United States: New ERISA Notice Requirement May Require Action By December 2, 2006

For 401(k) and other retirement plans that offer company stock investments to participants, the Pension Protection Act of 2006 ("PPA") creates new diversification rights for participants and bolsters these rights with a notice requirement that may be effective as soon as December 2, 2006.

Retirement plan assets may not be invested in securities issued by their sponsoring employers unless those securities meet certain requirements set forth in the Employee Retirement Income Security Act of 1974, as amended ("ERISA"). For defined contribution plans like "401(k)" plans, these requirements are not particularly onerous, and many publicly traded companies either permit or require participants to invest in their securities through a "company stock fund." Enron, WorldCom, and other financially troubled companies were among this group, and following their collapse, Congress began to focus more intently on the risks inherent in company stock investments.

Congress debated various statutory fixes over the past several years, all of which were generally intended to encourage or require diversification of company stock investments or otherwise placed limits on the investment (voluntary or mandatory) of retirement plan assets in company stock. After an impressively lengthy gestation period, Congress has finally taken action to address these concerns as part of the PPA.

The PPA imposes specific new diversification requirements on most tax-qualified retirement plans that permit or require investments in company stock.¹ In addition, the PPA requires the employers that maintain these plans to provide notice to participants on their new diversification rights. This notice requirement may require action in the near future, even for employers whose plans already satisfy the new diversification requirements.

The diversification requirements are incorporated into Section 401(a)(35) of the Internal Revenue Code of 1986, as amended (the "Code"); the inclusion of these requirements in Code Section 401(a) is significant because it means that compliance with them is a precondition of initial or continuing plan qualification and will be subject to greater scrutiny by the IRS during the determination letter process and during plan audits than might otherwise be the case. Comparable provisions are incorporated into Section 204(j) of ERISA.

The diversification requirements apply to all "applicable individuals" participating in any "applicable defined contribution plan."² For this purpose, an "applicable individual" is any participant or beneficiary who has an account in a plan and an "applicable defined contribution plan" is any defined contribution plan that holds any publicly traded company stock. In general, company stock will be regarded as "publicly traded" if it is readily tradable on an established securities market. However, a plan holding non-public company stock may nonetheless be deemed to hold publicly traded company stock if any member of the plan sponsor’s corporate "relatives" has issued a class of stock that is publicly traded. This expansive provision can cause the diversification requirements to be applicable in unexpected circumstances. As a result, plan sponsors who permit investments in non-public company stock should not assume that their plans are excused from compliance but should instead carefully consider whether any of their corporate relatives may have any publicly traded stock.

If a plan is covered by Code Section 401(a)(35), its participants must be allowed to divest any company stock allocated to their accounts and must be permitted to reinvest an equivalent amount in other approved investment alternatives. A covered plan must provide at least three other investment alternatives, each of which has materially different risk and return characteristics. A covered plan may impose reasonable limits on participant diversification rights but at a minimum must allow participants to exercise these rights on a quarterly basis. Further, any limits on diversification imposed on company stock investments must be generally applicable to the plan’s other investment alternatives (except for any restrictions tied to compliance with securities law).

Participants must be permitted to diversify the investment of their own elective contributions without restriction or limitation. Further, participants must be allowed to diversify any matching or other employer contributions after completing three years of service with the employer.³ The latter requirement is subject to a three-year phase-in period beginning in 2007.⁴

To ensure that participants and beneficiaries are made aware of their new diversification rights, the PPA amended Section 101 of ERISA to require plan sponsors to provide written notice of these new rights. This notice must be distributed not later than 30 days before the first date on which a participant or beneficiary will be able to exercise his or her diversification rights. The Secretary of the Treasury is directed to prepare a model notice describing the diversification rights and emphasizing the importance of diversifying retirement plan assets.

Pending the issuance of the model notice, plan sponsors may be required to create their own version.

The notice requirement is effective for plan years beginning on or after December 31, 2006. Thus, for covered plans with calendar year plan years, the notice requirement becomes effective on January 1, 2007 meaning that the notices must be distributed no later than December 2, 2006.

The PPA further amended ERISA to allow the Department of Labor to assess a per-participant penalty of up to $100 per day for delinquent notices. Since many covered plans will cover large groups of participants, this penalty could be substantial: even for a plan with only 100 participants, this penalty could be up to $10,000 per day.