3732 / What is the diversification requirement for defined contribution plans?

In plan years beginning after December 31, 2006, defined contribution plans (other than certain ESOPs) that hold publicly traded employer securities must satisfy a diversification requirement to be qualified.¹ In May 2010, the IRS issued final regulations on the diversification requirement.² The final regulations are effective for plan years beginning on or after January 1, 2011.³ Until that effective date, a plan was required to comply with the diversification requirement, but could rely on the proposed regulations, or the final regulations for purposes of satisfying the requirements of IRC Section 401(a)(35).

Defined contribution plans subject to this requirement must permit participants to direct the plan to divest the portion of their account attributable to employee contributions and elective deferrals invested in employer securities, and reinvest an equivalent amount in other investment options.⁴ With respect to employer contributions only, the diversification feature may be restricted to participants with at least three years of service, their beneficiaries, and the beneficiaries of deceased participants.⁵

The plan must offer at least three investment options (other than employer securities) to which an employee affected by this provision may direct the proceeds from the divestment of the employer securities. Each investment option must be diversified and have materially different risk and return characteristics.⁶ A plan may limit the time for divestment and reinvestment to periodic, reasonable opportunities, provided they occur at least quarterly. If the plan places restrictions or conditions (other than the application of securities laws) with respect to the investment of employer securities that are not imposed on the investment of other assets in the plan, it will not satisfy the provisions of the diversification requirement.⁷

A transition rule, applicable only to securities acquired before January 1, 2007,⁸ allowed the plan to phase in the diversification requirement ratably over three years. The phase-in did not apply to participants who reached age 55 and completed three years of service before the first plan year beginning after December 31, 2005. Under the phase-in, an “applicable percentage” of the portion of an account attributable to employer contributions (other than elective deferrals) invested in employer securities is subject to the requirement as follows: 33 percent after the first plan year, 66 percent after the second plan year, and 100 percent after the third and subsequent plan years.

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Planning Point: A significant amount of litigation has been directed at plan sponsors’ failure to satisfy their fiduciary obligations based on poor investment decisions. In the closely-watched Intel case, participants alleged that the plan over-invested in hedge funds and private equity investments. Intel countered by alleging that the participants had received “actual knowledge” of the potential violation, thereby triggering the running of a three-year limitations period for filing suit. The case made it all the way to the Supreme Court, which ruled in favor of the plaintiffs that the generally applicable six-year limitations period for fiduciary breach applied. This was the case even though the plan sponsor mailed information about the investments that may have been sufficient to inform them of the violation—because the plaintiffs did not recall ever reading the information.⁹ While the decision leaves much unanswered, plan sponsors should exercise extreme caution in providing notice of investments to participants.

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The diversification requirement does not apply to certain ESOPs. If an ESOP does not hold any 401(k) contributions, Section 401(m) match amounts, or earnings attributable to them and the plan is a separate plan for purposes of the merger and consolidation requirements of IRC Section 414(l) with respect to any other defined benefit or defined contribution plan of the same employer or employers, then the diversification requirement does not apply.¹⁰

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Planning Point: The IRS has issued relief from the anti-cutback rules of Section 411(d)((6) for a plan sponsor who amends a non-exempt ESOP to eliminate a distribution option that had previously satisfied the diversification requirements of Section 401(a)(28)(B) if the amendment occurs no later than the last day of the first plan year beginning on or after January 1, 2013 or by the deadline for the plan to satisfy Section 401(a)(35), if later.¹¹

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Publicly traded employer securities for purposes of this requirement means employer securities that are readily tradable on an established securities market.¹²

Employer security means a security issued by an employer of employees covered by the plan or by an affiliate of such an employer. Life insurance, health insurance, and annuity contracts are not securities for this purpose.¹³

If an employer corporation, or any member of a controlled group that includes the employer corporation, has issued a class of stock that is publicly traded, the employer may be treated as holding publicly traded employer securities even if its securities are not otherwise publicly traded. Controlled group status is determined using a 50 percent test instead of an 80 percent test for this purpose.¹⁴

The diversification requirement does not apply to plans that meet the definition of a one-participant plan.¹⁵ This definition has the following five criteria:

(1)  On the first day of the plan year, the plan covered only one individual or that individual and his or her spouse, and the individual owns 100 percent of the plan sponsor (whether incorporated or not), or it covered only one or more partners and their spouses in the plan sponsor.

(2)  It meets the minimum coverage requirements of IRC Section 410(b) ( Q 3842) without being combined with any other plan of the business that covers its
employees.

(3)  It does not provide benefits to anyone except the individual or the partners and their spouses.

(4)  It does not cover a business that is a member of an affiliated service group, a controlled group or a group of businesses under common control ( Q 3933, Q 3935).

(5)  It does not cover a business that uses the services of leased employees as defined in IRC Section 414(n) ( Q 3929).

A partner, for purposes of this definition, also includes a 2 percent shareholder of an S corporation.¹⁶