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