December 13, 06

NEWS / Qualified Retirement Plans: November 2006 Developments

IRS has issued transitional guidance on new Code Section 401(a)(35) diversification requirements for defined contribution plans holding publicly traded employer securities, as added to the Code by the Pension Protection Act of 2006 (Notice 2006-107). Generally effective for plan years beginning after 2006, such a plan must satisfy new diversification requirements and provide applicable individuals with a notice describing the diversification rights and providing information about the importance of diversification.

ESOPs are exempt from the new diversification requirements unless the ESOP holds any contributions to which Code Section 401(k) or 401(m) applies, or the ESOP is a portion of a plan that holds any amounts that are not part of the ESOP.

The "applicable individuals" who have the new diversification rights include participants, alternate payees with account balances under the plan, and any beneficiary of a deceased participant. The new diversification rights apply to elective contributions and employee contributions, which include both employee after-tax contributions and rollover contributions. The new diversification rights also apply to employer contributions but a three-year service requirement may be required by the plan in this case.

Under the new diversification requirements, an applicable individual must be able to elect to direct the plan to divest any publicly-traded employer securities held in the individual??™s account and to reinvest an equivalent amount in other investment options under the plan. A restriction imposed by reason of the application of securities laws, or that is reasonably designed to assure compliance with such laws is not an impermissible restriction on the right to diversify. Thus, for example, for purposes of complying with SEC Rule 10b-5, a plan may limit divestiture rights for participants who are subject to Section 16(b) of the Securities Exchange Act of 1934 to a period (such as 3??”12 days) following publication of the employer??™s quarterly earnings statements. A restriction that limits the extent to which an individual??™s account may be invested in employer securities (e. g., not to exceed 10%) is also acceptable.

Two transition rules are provided by Notice 2006-107. The first is a transition rule through March 30, 2007, pertaining to the continuation of existing restrictions or conditions. For the period from January 1, 2007, through March 30, 2007, a plan does not violate the new law merely because it restricts diversification rights with respect to publicly-traded employer securities under a plan provision that was in effect on December 18, 2006.

A second transition rule is for grandfathered investments for 2007. For the period before January 1, 2008, a plan does not violate the law merely because the plan, as in effect on December 18, 2006, (1) does not impose an otherwise applicable restriction on a stable value fund, or (2) allows applicable individuals the right to divest employer securities on a periodic basis, but permits divestiture of another investment on a more frequent basis, provided that the other investment is not a generally available investment.

A third transition rule is included in Code Section 401(a)(35)(h). Under this rule, for employer securities acquired in a plan year before January 1, 2007, the diversification requirements only apply to the applicable percentage of those securities. The applicable percentage is 33% for the first plan year to which Code Section 401(a)(35) applies; 66% for the second plan year; and 100% for all later plan years. This phase-in rule does not apply to a participant who, before the first plan year beginning after December 31, 2005, had attained age 55 and completed at least 3 years of service.

Notice 2006-107 also explains the notice that is required by ERISA Section 101(m), provides a model notice, and explains when plans must first provide the notice. The statute requires that notice be provided to applicable individuals not later than 30 days before the first date on which the individuals are eligible to exercise their diversification rights. Although some plans are required to comply with part or all of the new diversification requirements beginning January 1, 2007, Notice 2006-107 reports that the Department of Labor (which has jurisdiction over the notice requirements of ERISA) has advised that it does not require plans to furnish notices before January 1, 2007, and, pursuant to this interpretation, plans with plan years beginning on or after January 1, 2007, but before February 1, 2007, are not required to furnish the required notice earlier than January 1, 2007.

Notice 2006-107 is available at: http://www.irs.gov/pub/irs-drop/n-06-107.pdf.
Article by Harvey Kurtz