By: Brant Griffin – November 6, 2014
On October 24, 2014, the IRS and DOL issued coordinated guidance in the form of Notice 2014-66 and a DOL Information Letter, which detailed rules for qualified defined contribution plans to invest in deferred annuities within a target date fund (TDF) series. If certain conditions are met, the Notice allows a TDF series to be evaluated for the nondiscrimination requirements of IRC §401(a)(4), treating the entire series of TDFs as a single right or feature, even if any individual TDF would not satisfy the requirements on its own.
TDFs were designed to be a simple and coherent investment strategy for retirement savers by adjusting their asset allocation mix to become more conservative as the target date approaches. These investment products have gained far-reaching acceptance since the passage of the Pension Protection Act of 2006, which provided the statutory authority for plan sponsors to enroll workers automatically. The legislation further paved the way for TDFs to be used as Qualifying Default Investment Alternatives (QDIAs), receiving the contributions of participants in the absence of an affirmative investment election. As a result, TDFs have become nearly ubiquitous offerings in defined contribution plans reaching $621 billion in plan assets at 2013 year end (according to Morningstar).
Treasury Regulation §1.401(a)(4)-4 provides that optional forms of benefit, ancillary benefits, and other benefits, rights, and features must be available to a group of employees that satisfies the nondiscriminatory classification requirement of IRC §410(b). The traditional concern in having TDFs hold investments of deferred annuities is that the TDFs would need to be limited to the individuals in the TDF’s age-band, which might result in a TDF being disproportionately utilized by older employees (who are more likely to be highly compensated). This possibility causes practitioners to question whether limiting specific TDFs to older participants would violate the current availability or effective availability requirement for benefits, rights, and features under the regulations.
IRS Notice 2014-66 addresses this matter for a TDF series investing in deferred annuities, by providing an alternative method to satisfy the non-discrimination requirements. A TDF series is eligible to use the alternative nondiscrimination requirements if the following conditions are satisfied:
- The TDF series is designed to serve as a single integrated investment offering, with the same investment manager and the same generally accepted investment theories applied across the TDF series.
- The deferred annuities invested within the TDF series do not provide a guaranteed lifetime withdrawal benefit or guaranteed minimum withdrawal benefit feature.
- The TDF does not invest in employer securities that are not readily tradable on an established securities market.
- Each individual TDF is treated in the same manner in regards to rights and features other than its mix of investments (such as fees and administrative expenses).
If the TDF series is eligible for the alternative method of satisfying the non-discrimination requirements, then the TDF series may be treated as a single right or feature for purposes of satisfying the requirements of IRC §401(a)(4) and Treasury Regulation §1.401(a)(4)-4.
Alongside the IRS Notice, the DOL crafted a communication to the Treasury confirming that TDFs, which included unallocated deferred annuities among their investments, would not cause the funds to fail to meet the requirements of the QDIA regulations (29 CFR 2550.404c-5). Furthermore, the letter stated the DOL’s opinion that the selection of a TDF with a mix of unallocated annuity contracts would satisfy the requirements of ERISA §404(a)(1)(B) if:
- The TDF’s investment manager has been properly designated as an ERISA §3(38) investment manager, and
- The designated investment manager complies with each of the conditions of the annuity selection safe harbor (29 CFR §2550.404a-4).
The DOL further stressed that a plan sponsor would retain a fiduciary obligation to “prudently select the investment manager and monitor the selection at reasonable intervals, in such a manner as may be reasonably expected to ensure that the investment manager’s performance has been in compliance with the terms of the Plan and statutory standards, and satisfies the needs of the Plan”.
This IRS Notice and the DOL Letter follow the final regulations issued on July 1, 2014, which permit the use of longevity annuities (annuities that provide payments that begin at an advanced age) in defined contribution plans. This cross-agency effort highlights the broader public policy goal of encouraging the use of lifetime income products by defined contribution plans.
The guidance will not only have an impact on employee investment outcomes, but will have broad implications for plan fiduciaries as well. The guidance demonstrates that TDFs are continually evolving, which makes monitoring and selecting TDFs even more challenging.