The increasing
popularity of salary deferral plans has led to a rise in the number
of retirement accounts that allow participants to self-direct their
investments. Participants like it because it gives them control over
their accounts which are at least partially funded by their own
contributions. Employers like it because it reduces the investment
responsibilities of plan fiduciaries.
Sometimes a participant may fail to give investment direction
although the opportunity exists. A fiduciary must then invest the
assets on behalf of the participant. This is more prevalent in plans
using an automatic enrollment feature, which signs up an eligible
employee at a specified deferral rate unless the employee elects
otherwise. If election forms are not returned, the account is
established and contributions are placed in a default investment.
In non-safe harbor plans, automatic enrollment can help passage
of the average deferral percentage (ADP) and average contribution
percentage (ACP) tests by increasing plan participation. This can
result in higher contributions being allowed for highly compensated
employees (generally owners and those earning over $100,000 in
2007). It also results in more money being saved for retirement
which is beneficial in light of concerns about the social security
system.
The Pension Protection Act of 2006 (PPA) created an "eligible
automatic contribution arrangement" effective in 2008. Among other
things, it requires default investments to meet certain guidelines.
The Department of Labor (DOL) recently issued final regulations for
a "qualified default investment alternative" (QDIA). This article
will take a close-up look at the QDIA provisions and how they apply
to automatic enrollment arrangements.
Automatic Enrollment
The most common use of QDIAs will be under automatic enrollment
provisions when employees fail to return participation election
forms. But they can also be used any time a participant fails to
exercise the right to direct investments.
PPA established criteria for eligible automatic contribution
arrangements under which salary deferrals to a 401(k), 403(b) or
457(b) plan could be automatically deducted at a specified rate
unless the employee elects not to have the deduction or elects a
different rate. Employees must receive a notice within a reasonable
time before their eligibility and prior to each plan year explaining
their right to elect not to participate or a different deferral rate
from the default election. It must also explain how contributions
will be invested in the absence of their election. Participants may
be given a 90-day period during which they can request a return of
their deferrals deducted without their election pursuant to an
automatic enrollment program.
Plans that meet the eligible automatic contribution arrangement
requirements are subject to relaxed rules for correcting a failed
ADP or ACP test. This includes the extension of the 2½-month period
for penalty-free corrective distributions to six months. In
addition, fiduciaries are granted liability protection by using the
default investments provided under the QDIA rules.
PPA also provided for a "qualified automatic contribution
arrangement" which, like safe harbor 401(k) plans, automatically
satisfies the ADP and ACP tests, as well as the top heavy
requirements. The default election must be at least 3% the first
year, 4% the second, 5% the third and 6% thereafter, not to exceed
10%. In addition, the employer must make either a 3% non-elective
contribution for all non-highly compensated employees (generally
non-owners and those earning less than $100,000 in 2007) or a match
contribution of 100% of the first 1% deferred and 50% of the next 5%
deferred. Employer contributions must be fully vested after two
years of service.
The final regulations reiterate that any state law that directly
or indirectly prohibits or restricts the inclusion in any plan of an
automatic contribution arrangement is pre-empted by ERISA as amended
by PPA.
Qualified Default Investment Alternative
(QDIA)
Employers who want to implement automatic enrollment can now do
so without concern over fiduciary liability. Adherence to the
guidelines of the final regulations will protect plan fiduciaries
from exposure resulting from investment losses.
The new regulations were designed to meet the long-term
retirement savings needs of each employee. A plan must meet the
following requirements to satisfy the QDIA provisions:
- Assets must be invested in one of the allowable QDIA
categories (see below);
- Participants must first be given an opportunity to provide
investment direction;
- A notice must be provided to participants containing
information about the QDIA and how to obtain information about the
other investment options under the plan (see below);
- Materials concerning the QDIA investment, such as mutual fund
prospectuses and proxy voting rights, which would normally be
provided to participants allowed to self-direct, must be furnished
to participants;
- Participants must be given the opportunity to transfer their
QDIA investment to any other investment option allowed under the
plan as often as the plan allows transfers by those who exercise
investment control, but not less frequently than once within any
three-month period;
- No fees or expenses can be charged for transfers or
permissible withdrawals out of a QDIA during the first 90 days;
and
- The plan must offer a broad range of investment alternatives
in accordance with ERISA section 404(c) which governs
participant-directed accounts.
Allowable Investment Alternatives
In order to be considered a QDIA, the investment must be in one
of the following categories:
- A mix of investments that takes into consideration a
participant’s age, projected retirement date or life expectancy
(such as a life-cycle or target-retirement-date fund);
- A mix of investments which bases its investment risk on the
participants of the plan as a whole (such as a balanced fund); or
- A professionally managed account that is diversified and
considers the participant’s age, projected retirement date or life
expectancy.
With certain exceptions, employer securities cannot be part of a
QDIA.
In addition, a capital preservation investment, such as a money
market account, may be utilized during the first 120 days after
which time it must be transferred into one of the three alternatives
described above. This will preserve the principal in the event the
participant requests a refund during the 90-day revocation period
provided by some auto enrollment programs.
Investments that meet these guidelines will provide fiduciary
protection under ERISA section 404(c) as if participants had
exercised control over such assets. However, as is the case with all
404(c) participant-directed accounts, fiduciaries must still
prudently select and monitor any qualified default investment
alternative under the plan.
QDIA Notice
The notice to participants must be written in a manner expected
to be understood by the average participant and contain the
following information:
- A description of the circumstances under which a participant’s
account may be invested in a QDIA and, if applicable, the
circumstances under which deferrals will be deducted and
contributed to the plan under an automatic enrollment program,
including the deferral percentage and the participant’s right to
elect a different percentage or to decline participation;
- An explanation of the right of participants to direct the
investment of the assets in their individual accounts;
- A description of the QDIA, including investment objectives,
risk and return characteristics (if applicable) and any fees and
expenses;
- A description of the right of participants whose accounts are
invested in a QDIA to direct the investment of those assets to any
other investment alternative available under the plan, including
any restrictions, fees or expenses applicable to such transfer;
and
- An explanation of where participants can obtain information
about other investment alternatives under the plan.
The notice must be distributed at least 30 days prior to a
participant’s eligibility; 30 days before the first QDIA investment;
or anytime up to the eligibility date if the participant can
exercise the 90-day permissible withdrawal option in an automatic
enrollment program. In addition, the notice must be given out at
least 30 days prior to each subsequent plan year.
Effective Date
The QDIA rules take effect on December 24, 2007. Default
investments made prior to that date will be "grandfathered" if they
meet certain requirements of guaranteed principal, rate of return
and withdrawal without fees or surrender charges.
Conclusion
The DOL’s final regulations on QDIAs provide welcome guidance for
employers utilizing automatic enrollment provisions in their salary
deferral plans. Fiduciaries will now be protected when they
establish default investments that meet the new guidelines. Now that
these rules are in place, it is expected that automatic enrollment
will significantly increase participation in salary deferral plans
in the coming years.
IRS and Social Security Annual Limitations
Each year the U.S. government adjusts the limits for qualified
plans and social security to reflect cost of living adjustments and
changes in the law. Many of these limits are based on the “plan
year.” The elective deferral and catch-up limits are always based on
the calendar year. Click here to view the
2008 limits as well as the three prior years for comparative
purposes.
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