Legal Alert: IRS and DOL Issue Favorable Guidance on Lifetime Income Provided Through Target Date Funds in Retirement Plans

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By W. Mark Smith, Esq.and Joanna G. Myers, Esq.

Sutherland, Washington, D.C.

On October 23 and 24, the Internal Revenue Service (IRS) and the Department of Labor (DOL) issued coordinated guidance on lifetime income provided through target date funds held by retirement plans. According to an accompanying press release from the Treasury and, like the final regulations on longevity contracts issued in July 2014, the guidance is intended to encourage and expand the availability of retirement income options in defined contribution plans. It thus continues the pattern of resolving regulatory uncertainties that can impede the utilization of these options in 401(k) and other plans.

The guidance considers a retirement plan investment option structured as a series of target date funds (TDFs) that may buy, as part of their fixed income allocation, deferred income annuity contracts providing specified amounts of lifetime or periodic income commencing (usually) in the future. Each TDF is available to participants of a specific age or in an age band, in part because the price of the future annuity income actuarially varies with the age of the participants.  The investment manager manages each age-restricted TDF to become more conservative as the age of the participant cohort advances, which may increase the allocation to the annuity. The annuities are distributed to the participants at the target date.

IRS Notice 2014-66

In Notice 2014-66, the IRS considered the permissibility of this structure under the I.R.C. §401(a)(4) nondiscrimination requirement for qualified retirement plans, and specifically the rules that: 

  •   Benefits, rights and features under the plan must be currently available to a nondiscriminatory classification of employees, and
  •   The group of employees to whom benefits, rights and features are effectively available must not substantially favor highly compensated employees.
    Age-restricted TDFs at older ages could disproportionately be available to highly compensated employees because older employees often tend to be more highly paid than younger employees. As a tax policy matter, however, the regulations under I.R.C. §401(a)(4) specifically allow social security supplements and optional forms of benefits that include age restrictions. Noting those tax policy judgments, the IRS exercised its authority under the regulations to publish in the Notice a special rule that a series of age-restricted TDFs would be treated as a single "right or feature" for these purposes, thus avoiding the need for each TDF to qualify separately, if: 
  •   The series of TDFs is designed to serve as a single, integrated investment program managed by the same manager applying the same generally accepted investment theories, with the result that the only difference among the TDFs is the mix of assets selected for the level of risk appropriate at each age band.
  •   Each TDF is treated in the same manner with respect to rights and features – e.g., the manner in which fees and administrative expenses are determined and paid – other than the mix of assets.    
Sutherland Comment: These two conditions appear intended to ensure that the TDFs are not otherwise treating older and younger participants in a discriminatory manner. For example, the Notice requires that the fee structure, including any portion paid by the plan sponsor, be determined in a consistent manner among the TDFs. The Notice presumably is not intended to require that the TDF glide path manager, the manager of the equity sleeve and the manager of the fixed income sleeve are all the same entity, but only that each of those separate functions is consistently carried out by a single entity.
  •   Some of the TDFs available at older ages include deferred annuities that do not provide guaranteed lifetime withdrawal benefits or guaranteed minimum withdrawal benefits (GLWBs or GMWBs).
  •   The TDFs do not hold employer securities as described in Employment Retirement Income Security Act (ERISA) §407(d)(1) unless they are readily tradable on an established securities exchange.    
Sutherland Comment: Other than with respect to GLWBs and GMWBs, about which the Treasury is still considering guidance, and employer securities, presumably to avoid familiar issues when plans hold untraded employer securities, the Notice does not appear prescriptive with respect to the form of the annuities or the TDFs, which would need to comport with applicable ERISA, banking, insurance, securities or other requirements. The tax guidance contemplates that the TDFs may be either a default or a regular investment option under the plan.

DOL Information Letter

In an information letter dated October 23, DOL confirmed that a properly structured TDF that includes a deferred

annuity will be a qualified default investment alternative (QDIA) and that a responsible plan fiduciary who prudently appoints the TDF investment manager will generally not be liable for the manager's selection of an annuity provider.

  •   Under the QDIA rules, the plan fiduciary responsible for plan investments is liable as an ERISA fiduciary for the selection of the QDIA but not for the consequences of the participant's investment in the QDIA by default. So long as the TDF otherwise meets the QDIA requirements – including a more conservative investment allocation among fixed income and equities as the target date approaches, specified notice to participants, unrestricted transferability during the first 90 days and quarterly transferability thereafter subject to fees, if any, that do not difference between investment by default or affirmative direction – DOL confirmed that, pursuant to its regulations, neither the presence of unallocated annuity contracts in the TDFs nor the distribution of the annuities at the target date would cause the TDF to fail to be a QDIA.
  •   DOL also confirmed that, under the usual rules for the allocation of ERISA fiduciary responsibility, the responsible plan fiduciary is responsible for selecting and monitoring a §3(38) investment manager, but that manager is responsible for its investment decisions including the selection of the annuity provider pursuant to DOL's optional safe harbor for such selections in defined contribution plans or otherwise.
Sutherland Comment: The information letter specifically addresses "unallocated" annuity contracts – i.e., contracts held for the TDF without allocation to individual participants – and the Notice in an example contains a similar reference. Thus, it is clear that allocation in the contracts of specific annuity benefits to specific participants is not necessary to the results in the guidance.  We see no reason why properly structured allocated contracts should be treated differently than unallocated contracts for these purposes.

Sutherland assisted in requesting this guidance.

For more information, in the Tax Management Portfolios, see Horahan and Hennessy, 365 T.M., ERISA — Fiduciary Responsibility and Prohibited Transactions,  and in Tax Practice Series, see ¶5530, Fiduciary Duties and Prohibited Transactions.

© 2014 Sutherland Asbill & Brennan LLP.