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IRS removes nondiscrimination hurdle for target date funds in 401(k) plans

Notice 2014-66, 2014-46 IRB

Click here for the Treasury Department Announcement titled “Treasury Issues Guidance to Encourage Annuities in 401(k) Plans.”

In a notice and accompanying Treasury Department release, IRS has provided a special rule that enables qualified defined contribution plans, including 401(k) plans, to provide lifetime income by offering, as investment options, a series of target date funds (TDFs) that include deferred annuities among their assets, even if some of the TDFs within the series are available only to older participants.Under this rule, if certain conditions are satisfied, a series of TDFs in a defined contribution plan will be treated as a single right or feature for purposes of the Code Sec. 401(a)(4) nondiscrimination requirements.This permits the TDFs to satisfy those requirements as they apply to rights or features, even if one or more of the TDFs considered on its own wouldn’t.

Background.  Many employer-sponsored 401(k) plans offer TDFs as a default investment for participants who do not affirmatively elect a different investment.TDFs get their name from the fact that their allocation of investments shifts gradually from equities to fixed income as participants approach an intended target retirement year.

A deferred income annuity provides an income stream that generally continues throughout an individual’s life, but is not intended to begin until some time after it is purchased.This can provide a cost-effective solution for retirees willing to use part of their savings to protect against outliving the rest of their assets, and can also help them avoid overcompensating, i.e., unnecessarily limiting their spending in retirement.

Code Sec. 410(b) generally provides that a plan is a qualified plan only if the classification of employees who benefit under the plan does not discriminate in favor of highly compensated employees (HCEs).

Code Sec. 401(a)(4) generally provides that a plan is a qualified plan only if the contributions or the benefits provided under the plan do not discriminate in favor of HCEs.Optional forms of benefit, ancillary benefits, and “other rights and features” must be currently available to a group of employees that satisfies the nondiscriminatory classification requirement of Code Sec. 410(b) (without regard to the average benefit percentage test).(Reg. § 1.401(a)(4)-4) In addition, the group of employees to whom these benefits, rights, and features are effectively available must not substantially favor HCEs. “Other rights or features” generally means any right or feature applicable to employees under the plan.Different rights or features exist if a right or feature is not available on substantially the same terms as another right or feature.(Reg. § 1.401(a)(4)-4(e)(3)(i)) Reg. § 1.401(a)(4)-4(e)(3)(iii)(C) provides, as an example, that the right to a particular form of investment is an other right or feature.

Impetus for the new guidance.  As detailed in Notice 2014-66, Sec. II, questions have arisen regarding compliance with the Code Sec. 401(a)(4) nondiscrimination requirements for an arrangement under which a plan’s investment options include a series of TDFs, some of which hold deferred annuities.Under the arrangement, the TDF series is a group of TDFs managed by an investment manager, and each of the TDFs is invested in a manner appropriate for a particular age group, with the mix of equity and fixed income exposure becoming more conservative over time in order to reflect the applicable age group’s advancing age.

Some of the fixed income exposure in the TDFs for older age groups results from the purchase of deferred annuities, which will be distributed to participants when the TDF is dissolved at its target date.As each group’s age advances, an increasing portion of the portfolio is applied to the purchase of deferred annuities.It is not actuarially reasonable for an insurer to offer a deferred annuity at a price that does not vary based on the age of the purchaser.Accordingly, a TDF that holds deferred annuities should not be expected to permit participants whose ages fall outside the designated age-band for the TDF to hold an interest in that TDF.

If the deferred annuity within a TDF is made available only to older participants, these participants could disproportionately consist of HCEs (because, as a group, older employees are often higher paid than younger employees).If so, making TDFs with deferred annuities available only to older participants presents the question of whether the use of age-restricted TDFs violates the current availability or effective availability requirement for benefits, rights, and features under Reg. § 1.401(a)(4)-4.

Relief under the notice.The right to each form of investment available under a plan, including each TDF in a series of TDFs, is an other right or feature within the meaning of Reg. § 1.401(a)(4)-4(e)(3)(iii)(C).Therefore, each TDF must be made available in a nondiscriminatory manner and must otherwise satisfy the nondiscrimination requirements under Code Sec. 401(a)(4) and Reg. § 1.401(a)(4)-4.

Pursuant to IRS’s authority under Reg. § 1.401(a)(4)-1(d) to provide an alternative method for satisfying the nondiscrimination requirements, a series of TDFs under a defined contribution plan in which participation in some TDFs is restricted to participants in particular age-bands is permitted to be treated as a single “other right or feature” for purposes of Reg. § 1.401(a)(4)-4, provided that the following conditions, as spelled out in greater detail in the new notice, are satisfied:

1. The series of TDFs is 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.
2. Some of the TDFs available to participants in older age-bands include deferred annuities, and none of the deferred annuities provide a guaranteed lifetime withdrawal benefit (GLWB) or guaranteed minimum withdrawal benefit (GMWB) feature.
3. The TDFs do not hold employer securities that are not readily tradable on an established securities market.
4. Each TDF in the series is treated in the same manner with respect to rights or features other than the mix of assets. (Notice 2014-66, Sec. III)

Example of a TDF series eligible for relief.  Notice 2014-66, Sec. IV provides a detailed example of a TDF series eligible for relief under the notice.

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Meet Paul Raymond

Meet Paul Raymond

Mr. Raymond is a sought after speaker in tax controversy law by many attorney, accountant, and business groups and at the request of the Internal Revenue Service, has presented programs at the IRS Nationwide Tax Forum, attended by tax professionals throughout the United States.

Additionally, he continues to be an active member in the Section of Taxation, American Bar Association, where he was the Past Chair of the Employment Taxes Committee.

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