ERISA Amendments Effective Dec. 31

Background

The passage of ' 624 of the act stems from Congress' concern that too few employees are participating in their employers' defined contribution plans and, therefore, not adequately saving for retirement. In addition, those employees who do not assume responsibility for their investments risk having their assets placed in a conservative alternative that will not provide adequate savings for a secure retirement. Recent studies have shown that adoption of automatic enrollment provisions can dramatically increase plan participation rates by an average of about 20% per plan. At this time, however, fewer than 20% of the employers sponsoring 401(k) plans have adopted such a provision. One likely reason for the slow adoption of automatic enrollment provisions in individual account plans is the fiduciary responsibility that a plan fiduciary assumes when it makes investment decisions on behalf of the automatically enrolled participants.

Prior to passage of ' 624 of the act, the department ruled that a participant or beneficiary would not be considered to have exercised control over his or her investments when the participant or beneficiary is merely ap-praised of investments that will be made on his or her behalf in the absence of instructions to the contrary. See Revenue Ruling 2000-8, dated Jan. 27, 2000. Therefore, plan fiduciaries would have fiduciary responsibility for the default investment decisions. As a result, many plans did not offer automatic enrollment provisions and those that did attempted to minimize the fiduciary liability by limiting default investments to those that emphasize preservation of capital and little risk of loss such as money market and stable value funds.

Conditions to Fiduciary Relief

The proposed regulations impose six conditions that must be satisfied for a fiduciary to be relieved of fiduciary responsibility in connection with the utilization of a default investment alternative. The relief provided under ' 404(c)(5) with respect to default investment alternatives is the same as is provided to fiduciaries of participant-directed plans under ' 404(c)(1)(B) of ERISA ('404(c) Plans) although, in the case of the relief extended with respect to default investment alternatives, the plan at issue does not need to be a ' 404(c) Plan. As is the case with the relief provided to '404(c) Plans, the proposed regulations do not provide relief from the general fiduciary duties applicable to the selection and monitoring of the investment alternatives. In addition, the proposed regulations provide no relief from the prohibited transaction requirements of ' 406 of ERISA.

The first condition for the fiduciary relief is that the investment must be made in a 'qualified default investment alternative' and the proposed regulation sets forth five requirements that must be satisfied for such qualification to be met. First, for an investment to be a qualified default investment alternative, the investment may not impose financial penalties or otherwise restrict the ability of a participant or beneficiary to transfer, in whole or in part, his or her investment from the qualified default investment alternative to another investment alternative available under the plan. Second, to qualify as a default investment alternative, the investment must be managed by an investment manager as defined in ' 3(38) of ERISA or must be an investment company registered under the Investment Company Act of 1940. The third requirement states that the default investment must be diversified so as to minimize the risk of large losses.

The fourth requirement provides that the qualified default investment alternative must be one of three types of investments. The first type of investment alternative permitted is a 'life-cycle,' 'targeted-retirement-date' or similar fund. Such a fund provides varying degrees of long-term appreciation and capital preservation through a mix of equity and fixed-income exposure based on the participant's age, target retirement date or life expectancy. The second type of permitted investment is one designed to provide long-term appreciation and capital preservation through a mix of equity and fixed-income exposures consistent with a target level of risk appropriate for participants of the plan as a whole. An example may be a 'balanced' fund. The third type of investment would be one which an investment manager allocates the assets of a participant's individual account in a manner similar to a life-cycle fund using the investment alternatives otherwise available under the plan. An example of such a service may be a 'managed account.'

Requirements

Significantly, none of the investment types are required to take into account risk tolerances, investment or other preferences of any individual participant. The final requirement is that a qualified default investment alternative may not hold or permit the acquisition of employer securities. However, it is not a violation of this requirement with respect to employer securities held or acquired by an investment company registered under the Investment Act of 1940 or a similar pooled investment vehicle or, with respect to a managed account type default investment described above, for employer securities acquired as a matching contribution from the employer/plan sponsor previously at the direction of the participant or beneficiary.

The second condition for the ' 404(c)(5) relief is that the participant or beneficiary on whose behalf assets are being invested had the opportunity to but did not direct the investment of assets in his or her account. Thus, the relief will not be available where the default investment is applied to override a participant's actual investment direction. The third condition states that the participant must be furnished, at least 30 days in advance of such investment and within 30 days in advance of each subsequent year, a notice that meets the requirements of the regulation. This notice must contain:

• a description of the circumstances under which assets in the individual account of a participant may be invested on behalf of the participant and beneficiary in a qualified default investment alternative,
• a description of the qualified investment alternative, including a description of the investment objectives, risk and return characteristics and fees and expenses,
• a description of the right of the participants and beneficiaries on whose behalf assets are invested to direct the investment to any other investment alternative under the plan without financial penalty, and
• an explanation of where the participants and beneficiaries can obtain investment information concerning the other investment alternatives available under the plan.

Plan sponsors that have plans with an automatic enrollment feature should review their plans to ensure that they can comply with the 30-day advance notice requirement for new participants.

The fourth condition requires that the terms of the plan provide that any material provided to the plan relating to a participant's investment in a qualified default investment alternative (eg, account statements, prospectuses, proxy voting material) will be provided to the participant or beneficiary. This may necessitate the implementation of additional administrative procedures to ensure that all such materials are actually provided to participants. This is in contrast to the requirement applicable to ' 404(c) Plans that only requires this information to be provided upon request. It is possible that some or all of the materials may be distributed to participants electronically in accordance with ' 29 CFR 2520.104b-1(c) of the labor regulations.

The fifth condition requires that any participant or beneficiary on whose behalf assets are invested in a qualified default investment alternative be afforded the opportunity, consistent with the terms of the plan (but in no event less frequently than once within any 3-month period), to transfer in whole or in part, such assets to any other investment alternative available under the plan without financial penalty. The final condition requires the plan to offer participants and beneficiaries the opportunity to invest in a 'broad range of investment alternatives' within the meaning of ' 29 CFR 2550.404c-1(b)(3). The department has stated it believes virtually all individual account plans that provide for participant direction, likely will meet this standard without having to undertake significant changes in available investment alternatives.

New Section

In addition to ' 404(c)(5), the act also added a new ' 514(e)(q) to ERISA providing that Title I of ERISA shall supersede any state law that would directly or indirectly prohibit or restrict the inclusion in any plan of an automatic contribution arrangement. In the preamble to the proposed regulations, the department specifically requested comment on whether and to what extent it should issue regulations addressing the preemption provisions

Related Statutory Changes

In furthering its efforts to increase plan participation through the adoption of automatic enrollment provisions, the act also adds a new ' 401(k)(13) to the Internal Revenue Code of 1986, as amended (the code) which provides for a safe harbor from the code's ADP and ACP tests for those plans with automatic enrollment features that meets certain requirements outlined in the statute. One such requirement is that the employer either: 1) make matching contributions on behalf of each employee who is not a highly compensated employee in an amount equal to the sum of 100% of the elective contributions of the employee to the extent that such contributions do not exceed 1% of compensation plus 50% of so much of such compensation as exceeds 1% but does not exceed 6% of compensation; or 2) make a nonelective contribution of at least 3% of compensation. In addition, ' 401(k)(13) contains a notice provision. In the preamble to the proposed regulations discussed above, the department has stated it believes that both notice requirements will be able to be satisfied with a single notice. The code ' 401(k)(13) safe harbor will not become effective until after Dec. 31, 2007 and the IRS has yet to issue regulations thereunder.

Plan sponsors are encouraged to review their plans that currently have a default investment alternative to ensure that it satisfies the requirements for qualified default investments under the proposed regulations. In addition, administrative procedures will need to be implemented to ensure the notice and other requirements of the proposed regulations will be met. Finally, plan sponsors that do not have an automatic enrollment feature may want to consider adding one to their plans now that a significant impediment to doing so has been eliminated.

Donald P. Carleen is a partner and chairs the executive compensation and employee benefits group at Fried, Frank, Harris, Shriver and Jacobson. Matthew Behrens, an associate with the firm, assisted in the preparation of this article, which originally published in the New York Law Journal, a sister publication of this newsletter.

On Sept. 26, the Employee Benefits Security Administration of the Department of Labor (department) issued proposed regulations implementing amendments to ' 404(c) of the Employee Retirement Income Securities Act of 1974, as amended (ERISA).(The proposed regulations are at 29 CFR ' 550.404c-5.)

These amendments were made by ' 624 of the Pension Protection Act of 2006 (the act) and provide relief to fiduciaries of participant-directed individual account plans where, in the absence of investment directions from a participant, the plan invests such participant's assets in a 'qualified default investment alternative.'

In that case, new ' 404(c)(5)(A) to ERISA provides that participants will be deemed to have exercised control over the assets in their accounts with respect to the amount of contributions and earnings for purposes of ' 404(c)(1) of ERISA if such investment is made in accordance with regulations prescribed by the Secretary of Labor. Section 624(b) of the act directs the department to issue final regulations under ' 404(c)(5)(A) of ERISA no later than six months after the date of enactment of the act. Section 404(c)(5) and its corresponding regulations will become effective for plan years beginning after Dec. 31, 2006.

Background

The passage of ' 624 of the act stems from Congress' concern that too few employees are participating in their employers' defined contribution plans and, therefore, not adequately saving for retirement. In addition, those employees who do not assume responsibility for their investments risk having their assets placed in a conservative alternative that will not provide adequate savings for a secure retirement. Recent studies have shown that adoption of automatic enrollment provisions can dramatically increase plan participation rates by an average of about 20% per plan. At this time, however, fewer than 20% of the employers sponsoring 401(k) plans have adopted such a provision. One likely reason for the slow adoption of automatic enrollment provisions in individual account plans is the fiduciary responsibility that a plan fiduciary assumes when it makes investment decisions on behalf of the automatically enrolled participants.

Prior to passage of ' 624 of the act, the department ruled that a participant or beneficiary would not be considered to have exercised control over his or her investments when the participant or beneficiary is merely ap-praised of investments that will be made on his or her behalf in the absence of instructions to the contrary. See Revenue Ruling 2000-8, dated Jan. 27, 2000. Therefore, plan fiduciaries would have fiduciary responsibility for the default investment decisions. As a result, many plans did not offer automatic enrollment provisions and those that did attempted to minimize the fiduciary liability by limiting default investments to those that emphasize preservation of capital and little risk of loss such as money market and stable value funds.

Conditions to Fiduciary Relief

The proposed regulations impose six conditions that must be satisfied for a fiduciary to be relieved of fiduciary responsibility in connection with the utilization of a default investment alternative. The relief provided under ' 404(c)(5) with respect to default investment alternatives is the same as is provided to fiduciaries of participant-directed plans under ' 404(c)(1)(B) of ERISA ('404(c) Plans) although, in the case of the relief extended with respect to default investment alternatives, the plan at issue does not need to be a ' 404(c) Plan. As is the case with the relief provided to '404(c) Plans, the proposed regulations do not provide relief from the general fiduciary duties applicable to the selection and monitoring of the investment alternatives. In addition, the proposed regulations provide no relief from the prohibited transaction requirements of ' 406 of ERISA.

The first condition for the fiduciary relief is that the investment must be made in a 'qualified default investment alternative' and the proposed regulation sets forth five requirements that must be satisfied for such qualification to be met. First, for an investment to be a qualified default investment alternative, the investment may not impose financial penalties or otherwise restrict the ability of a participant or beneficiary to transfer, in whole or in part, his or her investment from the qualified default investment alternative to another investment alternative available under the plan. Second, to qualify as a default investment alternative, the investment must be managed by an investment manager as defined in ' 3(38) of ERISA or must be an investment company registered under the Investment Company Act of 1940. The third requirement states that the default investment must be diversified so as to minimize the risk of large losses.

The fourth requirement provides that the qualified default investment alternative must be one of three types of investments. The first type of investment alternative permitted is a 'life-cycle,' 'targeted-retirement-date' or similar fund. Such a fund provides varying degrees of long-term appreciation and capital preservation through a mix of equity and fixed-income exposure based on the participant's age, target retirement date or life expectancy. The second type of permitted investment is one designed to provide long-term appreciation and capital preservation through a mix of equity and fixed-income exposures consistent with a target level of risk appropriate for participants of the plan as a whole. An example may be a 'balanced' fund. The third type of investment would be one which an investment manager allocates the assets of a participant's individual account in a manner similar to a life-cycle fund using the investment alternatives otherwise available under the plan. An example of such a service may be a 'managed account.'

Requirements

Significantly, none of the investment types are required to take into account risk tolerances, investment or other preferences of any individual participant. The final requirement is that a qualified default investment alternative may not hold or permit the acquisition of employer securities. However, it is not a violation of this requirement with respect to employer securities held or acquired by an investment company registered under the Investment Act of 1940 or a similar pooled investment vehicle or, with respect to a managed account type default investment described above, for employer securities acquired as a matching contribution from the employer/plan sponsor previously at the direction of the participant or beneficiary.

The second condition for the ' 404(c)(5) relief is that the participant or beneficiary on whose behalf assets are being invested had the opportunity to but did not direct the investment of assets in his or her account. Thus, the relief will not be available where the default investment is applied to override a participant's actual investment direction. The third condition states that the participant must be furnished, at least 30 days in advance of such investment and within 30 days in advance of each subsequent year, a notice that meets the requirements of the regulation. This notice must contain:

• a description of the circumstances under which assets in the individual account of a participant may be invested on behalf of the participant and beneficiary in a qualified default investment alternative,
• a description of the qualified investment alternative, including a description of the investment objectives, risk and return characteristics and fees and expenses,
• a description of the right of the participants and beneficiaries on whose behalf assets are invested to direct the investment to any other investment alternative under the plan without financial penalty, and
• an explanation of where the participants and beneficiaries can obtain investment information concerning the other investment alternatives available under the plan.

Plan sponsors that have plans with an automatic enrollment feature should review their plans to ensure that they can comply with the 30-day advance notice requirement for new participants.

The fourth condition requires that the terms of the plan provide that any material provided to the plan relating to a participant's investment in a qualified default investment alternative (eg, account statements, prospectuses, proxy voting material) will be provided to the participant or beneficiary. This may necessitate the implementation of additional administrative procedures to ensure that all such materials are actually provided to participants. This is in contrast to the requirement applicable to ' 404(c) Plans that only requires this information to be provided upon request. It is possible that some or all of the materials may be distributed to participants electronically in accordance with ' 29 CFR 2520.104b-1(c) of the labor regulations.

The fifth condition requires that any participant or beneficiary on whose behalf assets are invested in a qualified default investment alternative be afforded the opportunity, consistent with the terms of the plan (but in no event less frequently than once within any 3-month period), to transfer in whole or in part, such assets to any other investment alternative available under the plan without financial penalty. The final condition requires the plan to offer participants and beneficiaries the opportunity to invest in a 'broad range of investment alternatives' within the meaning of ' 29 CFR 2550.404c-1(b)(3). The department has stated it believes virtually all individual account plans that provide for participant direction, likely will meet this standard without having to undertake significant changes in available investment alternatives.

New Section

In addition to ' 404(c)(5), the act also added a new ' 514(e)(q) to ERISA providing that Title I of ERISA shall supersede any state law that would directly or indirectly prohibit or restrict the inclusion in any plan of an automatic contribution arrangement. In the preamble to the proposed regulations, the department specifically requested comment on whether and to what extent it should issue regulations addressing the preemption provisions

Related Statutory Changes

In furthering its efforts to increase plan participation through the adoption of automatic enrollment provisions, the act also adds a new ' 401(k)(13) to the Internal Revenue Code of 1986, as amended (the code) which provides for a safe harbor from the code's ADP and ACP tests for those plans with automatic enrollment features that meets certain requirements outlined in the statute. One such requirement is that the employer either: 1) make matching contributions on behalf of each employee who is not a highly compensated employee in an amount equal to the sum of 100% of the elective contributions of the employee to the extent that such contributions do not exceed 1% of compensation plus 50% of so much of such compensation as exceeds 1% but does not exceed 6% of compensation; or 2) make a nonelective contribution of at least 3% of compensation. In addition, ' 401(k)(13) contains a notice provision. In the preamble to the proposed regulations discussed above, the department has stated it believes that both notice requirements will be able to be satisfied with a single notice. The code ' 401(k)(13) safe harbor will not become effective until after Dec. 31, 2007 and the IRS has yet to issue regulations thereunder.

Plan sponsors are encouraged to review their plans that currently have a default investment alternative to ensure that it satisfies the requirements for qualified default investments under the proposed regulations. In addition, administrative procedures will need to be implemented to ensure the notice and other requirements of the proposed regulations will be met. Finally, plan sponsors that do not have an automatic enrollment feature may want to consider adding one to their plans now that a significant impediment to doing so has been eliminated.

Donald P. Carleen is a partner and chairs the executive compensation and employee benefits group at Fried, Frank, Harris, Shriver and Jacobson. Matthew Behrens, an associate with the firm, assisted in the preparation of this article, which originally published in the New York Law Journal, a sister publication of this newsletter.