content of the notice.

Under the proposed rule, plans were required to give 30 days’ notice before making the first QDIA investment.  The effect of this requirement would have been to preclude plans with immediate eligibility and automatic enrollment from withholding during the first pay period.  To address this problem, the notice requirement was amended to permit notice (i) at least 30 days in advance of the date of plan eligibility or the first investment in a QDIA, or (ii) on or before the date of plan eligibility, provided the participant has the opportunity to make a tax permissible withdrawal.  Importantly, if a fiduciary errs in providing initial notice, the fiduciary can still obtain relief for later contributions where the 30 day notice requirement is satisfied. 

Additionally, the Department eliminated references in the proposed rule to providing required notices through a summary plan description or summary of material modifications.  The plan must provide a separate QDIA notice, although that notice can be distributed with other materials furnished to participants or as part of a single disclosure document.

The required content of the notice is also altered in the final rule.  The proposed rule would have required a description of the circumstances under which an employee’s contributions would be invested in a QDIA, a description of the QDIA, a description of the participants’ right to direct the investment of any assets invested in a QDIA to any other investment alternatives, and an explanation of where participants could obtain investment information concerning the other investment alternatives available under the plan.  In addition to these disclosures, the notice provisions in the final rule require a description of the circumstances under which elective contributions, if any, will be made on a participant’s behalf, the percentage of such contributions, and the right of the participant to elect not to have those contributions made on his or her behalf.  Additionally, the final rule requires an explanation of the right of participants and beneficiaries to direct investment of their individual account assets.  Last, the final rule revises the disclosures regarding “financial penalties” to conform to other changes relating to restrictions, fees and expenses, which are discussed below.

B.                Pass-Through Disclosure Duties

The final rule eliminates confusing language from the proposed rule and modifies the pass-through disclosure duties of fiduciaries.

The proposed rule stated that, “[u]nder the terms of the plan any material provided to the plan relating to a participant’s or beneficiary’s investment in a qualified default investment alternative (e.g., account statements, prospectuses, proxy voting material) would be provided to the participant or beneficiary.” (Emphasis added)  The Department eliminated the phrase “under the terms of the plan” in response to comments asking it to clarify whether sponsors would have to amend their plans to specifically incorporate the disclosure provision.  The Department indicated that it did not intend to require a plan amendment; this provision was included simply to ensure that the plan distributes all QDIA-related material to participants and beneficiaries.  The Department stated that these pass-through disclosure duties can be satisfied by the plan, a QDIA provider, or a third party.

Furthermore, the Department modified the pass-through disclosure duties under the final rule to make them identical to the disclosure requirements applicable to 404(c) plans, which are currently being reviewed as part of a separate regulatory initiative.  See EBSA Request for Information, Fee and Expense Disclosures to Participants in Individual Account Plans, 72 Fed. Reg. 20457 (April 25, 2007).  The Department indicated that it included this change to ensure that individuals who fail to direct their investments are furnished with no more and no less information than is required to be passed through to participants who elect to direct their investments.

C.                Financial Penalties

The final rule changes the provision of the proposed rule requiring that participants be permitted to transfer assets invested in a QDIA to another investment alternative available under the plan “without financial penalty.”  The proposed rule limited imposition of financial penalties for the period of a defaulted participant’s or beneficiary’s investment.  A number of commenters argued that investment-level fees and restrictions (e.g., redemption fees, back-end sales loads, reinvestment timing restrictions, market value adjustments, equity “wash” restrictions, and surrender charges) should not be considered “financial penalties” because they are outside the plan sponsor’s control.

The Department rejected this argument in the final rule, opting instead for a broad prohibition against “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).”  (Emphasis added)  However, the Department limited the time period of this prohibition to “90 days beginning on the date of the participant’s first elective contribution … or other first investment in a [QDIA].”  The Department limited the time period of the prohibition based upon its belief that “restrictions or fees on [QDIAs] are more likely to be waived if the period is shortened to 90 days.”  As long as the participant elects to transfer out of the QDIA within the 90-day period, no charges may be imposed, even if the transfer does not occur until after 90 days.  After 90 days, fees otherwise applicable to plan participants can be applied.

Notably, an investment alternative cannot qualify as a QDIA if it imposes “any restriction, fee or expense” during the applicable 90-day period based on a participant’s decision to withdraw or transfer out of the investment alternative.  The 90-day prohibition does not apply, however, to fees and expenses that are charged on an ongoing basis for the operation of the investment itself (e.g., 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 decision to withdraw, sell or transfer out of the QDIA.

D.                QDIAs

The proposed regulation provided only three general categories of QDIAs:  (1) a product with a mix of investments that takes into account the individual’s age or retirement date (e.g., a life-cycle or targeted-retirement-date fund); (2) a product with a mix of investments that takes into account the characteristics of the group of employees as a whole (e.g., a balanced fund); and (3) an investment service that allocates contributions among existing plan options to provide an asset mix that takes into account the individual’s age or retirement date (e.g., a professionally-managed account).  The final rule adds a fourth QDIA category, “grandfathers” existing stable value products, clarifies an exception regarding investments in employer securities, expands the class of individuals who can manage a QDIA, and adds a provision regarding products offered through annuity contracts, collective trusts and pooled investment funds.

The fourth QDIA category added by the final rule is for capital preservation products (e.g., stable value or money market funds), but only for the first 120 days after the date of the participant’s first elective contribution.  The Department indicated that including capital preservation products as limited-duration QDIAs is appropriate to “afford plan sponsors the flexibility of using a near risk-free investment alternative for the investment of contributions during the period of time when employees are most likely to opt out of plan participation.”

However, despite intense lobbying by the insurance industry, the Department declined to include capital preservation products as QDIAs for any period longer than the first 120 days of participation.  In the Department’s view, the lower rates of return generated by these products over the long term decreases the likelihood that participants investing in them will have adequate retirement savings.

For plan sponsors who have already adopted stable value products as their default investment, the final rule includes a “grandfather” clause that provides relief for contributions invested prior to its effective date in an investment product “designed to guarantee principal and a rate of return generally consistent with that earned on intermediate investment grade bonds, while providing liquidity for withdrawals by participants and beneficiaries, including transfers to other investment alternatives.”  Application of this “grandfather” clause is further conditioned on the investment product’s imposing no fees or surrender charges in connection with withdrawals initiated by a participant.  The final rule provides no relief for contributions invested in these products after the rule’s effective date.

The final rule also clarifies an exception to the prohibition against investing participant contributions in employer securities by requiring the investment management service to have discretionary authority over the disposition of the employer securities.  Therefore, relief is not available with respect to employer securities acquired through matching contributions unless the investment service has an unrestricted right to transfer the securities.

Further, the final rule expands the class of individuals who can manage a QDIA to include a trustee of the plan that meets the requirements of section 3(38)(A), (B), or (C) of ERISA and the plan sponsor who is a named fiduciary, within the meaning of section 402(a)(2) of ERISA.  The Department explained that it decided to include these individuals as permissible managers because of the potential cost saving benefits to plan participants.

Finally, the Department received a variety of comments regarding the application of the proposed rule to QDIAs that are offered through variable annuity contracts.  In response to these comments, the final rule contains a new provision specifying that an investment product is not disqualified from being a QDIA solely because it is offered through variable annuity or similar contracts, common or collective trust funds, or pooled investment funds.

E.                Guidance Regarding Transition Issues

Many commenters requested guidance on what steps should be taken to ensure that current default investments that meet the requirements of the final rule will be treated as QDIAs after the rule’s effective date.  Others requested guidance on what steps should be taken when a plan is moving to a QDIA from a default investment that does not meet the requirements of the final rule.  In both cases, commenters indicated that plans often would not have the records necessary to distinguish participants who were defaulted into a default investment from participants who affirmatively elected to invest in the default investment.

In response to these requests, the Department indicated that plan fiduciaries can ensure that an existing or new default investment satisfies the requirements for a QDIA with respect to both existing and new contributions by complying with the notice requirements of the final rule.  According to the Department, any participant who fails to give investment direction following the receipt of such a notice may be treated as failing to give investment direction regardless of whether the participant was defaulted into or elected to invest in the plan’s original default investment.

Although the rule only provides relief for investments in QDIAs when participants fail to give investment directions after its effective date, the Department indicated that compliance with the rule’s notice requirements may be achieved by providing the requisite notice before the rule’s effective date.

Implications for Plan Fiduciaries

Now that the final QDIA regulation has been issued, plans with existing default investments will have to determine whether their default investments satisfy all of the conditions set forth in the final rule.  For example, plans that currently have target date or balanced funds as default investments will have to make sure that defaulted participants can transfer out during the first 90 days of their investment without being subject to any restrictions, fees or expenses as a result of such transfer. Assuming that a plan’s existing default investment meets the conditions for a QDIA under the final rule, the plan’s fiduciaries still must provide the requisite notice to participants to obtain safe harbor protection from liability beginning on or after the rule’s effective date.

Fiduciaries of plans using stable value funds as their current default investment alternative will have to address a number of questions.  For contributions made after the effective date of the regulation, the plans’ fiduciaries will have to decide whether to select a new default investment that satisfies the requirements for a QDIA.  For contributions made prior to the rule’s effective date, they will have to determine whether the fund is “designed to guarantee principal and a rate of return generally consistent with that earned on intermediate grade bonds, while providing liquidity for withdrawals to participants and beneficiaries, including transfers to other investment alternatives.”  In addition, they will have to make sure that the investment imposes no fees or surrender charges in connection with participant-initiated withdrawals.  Assuming that a plan’s stable value fund satisfies these requirements, the plan’s fiduciaries still must provide the requisite notice to participants to obtain relief from liability going forward for contributions made prior to the final rule’s effective date.

If the plan’s fiduciaries determine that the current default stable value fund does not satisfy these requirements, they will have to consider whether it is prudent to terminate the stable value fund and move participants to a new default investment, notwithstanding any market value adjustment that may be imposed as a result of any such termination.  Plan fiduciaries will have to engage in a similar analysis for any existing default investment that does not satisfy all of the requirements for a QDIA and imposes redemption fees or other restrictions on transfers or withdrawals.

For more information on ERISA legal issues contact Eric Serron and Patrick Menasco at 202.429.3000.