Investment Management/ ERISA Fiduciary Alert. DOL Issues Final QDIA Regulation

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1 December 2007 K&L Gates comprises approximately 1,400 lawyers in 22 offices located in North America, Europe and Asia, and represents capital markets participants, entrepreneurs, growth and middle market companies, leading FORTUNE 100 and FTSE 100 global corporations and public sector entities. For more information, please visit DOL Issues Final QDIA Regulation The U.S. Department of Labor ( DOL ) has issued its long-awaited final regulation (the QDIA Regulation ) that describes qualified default investment alternatives ( QDIAs ) for participant-directed 401(k) plans subject to ERISA. In general, where the requirements of the QDIA Regulation, which is in the nature of a safe harbor for default investments, are satisfied, plan fiduciaries are relieved of liability for losses resulting from participants default investments in QDIAs to the same extent as they are relieved of liability for losses resulting from affirmative participant investment directions. The QDIA Regulation, which is effective on December 24, 2007, is expected to have a significant impact on the structure of investment options offered under 401(k) plans. Background As a result of changes made by the Pension Protection Act of 2006, employees may be automatically enrolled in qualified cash or deferred plans, including 401(k) plans. Automatically enrolled participants will have the opportunity to direct their individual account investments, but experience has shown that, in many cases, participants are unable or unwilling to make affirmative decisions, leaving the plan sponsor and other fiduciaries to face the dilemma of what to do with the money. The Pension Protection Act came to the rescue by amending ERISA specifically to provide that a non-directing participant will be deemed to have directed an investment of his or her account if the plan invests the participant s assets in a qualified default investment alternative, or QDIA. In such cases, plan fiduciaries are relieved of liability for losses resulting from the investment to the same extent as if the participants had made affirmative investment decisions. QDIAs especially when coupled with automatic enrollment and automatic contribution arrangements are likely to substantially increase assets invested in 401(k) plans. Important Changes from the Proposed Regulation The QDIA Regulation differs in a number of important ways from the proposed regulation issued on September 27, 2006 (the Proposed Regulation ). 1 The following summarizes the most significant of these changes. Stable Value Although insurance companies and related industries lobbied heavily to have stable value products qualify as QDIAs, the DOL concluded that these products, standing alone, generally would not meet participants long-term retirement needs. The QDIA Regulation does permit plan sponsors to use stable value funds for limited purposes, however: Under the QDIA Regulation, a plan may provide for default investments in a stable value product for up to 120 days after the date of the participant s first elective contribution Fed. Reg (Sept. 27, 2006). The DOL received over 120 comment letters on the Proposed Regulation.

2 As explained below, default investments in certain stable value products and certain other capital preservation funds made prior to the effective date of the QDIA Regulation (December 24, 2007) are treated as if made pursuant to a QDIA. In the preamble to the final rules, the DOL went out of its way to emphasize that the standards specified in the QDIA Regulation are not intended to be the exclusive means by which fiduciaries may fulfill their responsibilities with respect to default investments. Thus, other products, including stable value products, may be prudent default investment options even though they technically may not satisfy the standards for qualification as a QDIA. Finally, the DOL noted that stable value products will likely be important components of QDIA portfolio investments. QDIA Managers The DOL expanded the list of persons who are permitted to manage the assets of a QDIA to include: Plan sponsors that are named fiduciaries, and Trustees (including bank trustees of collective funds) who otherwise meet the definition of investment manager. Notice The DOL added an exception to the requirement that participants must receive at least 30 days advance notice of investment of a participant s individual account assets in a QDIA, allowing notice as late as the first date of plan eligibility, provided the participant has the opportunity to make a permissible withdrawal, as defined in Internal Revenue Code provisions relating to automatic enrollment (generally, a tax free withdrawal made within 90 days after the first contribution made on behalf of a participant under an automatic contribution arrangement). The QDIA Regulation requires: (1) during the first 90 days after the first default investment in a QDIA made on a participant s behalf, no restrictions, fees, or expenses, including any surrender or redemption fees, may be imposed, other than ongoing fees charged for the operation of the fund itself, and (2) after the first 90 days, any restriction or fee imposed must be the same for all participants regardless of whether the participant affirmatively elected the investment or the investment was made by default. Fiduciaries may select any type of QDIA In the preamble to the QDIA Regulation, the DOL expressly stated that fiduciaries are not required to evaluate different types of QDIAs to determine which is most suitable for participants in a particular plan. The DOL also noted, however, that the responsible fiduciary is obligated to prudently select the specific QDIA arrangement within a particular class. Conditions for Relief under the QDIA Regulation Relief from fiduciary liability is available under the QDIA Regulation if: Account assets of participants who have not provided an affirmative investment direction are invested in a QDIA. Participants have been given an opportunity to affirmatively direct their investments, but failed to do so. Participants are given both an initial and an annual notice. The initial notice may be made anytime on or before the date the participant becomes eligible for participation in the plan, as long as the participant is allowed to make a permissible withdrawal. 2 Transfer or Withdrawal Restrictions The DOL revised the Proposed Regulation s requirement that a participant must be allowed to transfer out of a QDIA without financial penalty. 2 Pursuant to Code section 414(w), relating to automatic enrollment, a participant generally has the ability to withdraw from his or her defaulted investment without tax penalty (i.e., a permissible withdrawal ), within 90 days from the first contribution made on the participant s behalf under an automatic contribution arrangement. December

3 If the participant is not allowed to make a permissible withdrawal as described above, the participant must be given advance notice at least 30 days before the date the participant becomes eligible for the plan or at least 30 days before the first default investment in a QDIA. Annual notice must be made at least 30 days before the beginning of each plan year. The notice must (i) describe how and when assets will be invested on a participant s behalf and the participant s right to opt out or invest alternative amounts, (ii) explain the participant s right to direct his or her investments, (iii) describe the QDIA including details such as investment objectives, risks and returns, and fees and expenses, (iv) explain the participant s right to transfer to alternative investments (and describe the costs associated with such a transfer), and (v) let the participant know how to obtain information on other investments available under the plan. Participants defaulted into a QDIA receive the same information that is passed through to participants who elect to direct their investments under the plan. 3 Participants defaulted into a QDIA have the opportunity to transfer out of the QDIA, in whole or in part, at least as often as any other participant and, in any event at least once every three months. Any transfer by a participant out of a QDIA within the first 90 days after investments are first made in a QDIA on his of her behalf may not be subject to any restrictions, fees or expenses, except those charged on an ongoing basis for the operation of the investment itself. 4 After the first 90 days, transfers may be subject only to fees or restrictions that would be imposed or not otherwise charged to participants who affirmatively chose to invest in the QDIA. 3 Specifically, the materials set forth in 29 C.F.R c-1(b) (2)(i)(b)(1)(viii) and (ix) and 29 C.F.R. 404c-1(b)(2)(i)(B)(2). 4 Such as investment management fees, distribution and/or service fees, 12b-1 fees, or legal, accounting, transfer agent and similar administrative expenses. The plan must offer a broad range of investment alternatives. Requirements for Qualification as a QDIA The QDIA Regulation includes four requirements for a QDIA. A QDIA may not hold or permit the acquisition of employer securities, subject to two exceptions: Employer securities may be held or acquired by a mutual fund or similar pooled investment vehicle which itself is a QDIA or in which a QDIA invests, if doing so is consistent with the fund s stated investment objectives and the fund is independent of the plan sponsor or any of the plan sponsor s affiliates. Employer securities may be held in a managed account type QDIA as a matching contribution from the employer/plan sponsor, or acquired before the investment management service began managing the account, as long as the QDIA manager has the authority to dispose of the securities. A QDIA must allow any participant defaulted into the QDIA to transfer all or part of his or her investment from the QDIA to any other investment available under the plan. A QDIA must be managed by an investment manager, as defined in section 3(38) of ERISA, 5 or a trustee of the plan that otherwise meets the requirements for treatment as an investment manager, or must be an investment company registered under the Investment Company Act of 1940 (or a stable value QDIA in the limited circumstances described below). 5 To be an investment manager pursuant to section 3(38) of ERISA, a manager must have power to manage, acquire, or dispose of any plan asset and be (i) registered as an investment adviser under the Investment Advisers Act of 1940 or under the laws of the state of its principal place of business, (ii) a bank, or (iii) an insurance company qualified in more than one state to manage, acquire, or dispose of any plan asset. The investment manager must also acknowledge in writing its fiduciary status with respect to the plan. December

4 A QDIA must be one of four types of investment products: Life-cycle Fund QDIA Type This type of QDIA seeks to provide varying degrees of long-term appreciation and capital preservation through a mix of equity and fixed income exposures based on a participant s age, target retirement date, or life expectancy. It must diversify investments to minimize the risk of large losses and apply generally accepted investment theories. It must change its asset allocations to become more conservative as participants in the target group age. Target date funds generally would fall in this category. Balanced Fund QDIA Type This type of QDIA seeks to provide long-term appreciation and capital preservation through a mix of equity and fixed income exposures consistent with a targeted level of risk appropriate for participants in the plan as a whole. It must diversify investments to minimize the risk of large losses and must apply generally accepted investment theories in developing asset allocation. Certain balanced funds fall within this category. Managed Account QDIA Type This type of QDIA is an investment management service in which a plan fiduciary applies generally accepted investment theories to allocate assets of a participant s individual account to various investment options available under the plan. The fiduciary must base its allocations on the participant s age, target retirement date, or life expectancy and must change allocations to become more conservative as a participant ages. It also must seek to achieve varying degrees of long-term appreciation and capital preservation through a mix of equity and fixed income exposures and be diversified to minimize the risk of large losses. Managed account programs generally fall within this category. Stable Value QDIA Type As noted above, stable value funds may qualify as QDIAs only in limited circumstances: For the first 120 days after the participant s first elective contribution only, an investment product or fund designed to preserve principal and provide a reasonable rate of return, consistent with liquidity, may qualify as a QDIA. Such a product or fund seeks to maintain a dollar value equal to the amount invested and is offered by a state or federally regulated financial institution. An investment product that is designed to guarantee principal and a rate of return generally consistent with that earned on intermediate investment grade bonds, while providing liquidity, and (i) imposes no fees or surrender charges on withdrawals by the participant, and (ii) guarantees principal and rates of return by a state or federally regulated financial institution may be treated as a QDIA, but only with respect to assets invested in the product prior to the effective date of the Final Regulation (December 24, 2007). December

5 Please contact any member of the K&L Gates ERISA Fiduciary Group if you have further questions on the issues discussed in this Alert. Members of the ERISA Fiduciary Group and their telephone numbers and addresses are listed below. Los Angeles Alexandra C. Sparling William P. Wade Washington, D.C. Catherine S. Bardsley Susan I. Gault-Brown David E. Pickle William A. Schmidt Kristina M. Zanotti K&L Gates comprises multiple affiliated partnerships: a limited liability partnership with the full name Kirkpatrick & Lockhart Preston Gates Ellis LLP qualified in Delaware and maintaining offices throughout the U.S., in Berlin, and in Beijing (Kirkpatrick & Lockhart Preston Gates Ellis LLP Beijing Representative Office); a limited liability partnership (also named Kirkpatrick & Lockhart Preston Gates Ellis LLP) incorporated in England and maintaining our London office; a Taiwan general partnership (Kirkpatrick & Lockhart Preston Gates Ellis - Taiwan Commercial Law Offices) which practices from our Taipei office; and a Hong Kong general partnership (Kirkpatrick & Lockhart Preston Gates Ellis, Solicitors) which practices from our Hong Kong office. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners in each entity is available for inspection at any K&L Gates office. This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. Data Protection Act 1998 We may contact you from time to time with information on Kirkpatrick & Lockhart Preston Gates Ellis LLP seminars and with our regular newsletters, which may be of interest to you. We will not provide your details to any third parties. Please london@klgates.com if you would prefer not to receive this information Kirkpatrick & Lockhart Preston Gates Ellis LLP. All Rights Reserved. December