Final Regulations Under Code Section 401(a)(35); Diversification of Employer Securities
Rev. 06/21/10; E-mail Alert 2010-9

On May 19, 2010, the IRS published final regulations under section 401(a)(35) of the Internal Revenue Code related to the diversification requirements of employer securities held in defined contribution plans.  Employers initially relied on Notice 2006-107 for guidance on diversification requirements until proposed regulations were issued in 2008.  Although these final regulations are very similar to the proposed regulations, several areas have been expanded and offer additional guidance. 

This article will review the provisions that remain intact from the proposed regulations and introduce the additional guidance published in the final regulations. 

1. any plan participant; and
2. any beneficiary who has an account under the plan with respect to which the beneficiary is entitled to exercise the rights of a participant.

The time when the diversification requirements apply depends on the type of contributions invested in employer securities.

Elective deferrals and after–tax employee contributions
In the case of amounts attributable to elective deferrals and employee after-tax contributions that are invested in employer securities, the applicable individual will have an immediate right to direct that such amounts be invested in alternative investments.

Employer contributions
In the case of amounts attributable to employer contributions that are invested in employer securities, an applicable individual who is a participant and has completed at least three years of service (as defined under the rules for vesting), a beneficiary of such a participant, or a beneficiary of a deceased participant will have the right to direct that such amounts be invested in alternative investments.

Rules relating to the election of investment alternatives
A plan subject to the diversification requirements is required to give applicable individuals a choice of at least three investment options in addition to employer securities. Each of the additional investment options must be diversified and have materially different risk and return characteristics. It is intended that any other investment options generally offered by the plan also must be available to applicable individuals.

The plan may limit the times when the participant may direct divestment and reinvestment to "periodic, reasonable opportunities" that occur at least quarterly. Generally, affected participants must be given the opportunity to make investment changes with respect to employer securities on the same basis, except in unusual circumstances, as they would have in making other investment changes. For example, investment changes related to employer securities must be permitted with the same frequency and implemented within the same time frame as afforded to other investments with, unless circumstances require different treatment. Thus, the quarterly rule does not apply if the plan allows daily changes of other investments.
A plan may not impose restrictions or conditions with respect to the investment of employer securities that are not imposed on the investment of other plan assets (other than restrictions or conditions imposed by reason of the application of securities laws). An example of such a prohibited restriction or condition would be a plan provision under which a participant who divests his or her account of employer securities will receive a less favorable treatment (such as a lower rate of employer contributions) than a participant whose account remains invested in employer securities. However, a plan could legitimately impose participant fees with respect to reinvestment in the other investment options available in the plan, even if fees are not imposed with respect to investments in employer securities.

The final regulations clarified several points regarding fund restrictions:

• Upon freezing an employer security fund, a plan may allow for dividends to be reinvested in that fund and the fund will still be considered “frozen”
• Transfers from a QDIA investment can be made more frequently than transfers from an employer security fund
• A plan may permit transfers in and out of a stable value (or similar fund) more frequently than other funds
• The term “stable value fund or similar fund” is defined as 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

Plans subject to §401(a)(35) requirements
The diversification requirements generally apply to an “applicable defined contribution plan,” which means a defined contribution plan holding publicly-traded employer securities (i.e., securities issued by the employer or a member of the employer’s controlled group of corporations that are readily tradable on an established securities market. [For this purpose, “controlled group of corporations” has the same meaning as under section 1563(a), except that, in applying that section, 50 percent is substituted for 80 percent].) This is similar to the controlled group rule for Code Section 415 purposes where 50% is similarly substituted for 80%.

Generally, a plan holding employer securities that are not publicly traded is also treated as being an applicable defined contribution plan if the employer (or any member of the employer’s controlled group of corporations) has issued a class of stock that is a publicly traded employer security. However, the diversification requirements will not apply to a plan maintained by a member of such a controlled group, provided that neither the employer nor a parent corporation of the employer has issued any publicly–traded security or any special class of stock that grants particular rights to, or bears particular risks for, the holder or issuer with respect to the controlled group member that has issued publicly–traded stock. The Secretary of the Treasury has the authority to provide other exceptions in regulations. For example, an exception may be appropriate if no stock of the employer maintaining the plan (including stock held in the plan) is publicly traded, but a member of the employer’s controlled group has issued a small amount of publicly traded stock.

• The proposed regulations stated that plans holding employer securities are exempt from §401(a)(35) requirements under the following circumstances:
  The employer security was held in a broader fund of an investment company registered under the Investment Company Act of 1940; certain common or collective trust funds or pooled investment funds; certain funds designated by the IRS
• The investment was independent of the employer and the value of the employer security did not exceed 10 percent of the fund’s value

The final regulations replaced the above reference to the “Investment Company Act of 1940” with “a regulated investment company as described in Code section 851(a)”, allowing for the exemption of exchange traded funds and also added the following clarifying points:

• Multiemployer plans will not be treated as holding employer securities as long as the securities are held indirectly through an independent investment fund managed by an investment manager that satisfies the 10 percent limit
• An investment fund that fails to meet the 10 percent limit or rule or fails to be independent of the employer will have 90 days to offer diversification rights to that investment
• The 10-percent limit will be based on the total value of the fund’s investments as of the end of the preceding plan year

Effective Date
The final regulations are effective for plan years beginning on or after January 1, 2011.  A plan may rely on Notice 2006-107, the proposed regulations, or the final regulations in order to satisfy §401(a)(35) requirements up until then.

For more on this subject come to either our Retirement Plan Insights or Practitioner seminars.