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On October 24, 2014, IRS released Notice 2014-66, providing guidance with respect to a program under which deferred annuities are included as “fixed income” investments in a target date fund (TDF). In connection with the Notice, the Department of Labor released a letter addressing certain fiduciary issues with respect to the program. In this article we first review the TDF annuity program and then discuss the IRS and DOL guidance.
As described in the Notice (and like other TDFs), the TDF annuity program under consideration:
[I]s designed to provide varying degrees of long-term appreciation and capital preservation through a mix of equity and fixed-income exposures based on generally accepted investment theories. The same investment manager manages all the TDFs … and makes asset allocation decisions using a consistent investment strategy under which the asset mix is designed to change over time, becoming more conservative through a gradual reduction in the allocation to equity investments and a gradual increase in the allocation to fixed-income exposure as the participants in each TDF grow older.
Under the TDF annuity program, the TDFs for ages 55 and older hold, as a fixed income investment, unallocated deferred annuity contracts. As the group ages, more deferred annuity contracts are purchased.
When the TDF target date is reached, e.g., with respect to the 2020 fund, when the year 2020 is reached, the TDF is dissolved, and participants in that cohort:
[R]eceive an annuity certificate representing the participant’s interest in the annuity contract held in the TDF. The certificate provides for immediate or deferred commencement of annuity payments in accordance with the terms of the annuity contract and the plan. The remaining portion of a participant’s interest in that TDF is reinvested in other investment options within [the plan].
Thus, the TDF annuity program provides a way for participants over age 55 and investing (whether by intention or by default) in the TDF to commit part of their plan assets to the purchase of annuities. The TDF is managed by an investment manager, and the annuities are purchased from an insurance company independent of the investment manager.
IRS Notice 2014-66 considered the question: does the TDF annuity program discriminate in favor of highly paid employees because (1) it limits the TDF annuity investments to older employees (those 55 and over), and (2) that older employee group could disproportionately consist of highly paid employees?
Generally, each investment in a 401(k) plan must be available to a nondiscriminatory group. This issue comes up with respect to, e.g., brokerage windows – generally, the Tax Code nondiscrimination rules would be violated if investment in a brokerage window were limited to highly compensated employees. This rule applies to each TDF in a TDF ‘series.’ So the issue here (in Notice 2014-66) is, if only older employees, via a TDF, can purchase annuities, and the older employee group is highly compensated, does that violate the nondiscrimination rules?
In the Notice, the IRS provides an alternative method for satisfying the nondiscrimination requirements. With respect to a TDF annuity program like the one under consideration, IRS will test nondiscrimination by looking at the entire TDF series, and not each particular TDF, provided:
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.
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. [In a footnote, IRS states: Treasury and the IRS are considering whether or not to provide guidance related to issues arising from the use of GLWB and GMWB features in defined contribution plans.]
The TDFs do not hold employer securities … that are not readily tradable on an established securities market.
Each TDF in the series is treated in the same manner with respect to rights or features other than the mix of assets. For example, the fees and administrative expenses for each TDF are determined in a consistent manner, and the extent to which those fees and expenses are paid from plan assets (rather than by the employer) is the same.
Thus, if these criteria are met, the TDF annuity program will not violate the nondiscrimination rules.
In connection with the TDF annuity program, J. Mark Iwry, Senior Advisor to the Secretary and Deputy Assistant Secretary for Retirement and Health Policy, Department of the Treasury, asked DOL to consider two questions: (1) Could the TDF annuity program serve as a qualified default investment alternative (QDIA)? And (2) would DOL’s annuity selection safe harbor be available for the annuities purchased under it?
We assume a general familiarity with the QDIA rules. Briefly, certain investment vehicles may be used as default investments without compromising 404(c) protection, so long as the participant has made no affirmative investment designation and certain notice, revocation, and transferability requirements are met.
For a TDF to qualify as a QDIA, it must: (1) apply generally accepted investment theories; (2) be diversified so as to minimize the risk of large losses; and (3) be designed to provide varying degrees of long-term appreciation and capital preservation through a mix of equity and fixed income exposures based on the participant’s age, target retirement date or life expectancy. In its letter to Mark Iwry, DOL stated that: “the use of unallocated deferred annuity contracts as fixed income investments, as described in the Notice, would not cause the Funds to fail to meet those requirements.”
Bottom line: deferred annuities may be used as ‘”fixed income exposures” in a TDF that is a QDIA.
In 2008, DOL issued a regulation providing a “safe harbor” for the selection of annuities as investments in a defined contribution plan. In its letter to Mark Iwry, DOL summarizes that safe harbor as follows:
Under the annuity selection safe harbor, the selection of an annuity provider and contract for benefit distributions from an individual account plan satisfies the requirements of section 404(a)(1)(B) of ERISA [ERISA’s prudence rule] if the fiduciary: (1) Engages in an objective, thorough and analytical search for the purpose of identifying and selecting providers from which to purchase annuities; (2) Appropriately considers information sufficient to assess the ability of the annuity provider to make all future payments under the annuity contract; (3) Appropriately considers the cost (including fees and commissions) of the annuity contract in relation to the benefits and administrative services to be provided under such contract; (4) Appropriately concludes that, at the time of the selection, the annuity provider is financially able to make all future payments under the annuity contract and the cost of the annuity contract is reasonable in relation to the benefits and services to be provided under the contract; and (5) If necessary, consults with an appropriate expert or experts for purposes of meeting these conditions.
In the letter, DOL said that if, with respect to the TDF annuity program, those enumerated requirements are met, then the annuity selection safe harbor would be satisfied.
The annuity selection safe harbor has never been regarded as particularly ‘safe’ – it still requires a thorough and prudent selection process, including a judgment about the capacity of the annuity carrier to pay future annuity commitments. The DOL letter doesn’t change the current state on this issue. It simply says that nothing in the structure of the TDF annuity program would make the safe harbor unavailable.
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The TDF annuity program discussed in the Notice is interesting. It adds what many would consider to be a ‘best practices’ retirement income solution – a life annuity distribution – to what many consider to be (for many participants, at least) the ‘best practices’ investment solution – a target date fund. The Notice solves a technical problem the program presents under the Tax Code nondiscrimination rules. The DOL letter in effect says that adding annuities to a TDF (in these circumstances) does not change the result under the QDIA or annuity selection rules.
There are (at least) two significant issues confronting sponsors thinking about including annuities in a defined contribution plan (including as part of a TDF). The first is the fiduciary issue. The annuity investment depends on the annuity carrier’s long-term solvency, so there is, in effect, a long-term tail to the fiduciary risk with respect to the selection of an annuity carrier. If the carrier goes insolvent 20 years in the future, the plan fiduciary may conceivably be held liable. There have been efforts to address this issue, including, in 2013, an ACLI proposal to, in effect, defer to state regulation.
The second issue, which has gotten very little attention, is that inside-the-plan annuities, like the ones used in the TDF annuity program considered in the Notice, must use unisex annuity tables. Outside-the-plan annuities use sex-based tables.
We will have to wait to see whether this program will become popular with sponsors.