Service issues final regs on diversification of defined contribution plans

Incorporating many of the changes requested by commentators, the Internal Revenue Service on May 18 issued final regulations under section 401(a)(35) regarding the diversification of defined contribution plans that hold publicly traded employer securities. The regulations are applicable for plan years beginning on or after January 1, 2011, but plans can rely on them now.


PPA imposed diversification requirements

The Pension Protection Act of 2006 added new section 401(a)(35) to the Internal Revenue Code to subject defined contribution plans that hold publicly traded employer securities to certain diversification requirements. Generally effective for plan years beginning after 2006, the new requirements mandate that individuals be allowed to: (1) divest employer securities attributable to employee contributions or deferrals and reinvest those amounts in other investment options and (2) divest employer securities and reinvest in other investment options after three years of service. At least three other investment options must be offered under the plan – each of which must be diversified and have materially different risk and return characteristics – and restrictions cannot generally be imposed on the investment in employer securities that are not imposed on the investment in other assets. Defined contribution plans that hold publicly traded employer securities are subject to the requirements, although employee stock ownership plans that hold no section 401(k) or (m) contributions (i.e., hold no deferrals, after-tax contributions, or matching contributions) are excepted if they are separate from other defined contribution plans of the employer under section 414(l).

The IRS issued Notice 2006-107 in December 2006 to provide guidance and transitional rules. Proposed regulations under the new section 401(a)(35) were released in January 2008.


Final regs incorporate requested changes

The final regulations incorporate many changes and refinements to the proposed regulations that were submitted by commentators. These include:

- Broader exemption for investment funds – Certain investment funds that hold employer securities as part of a larger fund (e.g., an investment company registered under the Investment Company Act of 1940, a common or collective trust fund maintained by a bank or trust company, or a pooled investment fund of an insurance company) are considered not to hold employer securities if the investment is independent of the employer and the employer securities do not exceed 10 percent of the fund. The group of investment funds eligible for this exception was expanded to include exchange traded funds that satisfy section 851(a). In the case of multiemployer plans, the group was further expanded to include funds managed by an investment manager within the meaning of ERISA.

- 90-day window for compliance – An investment fund that fails to meet the independence requirement (e.g., if it exceeds the 10 percent limit on employer securities) is treated as holding employer securities. However, the plan has 90 days (from when the fund is treated as holding employer securities) to offer the diversifications rights required under section 401(a)(35).

- Frozen fund exception clarified – Restrictions cannot be imposed on investment in employer securities that are not imposed on investment in other funds. An exception applies for frozen funds. The final regulations make clear that an employer securities fund would be considered frozen even though dividends on the employer securities are reinvested in additional employer securities. The regulations also make clear that the frozen fund exception is only available if the plan does not permit additional contributions or other investments to be invested in employer securities (i.e., the plan cannot have another "un-frozen" employer securities fund).

- Frozen fund transitional rule for leveraged ESOPS – Since leveraged ESOPs cannot halt the allocation of employer securities acquired with an exempt loan and held in a suspense account without impacting the company's debt arrangements, the regulations provide the following transition rule. An employer securities fund will still be considered frozen even though employer securities are being allocated as matching contributions from the plan's suspense account, but only if the employer securities were acquired in a plan year beginning before January 1, 2007, through an exempt loan under section 4975(d)(3) that has not been refinanced after the close of the last plan year beginning before January 1, 2007.

- Stable value fund can allow more frequent transfers – Notwithstanding the general rule that investment in employer securities may not be subject to greater restrictions than investment in other plan funds, the regulations allow the plan's stable value fund to permit more frequent transfers into and out of the fund.

- QDIA can allow more frequent transfers – Like stable value funds, a qualified default investment alternative (QDIA) may permit more frequent transfers into and out of the fund.

- Restricted reinvestment of employer securities – The regulations clarify that a plan does not impose an impermissible restriction if it prohibits an individual from reinvesting divested amounts in the same employer securities fund but allows investment of the divested amounts in another employer securities fund if the only relevant difference between the two funds is the trust's cost basis in the shares.

- Anti-cutback relief – Some ESOPs have been satisfying the diversification requirement of section 401(a)(28) by distributing a portion of the participant's account within 90 days after the election period, but are now subject to new section 401(a)(35), which is not satisfied by such a distribution option. The preamble to the final regulations explains that eliminating the distribution option would not violate the anti-cutback provisions of section 411(d)(6), and gives notice that anticipated guidance under section 411(d)(6) will permit the elimination of the distribution option during the current extended remedial amendment period that expires on the last day of the first plan year that begins on or after January 1, 2010.


Effective date

The final regulations are effective and applicable for plan years beginning on or after January 1, 2011. Until then, plans are permitted to rely on Notice 2006-107, the proposed regulations, or the final regulations in complying with section 401(a)(35).