Examining 401(k) Default Investment Safe Harbors

Published Tuesday, July 27, 2010 at: 7:00 AM EDT

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The rules on automatic enrollment in 401(k)s were established just in time for the bear market of 2008-2009, and plan participants who suffered deep investment losses may be inclined to blame plan sponsors. Your employees might claim you didn’t clearly explain their default investment options, or that the default choices under your plan are insufficient or inappropriate. But as long as you’ve followed ongoing guidance from the Department of Labor (DOL) and stayed within “safe harbors” for default investments, you should have a strong defense against such charges.

Congress addressed issues about investment options as part of the Pension Protection Act of 2006. A key component of the pension law provides safe harbor relief to employers who direct 401(k) assets into qualified default investment alternatives, or QDIAs. The DOL issued comprehensive regulations on QDIAs in 2007.

Default investment options are typically used by 401(k) plans that have an automatic enrollment feature. Such plans include employees as plan participants unless they opt not to be in the plan. Studies have shown that automatic enrollment increases plan participation, particularly among lower-compensated employees, and that makes it easier for a company’s 401(k) to meet nondiscrimination requirements. With automatic enrollment, contributions from employees who don’t make their own investment selections are directed into the default options.

Under current DOL regulations, plan sponsors are relieved from liability for losses resulting from default investments if they meet six requirements.

1. An appropriate financial professional, trustee, or fiduciary manages the plan’s QDIA, which can’t invest in the employer’s own securities and must put workers’ contributions in either of the following:

  • A “target maturity fund” geared to the age, normal retirement date, or life expectancy of participants
  • A balanced fund with an asset mix that takes into account participants’ ages—for example, employing a more conservative allocation for an older population
  • A professionally managed account in which the manager allocates assets based on the potential for long-term appreciation and capital preservation

The DOL regulations also allow employee contributions to go into a low-yielding capital preservation fund, but only for the first 120 days after a participant’s first elective contribution.

2. Plan participants have had the opportunity to direct how their assets are invested but haven’t done so. In other words, QDIA safe harbors don’t apply if the participant elected other investment choices.

3. Plan participants were notified of rules on default investments at least 30 days before they became eligible to participate in the plan. (Automatic enrollment plans that allow contribution withdrawals without a tax penalty may provide this notification up until the date of plan eligibility,) The notification must include:

  • A description of the circumstances under which assets may be defaulted to a QDIA
  • An explanation of the rights of participants and beneficiaries concerning investments
  • A description of the QDIA, including investment objectives, risk and return factors, and applicable fees and expenses 
  • A description of participants’ rights to redirect default investments to other alternatives
  • Information about how participants can learn more about their investment options

4. All materials relating to the QDIA have been provided to plan participants. This includes prospectuses, account statements, proxy voting materials, and other materials.

5. Participants can transfer QDIA assets as often as they are allowed to move non-default investments. In any event, transfers must be allowed at least once every three months. And if participants transfer money out of the QDIA or make withdrawals permitted under automatic enrollment rules during the first 90 days of the initial default investment, no additional restrictions, fees, or expenses may be imposed.

6. The 401(k) plan provides a “broad range” of investment alternatives. This mirrors rules for other 401(k) plans, which generally must let participants choose from among at least three funds with different risk and return profiles. If a 401(k) already meets this requirement, no changes are needed to qualify for the QDIA safe harbor. However, three funds is hardly a “broad range” so it’s good practice to offer more if possible.

According to the DOL regulations, these rules don’t apply only to plans with automatic enrollment, although they’re primarily focused on such plans. The rules may reassure employers and fiduciaries and help them design plans that meet the safe harbor requirements.

This article was written by a professional financial journalist for Advisor Products and is not intended as legal or investment advice.

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