3772 / When are default investments permitted under a 401(k) plan?

For plan years beginning after 2006, participants in individual account plans that meet specific notice requirements will be deemed to have exercised control over the assets in their accounts with respect to the amount of contributions and earnings that, in the absence of an investment election by the participants, are invested by the plan in accordance with regulations.¹ Final regulations offer fiduciaries relief from liability for losses resulting from automatically investing participant accounts in a qualified default investment alternative (QDIA). In addition, the fiduciary would not be liable for the decisions made by the entity managing the QDIA. Fiduciaries, however, remain liable for prudently selecting and monitoring any QDIA under the plan.²

For the regulatory relief to apply:

(1)  the assets must be invested in a QDIA, as defined below;

(2)  the participant or beneficiary on whose behalf the account is maintained must have had the opportunity to direct the investment of the assets in his or her account but did not do so;

(3)  the participant or beneficiary must be provided with a notice meeting requirements set forth in regulations, a summary plan description, and a summary of material modification at least 30 days before the first investment and at least 30 days before each plan year begins;

(4)  any material relating to the investment, such as account statements, prospectuses, and proxy voting material must be provided to the participant or beneficiary;

(5)  the participant or beneficiary must be permitted to make transfers to other investment alternatives at least once in any three month period without financial penalty; and

(6)  the plan must offer a “broad range of investment alternatives,” as defined in DOL Regulation Section 2550.404c-1(b)(3).³

The notice required for a QDIA must:

(1)  describe the circumstances under which assets in the individual account of an individual or beneficiary may be invested on behalf of a participant or beneficiary in a QDIA;

(2)  explain the right of participants and beneficiaries to direct the investment of assets in their individual accounts;

(3)  describe the QDIA, including its investment objectives, risk and return characteristics (if applicable), and fees and expenses;

(4)  describe the right of the participants and beneficiaries on whose behalf assets are invested in a QDIA to direct the investment of those assets to any other investment alternative under the plan, without financial penalty, and

(5)  explain where the participants and beneficiaries can obtain investment information concerning the other investment alternatives available under the plan.⁴

A qualified default investment alternative means an investment alternative that meets five requirements:

(1)  it does not hold or permit the acquisition of employer securities except as provided below;

(2)  it does not impose financial penalties or otherwise restrict the ability of the participant or beneficiary to make transfers from the default investment to another plan investment;

(3)  it is managed by an investment manager, a registered investment company, or a plan sponsor that is a named fiduciary;

(4)  it is diversified, to minimize the risk of large losses; and

(5)  it constitutes one of three investment products (for example, a life cycle fund, a balanced fund, and a managed account) described in the regulations, each of which offers long-term appreciation and capital preservation through a mix of equity and fixed income exposures.⁵

Final regulations permit the use of capital preservation funds (money market or stable value funds) only for a limited duration of not more than 120 days after a participant’s initial elective deferral. After 120 days, funds must be redirected to one of the three regular qualified default investment alternatives.⁶

The regulations set forth two exceptions for the holding of employer securities:

(1)  The first is for the acquisition of employer securities held or acquired by a registered investment company (or similar pooled investment vehicle that is subject to state or federal examination) with respect to which such investments are in accordance with the stated investment objectives of the investment vehicle and are independent of the plan sponsor or its affiliate.⁷ In the preamble to the proposed regulations, the DOL explained that this exception should accommodate large publicly traded employers whose default investment alternatives may include pooled investment vehicles that invest in such companies.⁸

(2)  A second exception is provided with respect to accounts managed by an investment management service for employer securities acquired as a matching contribution from the employer/plan sponsor or for employer securities acquired prior to management by the investment management service.⁹