ERISA – DOL Says That A Series Of Target Date Funds Could Serve As QDIAs

Basically at the same time that the IRS said that a qualified defined contribution plan could offer for investment a series of Target Date Funds (“TDFs”) (see yesterday’s blog), the U.S. Department of Labor (the “DOL”) offers some thoughts on the TDFs.

The DOL says, in an October 23, 2014 letter from Phyliss Borzi (Assistant Secretary) to J. Mark Iwry (the “Letter”), that the TDFs in the series could serve as “qualified default investment alternatives” or “QDIAs”, within the meaning 29 CFR §2550.404c-5 (the QDIA regulation), in light of the TDFs’ investments in unallocated deferred annuity contracts, described in IRS Notice 2014-66 (the” Notice”). If an investment fund qualifies as a QDIA, the plan does not lose the “no liability for bad investment” protection for its fiduciaries under ERISA section 404(c), merely because plan contributions are automatically invested in that fund without participant choice.

The Example. The Letter focuses on the following example in the Notice: The subject is a profit-sharing plan (the “Plan”) qualified under Code section 401(a). Participants in the Plan can commence distribution at age 65, the normal retirement age under the Plan, or upon severance from employment. The Plan provides for the allocation of investment responsibilities to participants and beneficiaries. The Plan offers an array of designated investment alternatives, including the TDFs. The TDFs are designed to provide varying degrees of long term appreciation and capital preservation through a mix of equity and fixed income exposures based on generally accepted investment theories. The TDFs’ asset mix is designed to change over time, becoming more conservative through a gradual reduction in the allocation to equity investments and a gradual increase in the allocation to fixed income investments as the participants in each TDF become older.

The intent of the plan sponsor is to satisfy the conditions of the QDIA regulation. Thus, for example, participants may transfer their holdings, in whole or in part, from the TDFs to other investment alternatives available under the Plan on at least a quarterly basis. The TDFs do not impose any fees or restrictions on the ability of a participant to transfer his or her holdings, in whole or in part, to other investments available under the Plan, or to make withdrawals pursuant to Code section 414(w)(2)(B), during the 90-day period beginning with the initial investment of a participant’s assets in a TDF. Following the end of this 90-day period, the TDFs do not have any transfer or withdrawal restrictions or fees that differ depending on whether the particular participants affirmatively selected the TDFs, rather than having been defaulted into the TDFs.

Each TDF within the series is available only to participants who will attain normal retirement age within a limited number of years around the TDF’s target date. Each TDF available to participants age 55 or older holds unallocated deferred annuity contracts, which constitute a portion of the TDF’s fixed income investments. TDFs with such annuities normally do not permit participants whose ages fall outside the designated age band for the TDF to hold an interest in that TDF, because it is not actuarially reasonable for an insurer to offer a deferred annuity at a price that does not vary based on the age of the purchaser. As the age of the group of participants in such TDF increases, a larger portion of the assets in the TDF will be used to purchase unallocated deferred annuity contracts each year. TDFs that are available to participants younger than age 55 do not include unallocated deferred annuity contracts. However, the series is designed so that as the asset allocation changes over time, each TDF will include unallocated deferred annuity contracts beginning when the participants in that TDF attain age 55.

An “unallocated deferred annuity contract” is a contract with a licensed insurance company that promises to pay income to covered plan participants at some date in the future (possibly far into the future) on a regular basis for a period of time or for life. The annuity is written on behalf of a group of participants and not issued to and owned by a specific individual. As such, unallocated deferred annuity contracts do not ordinarily require the insurance company to have or maintain any personal information on individuals in the group. Rather, units of the unallocated annuity generally are largely interchangeable among members of the covered group, which facilitates transferability and allocation within the group, for example at the dissolution date of each TDF.

At its target date, each TDF dissolves, and participants with an interest in the TDF will receive an annuity certificate providing for immediate or deferred commencement of annuity payments. The certificate represents the participant’s interest in the unallocated deferred annuity contracts held by the TDF. For instance, if a TDF ‘s asset mix contains a fifty percent investment in unallocated deferred annuity contracts, then half of each participant’s individual account balance will be reflected in the certificate. The remaining portion of each such participant’s interest in the TDF will be reinvested by the participant or plan fiduciary in other Plan investment alternatives in accordance with title I of ERISA.

The assets of the Funds include plan assets for purposes of part 4 of title I of ERISA and such Funds are managed by an investment manager as described in section 3(38) of ERISA. The investment manager has complete discretion to manage, acquire, or dispose of any assets of the Funds, including the unallocated deferred annuity contracts held by the Funds, and complete discretion to choose and retain the insurance company or companies issuing the contracts. The investment manager is independent from the insurance company or companies issuing such contracts. The investment manager acknowledges in writing that he is a fiduciary with respect to the Plan.

The QDIA Regulation. After reviewing the Notice’s example, the Letter explains that the the QDIA regulation implements ERISA section 404(c)(5). Under this section, a participant or beneficiary in an individual account plan who fails to provide investment directions for his or her account will be treated as exercising control over assets in the account, if the plan fiduciary complies with certain notice requirements and invests the assets in accordance with regulations prescribed by the DOL. The QDIA regulation requires, among other things, that participants on whose behalf the investment is made had the opportunity to direct the investment of the assets in their account but did not, and that they are furnished a notice describing the circumstances under which their assets may be invested in the QDIA, their right to direct the investment of their assets into any other plan investment alternatives, and the investment objectives, risk and return characteristics, and fees and expenses attendant to the QDIA.

The QDIA regulation also describes the attributes necessary for an investment fund, product, model portfolio, or managed account to be QDIA. A TDF that meets the specific requirements of the regulation is a type of fund that could be a QDIA. 29 CFR §2550.404c-5(e)(4)(i). Among other things, such a fund must be designed to produce varying degrees of long-term appreciation and capital preservation through a mix of equity and fixed income exposures based on the participant’s age or target retirement date. In the DOL’s view, the use of unallocated deferred annuity contracts as fixed income investments, as described in the Notice, would not cause the TDFs to fail to meet the requirements of paragraph (e)(4)(i) of the QDIA regulation. It is also the DOL’s view that the distribution of annuity certificates as each TDF dissolves on its target date is consistent with paragraph (e)(4)(vi) of the QDIA regulation. This section provides that an investment product will not fail to be a QDIA “solely because the product or portfolio is offered through variable annuity or similar contracts or through common or collective trust funds or pooled investment funds and without regard to whether such contracts or funds provide annuity purchase rights, investment guarantees, death benefit guarantees or other features ancillary to the investment [product.]”

Annuity Selection Safe Harbor. The Letter also provides guidance on whether, and to what extent, the DOL’s “annuity selection safe harbor,” 29 CFR §2550.404a-4, is available in connection with the selection of the unallocated deferred annuity contracts as investments of the TDFs.

Conclusion. The Letter concludes by stating that the use of unallocated deferred annuity contracts as fixed income investments, as described in the Notice, would not cause the TDFs to fail to meet the requirements of paragraph (e)(4)(i) of the QDIA regulation.