Lifetime Income Guidance on Target-date Funds (TDFs) Issued by IRS and DOL

Practical Law Legal Update 5-585-8145 (Approx. 9 pages)

Lifetime Income Guidance on Target-date Funds (TDFs) Issued by IRS and DOL

by Practical Law Employee Benefits & Executive Compensation

Target-date Funds (TDFs)

TDFs (also called life-cycle funds) are investment fund products or model portfolios that:

Apply generally accepted investment theories.
Use a mix of equity and fixed income exposures designed to provide varying degrees of long-term appreciation and capital preservation, based on the participant's
- age;
- target retirement date; or
- life expectancy.
Change their asset allocation and associated risk levels over time with the objective of becoming more conservative with increasing age.
Are not required to (but may) consider account risk tolerances, investment or other preferences of an individual participant for investment decisions.

(See Practice Note, Qualified Default Investment Alternatives: Lifecycle or Target-date Funds and DOL Regulation § 2550.404c-5(e)(4)(i).)

IRS Notice 2014-66

IRS Notice 2014-66 addresses a question that arose regarding a defined contribution plan's compliance with the nondiscrimination requirements of IRC Section 401(a)(4) for an arrangement under which the plan's investment options include a series of TDFs that include deferred annuities available only to older participants.

The series of TDFs analyzed, as is commonly the case, includes TDFs that are invested in a manner appropriate for a particular age group, with the mix of equity and fixed income exposure becoming more conservative over time. As each age group advances, an increasing portion of the portfolio is applied to the purchase of deferred annuities, which is made available only to older participants, many of whom could disproportionately consist of highly compensated employees. The question presented to the IRS is whether making TDFs with deferred annuities available only to older participants violated the current availability or effective availability requirement for benefits, rights and features of IRC Section 401(a)(4) and Treasury Regulation Section 1.401(a)(4)-4.

Current Availability Rule

The right to each form of investment available under the plan is an "other right or feature" that must:

Be made available in a nondiscriminatory manner.
Otherwise satisfy the nondiscrimination requirements under IRC Section 401(a)(4) and Treas. Reg. Section 1.401(a)(4)-4.

(Treas. Reg. Section 1.401(a)(4)-4(e)(3)(iii)(C) and IRC Section 401(a)(4).)

Many practitioners were concerned that a plan's inclusion of a TDF within a series of TDFs that included deferred annuities available only to older participants would violate these requirements if this TDF was analyzed independently of the series of TDFs for purposes of IRC Section 401(a)(4).

Treatment of a TDF Series as a Single Right or Feature

The IRS used its authority under Treas. Reg. Section 1.401(a)(4)-1(d) to provide a special rule in IRS Notice 2014-66 under which a series of TDFs in a defined contribution plan in which participation in some TDFs is restricted to older participants is permitted to be treated as a single "other right or feature" for purposes of Treas. Reg. Section 1.401(a)(4)-4, provided the following conditions are satisfied:

The series of TDFs is designed to serve as a single, integrated investment program under which the same investment manager (see Practice Note, Selecting and Hiring an Investment Manager: Investment Manager Defined) manages each TDF and applies the same generally accepted investment theories across the series of TDFs. This condition requires that:
- the only difference among the TDFs is the mix of assets selected by the investment manager, which results solely from the intent to achieve an appropriate level of risk for the age-band of individuals participating in each TDF; and
- the design for the TDF series is such that the TDF currently available for older participants will become available to each younger participant as the asset mix of each TDF for younger participants changes to reflect their increasing age.
Some of the TDFs available to older participants include deferred annuities and none of the deferred annuities provide a guaranteed lifetime withdrawal benefit (GLWB) or a guaranteed minimum withdrawal benefit (GMWB) feature. (IRS Notice 2014-66 noted that Treasury and the IRS are considering whether or not to provide guidance related to issues arising from the use of GLWB and GMWB features in defined contribution plans.)
The TDFs do not hold employer securities as described in ERISA Section 407(d)(1) that are not readily tradeable on an established securities market (see Practice Notes, Employer Securities and Real Property in Qualified Retirement Plans and Employee Stock Ownership Plans (ESOPs)).
Each TDF within the series is treated in the same manner regarding rights and features other than the mix of assets. For example, the fees and administrative expenses for each TDF are:
- determined in a consistent manner; and
- are paid from plan assets or by the employer to the same extent (see Practice Note, Paying Employee Benefit Plan Expenses and Paying Employee Benefit Plan Expenses Chart).

Example of Compliant TDF Series

The IRS provides an example of a TDF series that would be eligible for relief under the conditions outlined in IRS Notice 2014-66. This is also the example that was considered by the DOL in the Information Letter (see DOL Information Letter on TDFs).

Accordingly, plans that include TDF series with deferred annuities should be mindful of the requirements described by the IRS in this example, in addition to complying with the specific conditions of IRS Notice 2014-66.

These requirements include:

The investment manager managing the TDF series is an ERISA Section 3(38) manager that acknowledges in writing that it is a fiduciary of the plan (see Practice Note, Selecting and Hiring an Investment Manager: Investment Manager Defined).
The TDFs are designed to provide varying degrees of long-term appreciation and capital preservation through a mix of equity and fixed-income exposures based on generally accepted investment theories (see Target-date Funds (TDFs)).
Each TDF is available only to participants who will attain normal retirement age within a limited number of years around the target date for the fund. For example, investment in 2020 TDF is restricted to participants who reach normal retirement age in 2019, 2020 or 2021.
Each TDF is intended to be a QDIA within the meaning of DOL Reg. Section 2550.404c-5(e) and the plan sponsor represents that it will satisfy the conditions of DOL Reg. Section 2550.505c-5(c) (see Practice Note, Qualified Default Investment Alternatives and DOL Information Letter on TDFs).
Each TDF available to participants age 55 and older holds unallocated deferred annuity contracts as a portion of its fixed-income exposure that:
- are purchased from an insurance company that is independent from the investment manager; and
- do not provide GLWB or GMWB features.
Each TDF is dissolved at its target date and a participant who has an interest in that TDF:
- receives a certificate representing the participant's interest in the annuity contract held in the TDF; and
- the remaining portion of the participant's interest in that TDF is reinvested in other plan investment alternatives in accordance with ERISA Title I (see DOL Information Letter on TDFs).

DOL Information Letter on TDFs

The DOL was asked by the IRS to opine on whether a series of TDFs described in IRS Notice 2014-66:

May qualify as QDIAs within the meaning of ERISA Section 404(c) (29 U.S.C. § 1104(c)) and DOL Regulation Section 2550.404c-5.
May satisfy the requirements of ERISA Section 404(a)(1)(B) (29 U.S.C. § 1104(a)(1)(B)) if the conditions of the DOL's annuity selection safe harbor of DOL Regulation 2550.404a-4 are satisfied.

The Information Letter reviews the facts and conditions of IRS Notice 2014-66 and generally concludes that the series of TDFs described in IRS Notice 2014-66 would satisfy these rules.

TDFs and QDIA Regulations

Providing the conditions and requirements of the example in IRS Notice 2014-66 are satisfied, the Information Letter concludes that:

The use of unallocated deferred annuity contracts as fixed income investments within a TDF series would not cause the TDF series to fail to comply with the QDIA rules under DOL Reg. Section 2550.404c-5(e)(4)(i).
The distribution of annuity certificates as each TDF dissolves on its target date is consistent with DOL Reg. Section 2550.404c-5(e)(4)(vi), which provides generally that an investment product does not fail to be a QDIA solely because it is offered through variable annuity or similar contracts.

TDFs and the Annuity Selection Safe Harbor

The DOL's annuity selection safe harbor provides a safe harbor for an ERISA plan's selection of an annuity provider and contract for benefit distributions from a defined contribution plan with individual accounts. It provides that the plan satisfies the requirements of ERISA Section 404(a)(1)(B) (29 U.S.C. § 1104(a)(1)(B)) if the fiduciary:

Engages in an objective, thorough and analytical search for the purpose of identifying and selecting providers from which to purchase annuities.
Appropriately considers information sufficient to assess the ability of the annuity provider to make all future payments under the annuity contract.
Appropriately considers the cost (including fees and commissions) of the annuity contract in relation to the benefits and administrative services to be provided under the contract.
Appropriately concludes that, at the time of the selection, the annuity provider is financially able to make all future payments under the annuity contract and the cost of the contract is reasonable in relation to the benefits and services to be provided.
If necessary, consults with an appropriate expert or experts for purposes of satisfying these conditions.

(DOL Reg. Section 2550.404a-4.)

Provided the conditions and requirements of the example in IRS Notice 2014-66 are satisfied, the Information Letter concludes that the selection of unallocated deferred annuity contracts within the TDF series satisfies the requirements of ERISA Section 404(a)(1)(B) if:

The conditions of the DOL's annuity selection safe harbor are satisfied.
The plan sponsor prudently selects and appropriately monitors the investment manager (see Practice Notes, Selecting and Hiring an Investment Manager and Negotiating ERISA Service Provider Agreements).

The Information Letter notes that assuming the plan sponsor appropriately discharges its duties as the appointing fiduciary, it will not be liable for any acts or omissions of the investment manager, except for potential co-fiducicary liability under ERISA Section 405(a).

Practical Implications

This guidance follows the recent DOL and IRS position which seems to encourage plan sponsors to offer deferred annuities in their defined contribution plans.

Employers that sponsor defined contribution plans with individual accounts that offer or intend to offer TDFs that include a deferred annuity contract for older participants should review both IRS Notice 2014-66 and the DOL's Information Letter to ensure that the TDF arrangement within their plan satisfies:

The specific conditions of IRS Notice 2014-66.
The requirements outlined in the example described in IRS Notice 2014-66.
ERISA's QDIA rules.
The DOL's annuity selection safe harbor under ERISA Section 404(a)(1)(B).

Plan fiduciaries should also check the plan's investment policy statement (see Standard Document, Investment Policy Statement for Defined Contribution Plan), investment management agreement (see Standard Documents, Investment Management Agreement (IMA) for Pension Plans and Qualified Professional Asset Manager (QPAM) Agreement), investment guidelines and related plan documentation to ensure that these arrangements satisfy these requirements and that the inclusion of this type of TDF series is permitted by the plan.

Lifetime Income Guidance on Target-date Funds (TDFs) Issued by IRS and DOL | Practical Law