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.
Background
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.
New Diversification and Notice Requirements
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.
Diversification Rights
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]
Notice Requirement
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.
Footnotes:
1: Two types of defined contributions plans are specifically excepted from coverage under Code Section 401(a)(35) and the comparable
provisions of ERISA: (1) employee stock ownership plans are exempt if they are separate from other retirement plans maintained
by their sponsors and do not provide for either elective contributions by employees or matching contributions; and (2) single-participant
retirement plans are also exempt if certain conditions are satisfied.
2: ERISA Section 204(j) refers to “applicable individual account plans,” but the scope of coverage is identical to Code Section
401(a)(35).
3: The beneficiaries of deceased participants as well as the beneficiaries of participants who have completed three or more
years of service must also be permitted to freely diversify their investments in employer securities.
4: The transition rule requires plan participants to be given an opportunity to diversify 33% of their company stock investments
attributable to employer contributions in the first plan year beginning on or after January 1, 2007, 66% in the next following
plan year, and 100% in the next following and subsequent plan years. The transition rule does not apply to participants who
are aged 55 or older and who completed three or more years of service prior to the plan year beginning on or after January
1, 2006; these participants must be permitted to fully diversify the company stock investments beginning on January 1, 2007.
