Proposed Default Investment Rules Offer an Important New Avenue for Protection From Fiduciary Liability

October 30, 2006 — 2,463 views  
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The Pension Protection Act of 2006 made a number of changes to the ERISA rules that govern plan investments. One of the more significant changes was to create a special safe harbor from fiduciary liability for default investments in individual account plans (such as Section 401(k) plans). Beginning in the 2007 plan year, a fiduciary may be relieved from liability for investment losses that relate to investment of a participant's account in a default investment option following the participant's failure to affirmatively direct how his or her account should be invested. Under current rules, such fiduciary protection is only available where a participant has made an affirmative election to invest in an investment option.

The Department of Labor recently issued proposed regulations that explain the scope of the new rule and the requirements that must be met for fiduciaries to qualify for protection from liability for losses resulting from default investment (PDF document available from the DOL). The proposed regulations have important implications for plan sponsors and fiduciaries of Section 401(k) plans with automatic enrollment because many participants who are enrolled automatically fail to provide investment direction. Even in plans that do not provide for automatic enrollment, participants often fail to provide investment direction following the elimination of an investment option or when they roll over their accounts from a prior employer's plan. Although the regulations will not take effect until next year, plan sponsors and other fiduciaries who are interested in taking advantage of the default investment safe harbor should begin familiarizing themselves with the requirements that will need to be met. 

Proposed Requirements
The liability protection afforded under the new rule is only available if the participant's account is invested in a "qualified default investment alternative (QDIA). In addition, the plan must meet a participant notice requirement and certain other conditions.

Qualified Default Investment Alternatives. An investment option will be a QDIA if it meets the following conditions:

  • The investment option does not hold or permit the acquisition of employer securities. However, this restriction does not apply to a registered mutual fund or a regulated pooled investment vehicle (such as a bank collective investment fund). In addition, the restriction does not apply to employer securities that are held under a managed account-type investment and which are attributable to employer matching contributions or as a result of prior investment direction by plan participants.
  • The investment option cannot impose financial penalties or otherwise restrict transfers to other investment alternatives available under the plan.
  • The investment option must be managed by an ERISA "investment manager" or be a registered mutual fund. In addition the investment option must be diversified so as to minimize the risk of large losses. 
  • The investment option must be either (1) an investment fund or model portfolio designed to provide varying degrees of long-term appreciation and capital preservation based on a participant's age, target retirement date, or life expectancy (such as a target date life cycle fund), (2) an investment fund or model portfolio designed to provide long-term appreciation and capital preservation through a mix of equity and fixed income securities with risk appropriate for participants of the plan as a whole (such as a balanced fund) or (3) an investment management service where a manager allocates assets according to participants' individual characteristics (such as a managed account).

Participant Notice Requirement. Participants must receive notice at least 30 days before (1) the initial default investment, and (2) each plan year thereafter. This notice must describe the circumstances in which assets may be invested on behalf of the participant and beneficiary in a QDIA, the material features of the plan's QDIA (such as its investment objective, risk and return characteristics, fees and expenses), the participant's right to redirect investment out of the QDIA without penalty, and how participants may obtain information for other investment options offered under the plan.
Other Conditions.
Investment in a QDIA will qualify for the special liability relief only where the following additional conditions are met:

  • The participant must have had the opportunity to direct how to invest his or her accounts but failed to do so. 
  • The plan must provide to participants any material that it receives relating to their investment in a QDIA. Thus, the plan is required to pass along all account statements, prospectuses, proxy voting material and other information it receives from the QDIA. It is important to note that this is generally not required for a plan to qualify for Section 404(c) relief with respect to affirmative participant investment direction, except in the case of investments in employer securities. 
  • Transfers must be permitted between the QDIA and any other investment under the plan, with no financial penalty, at least once per quarter. For example, if a plan allows participants to redirect investments on a daily basis, an investment option that is a QDIA would similarly need to permit transfers into or out of that option on a daily basis.
  • The plan must otherwise offer a broad range of investment alternatives. This requires that participants be able to choose from at least three investment options which are diversified, have materially different risk and return characteristics, which in the aggregate enable a portfolio of normal risk and return for the participant, and which, in the aggregate, reduce the overall risk of the portfolio through diversification. 

Scope of Relief

The proposed regulations clarify that the default investment rules provide the same type of liability protection that is available under Section 404(c) of ERISA for situations in which participants make affirmative investment elections. However, in a welcome surprise, the regulations state that the safe harbor for default investments is not conditioned on the plan otherwise meeting the Section 404(c) requirements. Therefore, if a plan that is intended to comply with Section 404(c) fails to meet one or more of the applicable regulatory requirements (such as the prospectus delivery requirements or other information disclosure requirements), plan fiduciaries will not be prevented from claiming liability protection for losses on default investments so long as the plan meets the specific requirements of the default investment rule.

However, similar to Section 404(c) of ERISA, the proposed regulation does not provide relief from the general fiduciary obligation to prudently select and monitor the QDIA. As a result, the rule provides no relief from liability for investment losses which can be shown to result from a breach of these fiduciary duties. Nor does the rule provide relief for liability that results from breach of ERISA's prohibited transaction restrictions. Consequently, fiduciaries will need to show how they prudently selected a QDIA and will need to periodically monitor its performance and appropriateness. In addition, the DOL has cautioned that fiduciaries should take particular care in considering fees and expenses in choosing a QDIA.

In addition, the DOL has clarified that the 30 day notice requirement is not intended to foreclose availability of relief to fiduciaries that have already invested assets in an investment option that would constitute a QDIA. Thus, if a participant's account is currently defaulted to an investment that is a QDIA, amounts invested in the QDIA after the regulation takes effect will be able to qualify for the liability protection described above if the plan meets the conditions of the rule. This means that fiduciary protection could be obtained for amounts invested in the QDIA once the regulations take effect and after the 30 day notice has been given. The notice requirement can create problems where investments will be made under an automatic enrollment provision before the end of the prescribed 30 day notice period, for example, with recently hired employees. It is likely that the DOL will receive comments on this matter, and additional guidance may be forthcoming.
Effective Date
The comment period for the proposed regulations will end on November 13. The DOL has announced that the final regulations will not take effect until 60 days after they are published. Therefore, it is unlikely that the regulations will be effective until February of 2007, at the earliest.