IRS allows 401(k) plans to offer target date funds that include deferred income annuities in investments

 

The IRS has issued guidance enabling 401(k) retirement plans to offer target date funds that include deferred income annuities, even if the funds containing the annuities are limited to employees over a specified age. Plans may use such target date funds either as a default or as a regular investment alternative.

Background

The advantage of including deferred annuities in a target date fund (TDF) is that they provide steady income for the duration of a retiree’s life, while allowing a participant to invest in other kinds of investments. As a practical matter, it is not actuarially reasonable for insurers to offer deferred annuities in these funds at a price that does not vary based on the age of the purchaser. That means the target date funds would have to be closed to participants who fall outside the band of ages for which the funds are targeted.

Under IRS Reg. §1.401(a)(4)-4, optional forms of benefit, ancillary benefits, and others rights and features must be currently available to a group of employees that satisfies the nondiscriminatory classification requirement of Code Sec. 410(b). Plans have been concerned about offering these funds solely to older participants because older employees tend to be paid more and the arrangement might discriminate in favor of highly compensated employees. TDFs with deferred annuities available only to older participants presents the question of whether the use of age-restricted TDFs could violate the current availability or effective availability requirement for benefits, rights, and features under IRS Reg. §1.401(a)(4)-4.

IRS guidance

The IRS has provided a special rule for TDFs that include deferred income annuities. If a plan offers, as investment options, a series of TDFs for various age groups that meet certain conditions, the series will be treated as a single right or feature for purposes of the nondiscrimination requirements of Code Sec. 401(a)(4), despite the fact that only the TDFs reserved for the older participants include deferred annuities. This special rule permits the TDFs to satisfy those nondiscrimination requirements as they apply to rights or features, even if one or more of the TDFs considered on its own would not satisfy the requirements.

The IRS has put four conditions on TDF qualification for the rule. First, the series of TDFs must be designed to serve as a single integrated investment program under which the same investment manager manages each TDF and applies the same generally accepted investment theories across the series of TDFs. Second, some of the TDFs available to older participants include deferred annuities and none of the deferred annuities can provide a guaranteed lifetime withdrawal benefit or guaranteed minimum withdrawal benefit feature (the IRS is considering whether or not to provide future guidance on the use of these features). Third, the TDFs cannot hold employer securities that are not readily tradable on an established securities market. Fourth, each TDF in the series must be treated in the same manner with respect to rights or features other than the mix of assets.

DOL letter

In an accompanying letter, the Department of Labor confirmed that TDFs serving as qualified default investment alternatives (QDIAs) may include unallocated deferred annuities among their fixed income investments and remain in compliance with the QDIA requirements under ERISA Reg. §2550.404c-5. In addition, the distribution of annuity certificates as each TDF dissolves on its target date is consistent with the QDIA regulations. Finally, the selection of annuity providers and unallocated deferred annuity contracts may qualify for the annuity selection safe harbor under fiduciary rules in ERISA Reg. §2550.404a-4, provided that the designated investment manager satisfies the conditions of the safe harbor. However, the plan sponsor, who appoints the designated investment manager, must prudently select and monitor the investment manager.

Source: IRS Notice 2014-66.

Visit our News Library to read more news stories.