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Employee Plans Compliance Unit (EPCU) - Projects with Summary Reports – Diversification of Investments

Project Overview

The goal of this project was to identify plans that invest in employer securities which are publicly traded and determine whether the plans are in compliance with the diversification requirements under Code section 401(a)(35) both in operation and in form.

The Diversification of Investments project began in September 2013 and ended in December 2014.

Results

The overall compliance rate was very high in this project. The majority of the plans in the sample complied in operation with Code section 401(a)(35). In just about all cases, plan participants had self-directed investment accounts and, as a general rule, could trade in and out of employer securities on any business day. In all of the cases, investing elective deferrals in employer securities was optional. Participants could choose from an array of investment options offered by the plan.

All plans complied with Code section 401(a)(35) and the corresponding Regulations in terms of conditions and restrictions. The most common restriction was blackout dates for trading employer securities among “insiders” who had knowledge of the company’s performance prior to the issuance of quarterly reports. Another common restriction found in approximately 20% of the cases was to limit investments in employer securities to a certain percentage of a participant’s account balance (generally 20% or 25%). This is one of the permissible restrictions under the Regulations.

The one issue that we found in approximately 15% of the cases is that the plan document did not contain the diversification language required under Code section 401(a)(35). In these cases, the plan administrators either did not know of the language requirement, were unaware that their plans did not contain the required language or were incorrectly told by their attorneys that their plans did not need the section 401(a)(35) language because the participants were not required to invest in employer securities and did so only by choice.


Background

Code section 401(a)(35) regarding the diversification requirements of defined contribution plans holding publicly traded employer securities was added by the Pension Protection Act of 2006. In 2006, the IRS issued Notice 2006-07 which provided transitional guidance and relief. In 2008, the IRS issued proposed regulations on the diversification requirements and in 2010 the IRS issued final regulations which are effective for plan years beginning on or after January 1, 2011.

To satisfy the diversification requirements under Code section 401(a)(35) and the final regulations, a plan must permit participants, alternate payees to participant accounts and beneficiaries of participants to divest employer securities held in their defined contribution accounts and reinvest the funds in alternative investments. According to Code section 401(a)(35)(B) and Regulation 1.401(a)(35)-1(b) with regard to employer securities acquired with employee contributions, or attributed to rollover contributions, the plan must permit the divestment and reinvestment of funds immediately. According to Code section 401(a)(35)(C)
And Regulation 1.401(a)(35)-1(c), with regard to employer securities acquired with employer contributions, the plan may impose a service requirement of up to three years for the right to divest and reinvest the funds in alternative investments.  

According to Code section 401(a)(35)(D)(ii)(I) and Regulations 1.401(a)(35)-(b)(1) and 1.401(a)(35)-(c)(1), the opportunity to divest the employer securities and reinvest the equivalent amount in other investments must occur at least quarterly. According to Code section 401(a)(35)(D)(i) and Regulation 1.401(a)(35)-1(d)Participants must be permitted to select from at least three investment options when reinvesting funds, and each of these options must have materially different risk and return characteristics.

Code section 401(a)(35)(D)(ii)(II) and Regulations 1.401(a)(35)-1(e) address permissible and impermissible conditions and restrictions on the divestment of employer securities. Generally speaking, the plan may not impose conditions or restrictions on the divestment of employer securities that are not imposed on other plan assets. Examples of permissible restrictions include a provision that limits the extent to which an account balance can be invested in employer securities (i.e. no more than 20%), or a provision under which an employer securities fund is closed to new investments. These conditions do not affect divestment rights. Examples of permissible restrictions that do affect divestment rights include reasonably designed restrictions to comply with securities laws such as insider trading laws or a restriction of divestment rights up to 90 days following an initial public offering of employer stock.

Page Last Reviewed or Updated: 30-Jan-2017