The Pension Protection Act (“PPA”) provides new protections for fiduciaries by extending the application of ERISA section 404(c) to blackout periods, default investments and the mapping of participant accounts.
By way of background, fiduciaries of plans that comply with 404(c) are given protection against some fiduciary breach claims for investment decisions in plans where participants direct their investments. 404(c) provides fiduciaries of compliant plans with relief from liability for the investment decisions made by participants (that is, fiduciaries are protected from the imprudent use of the investment options by participants -– but are still legally responsible for the selection and monitoring of the investments).
If participants fail to direct their investments, however, the fiduciaries are responsible for prudently investing their accounts for them. When the fiduciaries make the decisions, 404(c) protection is lost, because the participants did not exercise control. This is true even if the fiduciaries use a default investment for this purpose. Although most plans want to obtain the fiduciary protection afforded by 404(c), many plans fall short due to the stringent requirements of the DOL regulation. Thus, while the new protections afforded under the PPA are welcome relief, to the extent plans are required to comply with the 404(c) regulation, the relief may be illusory.
Blackout Periods and Mapping
The PPA extends 404(c) protection (i) during blackout periods, if the plan sponsor otherwise meets the requirements of ERISA in connection with authorizing and implementing a blackout period, and (ii) for mapping that constitutes a “qualified change in investment options,” so long as certain conditions are met. This relief is available for plan years beginning after December 31, 2007 (with a delayed effective date for collectively bargained plans).
Prior to the PPA, it was not clear how 404(c) applied during a blackout period. In theory, a 404(c) compliant plan should have maintained its 404(c) protection because the 404(c) regulation only requires that participants be allowed to make investment changes once a quarter and few blackouts last longer than that.
The PPA makes two changes. First, it provides that 404(c) relief is generally not available during a blackout period. Second, however, the PPA provides that, if the fiduciaries implement a blackout period in accordance with ERISA, the fiduciaries will not be liable for any losses occurring during that period. (The language of the statute makes it clear that the fiduciary relief from liability is available regardless of whether the plan complied with 404(c) prior to the blackout.)
However, that protection ends with the blackout. To have 404(c) protection after the blackout, the plan must comply with 404(c) generally, or with the QDIA rules (see below), or with the mapping requirements (see below).
Mapping is treated somewhat differently under the PPA. Mapping occurs when a fiduciary removes and replaces an investment option, and transfers participants’ money from the removed option to the new investment option. Prior to the PPA, relief under section 404(c) was not available where participant assets were mapped to a replacement investment option.
In order to be a “qualified change in investment options” (the new term used in the PPA), the following requirements must be met:
- Participant investments must be moved to an investment option that is reasonably similar “in risk and rate of return” to the characteristics of the investment option offered immediately before the change;
- Participants must receive written notice of the change at least 30, but not more than 60 days, before the effective date of the change;
- The notice must include a comparison between the old and new investment options and must explain that, absent affirmative investment instructions from a participant to the contrary, the participant’s account will be invested in the new investment option, which has characteristics reasonably similar to the characteristics of the old investment option;
Finally, the plan must have satisfied the conditions of the 404(c) regulation prior to the change.
The requirement that, in order to get 404(c) protection, the participants’ money must be mapped to investments with similar risk and return characteristics poses practical problems for plan sponsors and fiduciaries. Specifically, who will make the determination that the replacement investment has reasonably similar risk-and-return characteristics? Also, who will be responsible for drafting the notice comparing the old and new investment options? Obviously, fiduciaries will have to make those decisions, but will they be able to adequately assess whether the replacement investment satisfies these requirements? As a practical matter, most fiduciaries are ill-equipped to make those types of decisions because they lack the technical expertise. As a result, they will need to rely on the advice of financial advisers, investment advisers or providers. The provision of that advice may cause concern for advisers and providers.
Finally, fiduciaries may be vulnerable to a later claim that the replacement investment was not similar in risk and rate of return to the removed investment. If so, what does a fiduciary need to do to protect himself? In addition, what level of documentation does a plan sponsor need to substantiate that the replacement investment is similar in risk and rate of return? As with all fiduciary decisions, in order to protect themselves, the fiduciaries must engage in a prudent process, reviewing information on the characteristics of the investment being removed and of the proposed replacement investments. (The recommendations of an adviser or provider can be critical evidence of a prudent process.) There is no specific answer for the amount or type of documentation the fiduciary will need to substantiate that the replacement is similar in risk and rate of return. But the fiduciaries must gather, review and maintain the documentation that a prudent person would want to review to make that decision.
Default Investment Options
For participant-directed plans, fiduciaries are required to exercise independent discretion and judgment in investing the money of those participants who do not direct their own investments. If the fiduciaries select a particular investment for that purpose -– as they often do -– it is called the “default investment” or “default account.”
Prior to the PPA, when participants failed to invest their accounts, the fiduciary could not obtain relief under 404(c) for the prudence of the default investment, because a critical component of 404(c) relief is that the participant must exercise control over the investment of the assets in his account. The PPA grants new relief for plan years beginning after December 31, 2006, by adding a new section 404(c)(5) to ERISA. This section extends the relief afforded by 404(c) to fiduciaries who invest participant assets in certain default investments.
Section 404(c)(5) provides that, in situations where participants have an opportunity to direct their investments but fail to do so, those participants will be treated as having exercised control over their accounts if they are invested in a qualified default investment alternative (“QDIA”). In that regard, the PPA directs the Department of Labor (“DOL”) to issue regulations defining the types of investments that will qualify as QDIAs. While the protections afforded by 404(c)(5) are available to all default investments that qualify as QDIAs, the protections are especially significant to plans with auto enrollment as a substantial portion of participants are invested in the default investment. Thus, by providing a default investment that meets the QDIA requirements and auto-enrolling participants in that investment, the fiduciaries are afforded the relief of 404(c)(5) for all auto-enrolled participants.
On September 27, 2006, the DOL issued a proposed regulation. The requirements contained in the regulation are delivered in the following portion of this Bulletin. Importantly, the proposed regulation provides that the relief under the PPA for QDIAs is available regardless of whether or not the plan meets the requirements of 404(c). Of course, the fiduciary is still responsible for the prudent selection and monitoring of the QDIA.
Requirements for QDIAs
The DOL proposed regulation provides five requirements for a QDIA. The QDIA:
- may not hold or acquire employer securities unless (i) the employer securities were held or acquired by a registered investment company or pooled investment vehicle that is independent of the plan sponsor or any affiliate, or (ii) the employer securities were acquired as a matching contribution from the employer or at the direction of the participant;
- must not impose financial penalties or otherwise restrict the ability of a participant to transfer his or her benefit to another investment alternative;
- must either be managed by a fiduciary (under section 3(38) of ERISA) or an investment company registered under the Investment Company Act of 1940;
- must be diversified to minimize the risk of large losses; and
- must be one of three types of investments (an agebased lifecycle or target date fund; a balanced fund, including risk-based lifestyle funds; or a managed account).
Unfortunately, the regulation does not provide guidance on what is meant by “financial penalty” or “otherwise restrict” in the second requirement. For example, it is unclear whether an investment that imposes a contingent deferred sales charge, redemption fee or surrender charge may be a QDIA. If those terms are defined broadly to include any type of financial charge or restriction, it would seem that investments which impose any fee upon transfers or restrict certain transfers may not be QDIAs. (We recently submitted two Comment Letters with the DOL on the proposed regulation; one on November 10, 2006 and the other on November 13, 2006. Please see the attached November 13th Comment Letter, which suggests that a more specific definition is needed for those terms.) Hopefully, the DOL will resolve this confusion by defining those terms in the final regulation.
The third requirement, that the QDIA must either be a mutual fund or that it be managed by a fiduciary, is also problematic. Because of that requirement, most asset allocation models will not qualify as QDIAs--even though they have been highly successful tools for improving participant investing.
In addition to meeting the QDIA requirements above, the plan must provide a “broad range of investment alternatives” and the participants must:
receive a notice, within a reasonable period of time before each plan year, which explains their right to direct the investment of their accounts and explains how their accounts will be invested if they do not make an affirmative election; and have a reasonable period of time after receiving the notice and before the default investment to make an election to direct the investment of their accounts.
The proposed regulation provides that, for purposes of the notice requirement, a “reasonable period of time” means that the notice must be furnished to participants at least 30 days in advance of the first default investment and annually thereafter. The notice must be written in a manner calculated to be understood by the average plan participant and must contain:
a description of the circumstances in which assets will be invested in the QDIA;
a description of the investment objectives of the QDIA, including its risk and return characteristics and fees and expenses;
a description of the participant’s right to move his investments to another investment alternative without financial penalty;
a description of how participants can obtain information about the other investment alternatives.
Most plans will be able to include the notice with their enrollment materials and provide that package to newly eligible participants more than 30 days before their enrollment date. However, for plans that use immediate automatic enrollment or immediate eligibility, it is unlikely that the notice could be provided 30 days in advance of the first default investment. Thus, the 30-day notice requirement may have the effect of discouraging employers who would like to take advantage of the relief afforded by 404(c)(5) from using immediate eligibility. In order to remedy this, we believe that the final regulation should provide a shorter notice period in those circumstances or, alternatively, provide that plans with immediate eligibility will be deemed to have satisfied the notice requirement if participants are furnished with a notice concurrent with their enrollment or shortly thereafter. (Our November 13th Comment Letter on the proposed regulation includes that suggestion.) We should point out that, if the final regulation does not solve this problem, the fiduciaries should nonetheless be protected (i.e., be entitled to QDIA treatment) for participant investments made 30 days after a notice is given.
The concerns over the timing of the notice are on-going. Consider, for example, a plan with monthly enrollment dates. For such a plan, assuming that there will be newly eligible employees enrolling in the plan every month of the year (i.e., monthly entry dates), the plan sponsor is responsible for providing notices on 13 occasions over the course of the plan year, that is, the initial notice to newly eligible participants at least 30 days before every month throughout the year and an annual notice. We believe that plan sponsors would like to issue fewer notices and still comply with the requirement that the notice be furnished “within a reasonable period of time of at least 30 days.” While the regulation does not define the outer limits of “within a reasonable period of time,” we would like for the final regulation to provide that 90 days is not unreasonable. If that is the case, practically speaking, a plan sponsor can issue fewer notices and still comply with the regulation. For example, if the plan sponsor issues 90-day notices, the plan sponsor would be able to issue 5 notices (4 notices throughout the year plus the annual notice) as opposed to 13.
As mentioned above, there are two notices required under the proposed regulation, the initial notice and the annual notice. The proposed regulation provides that the annual notice requirement can be met by including the four items of information, discussed above, in the summary plan description. Although the regulation does not include separate content requirements for the notices, from a practical standpoint it would seem that the initial notice would be worded slightly differently than the annual notice, especially when one considers the recipients. The initial notice is provided to all newly eligible employees, and while the regulation is not entirely clear, it would seem that the annual notice would only need to be provided to participants who are invested in the QDIA by default.
In addition to the concerns regarding the timing of the notice, there is an additional consideration -— that is, the content of the notice. The proposed regulation requires that the notice include a description of the QDIA (including a description of the investment objectives, risk-and-return characteristics -– if applicable -– and fees and expenses attendant to the investment alternative). Read literally, the requirement to include a description of the investment objectives and risk-and-return characteristics will prove to be difficult to comply with and overly burdensome. For example, if a plan uses age-based or target maturity funds, and if it offers eight funds with varying targeted dates, a notice would either need to be customized for eligible employees by age groups or, alternatively, the investment information would need to be provided to all eligible employees on all eight of the funds. Since it may be difficult, particularly for small- and mid-sized plans, to provide the customized information, it seems likely that many plans will include information on all of the funds. In order to avoid this, the DOL should consider modifying the regulation to clarify that the notice only requires a brief, general statement of the overall purpose of the QDIA, with references to other more detailed information (for example, to the prospectus).
Existing Default Accounts
Unfortunately, the proposed regulation does not provide guidance concerning the methodology, if any, by which fiduciaries can convert existing default accounts in nonqualifying investment vehicles into 404(c)(5) protected QDIAs. In our November 13th comment letter to the DOL regarding the proposed regulation, we suggested that a provision be added to the regulation indicating that, if the plan fiduciaries have defaulted participants into an investment alternative that does not satisfy the requirement of the regulation, then the fiduciaries should be able to “re-default” the participant to a QDIA. Similarly, if the fiduciaries had defaulted participants into investments that would satisfy one of the three alternatives in the regulation, but would not be entitled to the 404(c)(5) fiduciary protections (because, e.g., the defaults pre-dated the effective date of the statute or the notice did not satisfy the detailed requirements of the regulation), the fiduciaries should be allowed “re-notice” and/or to “re-default” those participants in order to obtain the 404(c)(5) protections.
Although the PPA provides welcome relief to fiduciaries, the guidance fails to address important issues. Hopefully, the DOL will provide the needed clarification. If the DOL provides guidance that is clear and complete, and that can be implemented cost-effectively, the new law will accomplish its goal of protecting fiduciaries, while providing quality investments and valuable information to participants.