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Plan sponsors have grappled with the issue of what to do when a participant with responsibility for investing his or her retirement plan accounts fails to give investment directions. That issue has taken on even greater significance with the rise of automatic enrollment, where employees are automatically enrolled in the plan and must affirmatively opt-out if they do not want to participate.
Plans generally specify a "default" investment option to be used when a participant fails to give investment directions. Many plans have in the past used a conservative fund, such as a money market or stable value fund, to protect against the loss of principal. Such a conservative option, however, may expose plan fiduciaries to claims of breach of fiduciary duty, the argument being that a conservative option is not a prudent choice for a long-term investment.
Congress provided relief from this conundrum in the Pension Protection Act of 2006 (the "PPA"), and the Department of Labor ("DOL") recently issued proposed regulations explaining how that protection works. Under the proposed regulations, plan fiduciaries will be relieved of liability for the performance of a default investment (other than liability for losses resulting from the fiduciary's failure to prudently select and monitor the default investment) if the plan invests those assets in a "qualified default investment alternative" ("QDIA"). Three types of investment products have been approved as QDIAs:
A "life-cycle" or "targeted-retirement-date" fund. This is an investment fund or model portfolio that is designed to produce varying degrees of long-term appreciation and capital preservation through a mix of equity and fixed income investments based on the participant's age, target retirement date, or life expectancy. Such funds change their asset allocations and associated risk levels to be more conservative as a participant becomes older.
A "balanced" fund. This is an investment fund or model portfolio that is designed to produce varying degrees of long-term appreciation and capital preservation through a mix of equity and fixed income investments consistent with a target level of risk appropriate for all the participants in the plan as a whole. It is based on the collective demographics of all participants.
A "managed account." This is an investment management service in which an investment manager allocates the assets of the defaulting participant's individual account, taking into account the participant's age, target retirement date, or life expectancy.
There are many other requirements that must be satisfied for a default investment to be a QDIA, which are summarized in a linked memo.
The recent regulations are currently just proposed. The PPA calls for final regulations to be issued no later than February 17, 2007 (six months after the PPA was enacted). It is not clear whether the DOL will meet this deadline. The DOL has indicated that the effective date of the final regulations will be 60 days after they are issued, which, if DOL meets the deadline, would be in April of next year. In the meantime, employers are attempting to determine what, if anything, they should do with respect to their current default investment options.
If a plan already offers an investment option that would qualify as a QDIA (such as a life-cycle fund), and that option is not currently the default investment option, you may want to consider making it the default investment option as of the beginning of 2007, including distributing the required notice to participants by December 1 of this year. That would provide a small increase in protection from potential participant lawsuits (the plan can argue good faith compliance with the proposed regulations), and the final regulations are not likely to include any changes that would invalidate that approach.
If the plan does not already offer an investment option that would qualify as a QDIA, you should start thinking about whether you want to establish a QDIA and, if so, what additional investment option would be specified as the QDIA. However, we suspect that many plan sponsors will want to hold off on making any actual changes until the final regulations are issued, as the final regulations may approve additional QDIA options. The final regulations also will likely provide clearer guidance on how to satisfy the notice requirement in the year of the change, and on how to transition existing default investments to the QDIA safe harbor.