The IRS issued final regulations (Final Regulations) on May 19, 2010, covering the diversification requirements imposed by Section 401(a)(35) of the Internal Revenue Code of 1986, as amended (Code), on defined contribution plans that hold employer securities. Although the Final Regulations are similar in most respects to the proposed regulations published in January 2008, the Final Regulations clarify and to some extent modify the scope of Code Section 401(a)(35) and the permitted restrictions and conditions on investments of employer securities. This Alert provides a brief background on Code Section 401(a)(35) and summarizes key changes made by the Final Regulations.
Background - Diversification Rights
Code Section 401(a)(35), added by the Pension Protection Act of 2006, imposes diversification requirements on certain defined contribution plans that hold publicly traded employer securities. These rules require that participants, their beneficiaries and alternate payees under qualified domestic relations orders (applicable individuals) be given the right to divest amounts invested in employer securities and to reinvest an equivalent amount in other investment options.
The right to divest applies to all amounts invested in employer securities that are attributable to a participant's elective deferrals and employee contributions. For amounts attributable to employer contributions, the diversification requirements apply to each participant who has completed (or is deemed to have completed) at least three years of service, each alternate payee with respect to such a participant and the beneficiary of any deceased participant. At least three alternative investment options must be offered; each must be diversified and have materially different risk and return characteristics.
Under Code Section 401(a)(35), a plan is generally not permitted to impose any direct or indirect restriction or condition with respect to the investment of employer securities that is not imposed on the investment of other assets of the plan, other than restrictions and conditions imposed by applicable securities laws.
Investment Funds Holding Employer Securities
Under the proposed regulations, certain types of pooled investment vehicles, such as mutual funds or bank common and collective trust funds, that include employer securities as part of a broader fund, were treated as not holding employer securities for purposes of Code Section 401(a)(35), provided that employer securities did not exceed 10 percent of the fund and that the investment was independent of the employer. The Final Regulations generally retain this rule, but with the following modifications and expansions:
- Exchange Traded Funds. The Final Regulations expand the list of investment funds that may be exempt from the diversification requirements to include exchange traded funds (i.e., unit investment trusts that satisfy Code Section 851(a)).
- Multiemployer Plans. In the case of a multiemployer plan, the Final Regulations provide that an investment option will not be treated as holding employer securities to the extent the employer securities are held indirectly through an investment fund managed by an investment manager if the investment is independent of the employer and the percentage limitation rule is satisfied.
- Application of Percentage Limitation Rule. The Final Regulations provide that the determination of whether the value of employer securities exceeds 10 percent of the total value of an investment fund is made as of the end of the preceding plan year. This determination can be based on the information in the latest disclosure of the fund's portfolio holdings that was filed with the Securities and Exchange Commission in that preceding plan year.
- 90-day Grace Period. If a fund that indirectly holds employer securities ceases to meet the requirement that the investment be independent of the employer (including a failure to satisfy the 10-percent limitation), the Final Regulations provide that the plan has up to 90 days to offer diversification rights with respect to the fund.
Exceptions to Prohibition on Additional Restrictions or Conditions
As noted above, a plan generally is not permitted to impose any direct or indirect restriction or condition with respect to the investment of employer securities that is not imposed on the investment of other assets of the plan, other than restrictions or conditions imposed by applicable securities laws. The proposed regulations contained limited exceptions to this requirement. For example, under the proposed regulations a plan could limit investments in employer securities (e.g., to no more than 10 percent of a participant's account), freeze employer securities as an investment option, impose a fee on other investment options that was not imposed on employer securities, impose a reasonable fee on the divestiture of employer securities or allow more frequent investments to be made in a stable value fund than in employer securities. The Final Regulations retain all of these exceptions and further expand the permitted restrictions and conditions on employer securities as follows:
- Frozen Employer Security Funds. Code Section 401(a)(35) generally requires that a participant who chooses to diversify investments must be permitted to reinvest in the same class of employer securities. The proposed regulations clarified that a plan is able to close an employer security investment option to new investments without violating this reinvestment rule. If a fund is frozen, an applicable individual who divests his or her interest in an employer security may be restricted from reinvesting such interest back into the employer security, provided that the plan does not allow any new investment in employer securities. The Final Regulations further clarify that, for purposes of this rule, an employer securities option will be considered frozen even if the plan provides that dividends paid on employer securities will be reinvested in the same employer securities. The Final Regulations also clarify that the exception for a frozen fund is available only if the plan does not have another employer securities fund. In addition, the Final Regulations provide a transition rule for certain employee stock ownership plans (ESOPs) permitting the allocation to an otherwise frozen fund of employer securities acquired in plan years before 2007 that are released as matching contributions from the plan's suspense account, provided the ESOP loan is not refinanced after the end of the last plan year beginning before 2007.
- Stable Value Fund Transfers. Under the proposed regulations, as noted above, a plan was permitted to allow transfers to be made into the stable value or similar fund more frequently than funds invested in employer securities. The Final Regulations expand this exception to allow for more frequent transfers either into or out of a stable value or similar fund. Further, the Final Regulations clarify that a stable value or similar fund means an investment product or fund designed to preserve or guarantee principal and provide a reasonable rate of return, while providing liquidity for benefit distributions or transfers to other investment alternatives.
- Qualified Default Investment Alternative. The Final Regulations allow a plan to provide for transfers from a qualified default investment alternative (within the meaning of section 404(c)(5) of ERISA) more frequently than from a fund invested in employer securities.
- Plans With Multiple Employer Stock Funds. Some plans maintain more than one stock fund, where the stock held in each fund is identical but for the tax cost basis of the stock. The Final Regulations allow such a plan to preclude an applicable individual from reinvesting divested amounts in the same employer security if reinvestment is permitted in an employer security that is identical but for any applicable tax consequences.
The Final Regulations are effective for plan years beginning on or after January 1, 2011. Prior to that date, plans may rely on the Final Regulations or may continue to rely on the proposed regulations and other prior guidance in satisfying the requirements of Code Section 401(a)(35).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.