The IRS confirms that target date funds restricted by age can comply with nondiscrimination requirements.
Under guidance released in October, qualified defined contribution plans will be allowed to provide lifetime income to plan participants by offering funds including deferred annuities among their assets, even if some of the funds are available only to older plan participants. In a notice, the IRS explained how target date funds (TDFs), which are funds offered to participants in specific age groups designed to change the investment mix as the groups age, can offer deferred annuities without violating the Sec. 401(a)(4) nondiscrimination requirements.
Among the requirements that a defined contribution plan, including a 401(k) plan, must meet is that the plan does not substantially favor highly compensated employees. However, because TDFs are restricted to particular age groups, and older employees usually earn more than younger ones, participants in TDFs for older employees will probably earn more than participants in TDFs for younger employees.
Some TDFs offer deferred annuities, which are distributed to the participants when the TDF reaches its target date (usually within a few years of the group’s normal retirement age). As each group’s age advances, an increasing portion of the portfolio is invested in deferred annuities. The IRS has been made aware that it would be actuarially unreasonable for insurers to offer a deferred annuity at a price that does not vary based on the purchaser’s age, and, accordingly, a TDF that holds deferred annuities should not be expected to permit participants whose ages fall outside the designated age range for the TDF to hold an interest in that TDF.
The IRS responded to concerns that these TDFs violate the prohibition against favoring highly compensated employees by providing the following safe harbor: A defined contribution plan will not violate the nondiscrimination requirements by offering TDFs that are restricted to particular age groups, as long as:
- The series of TDFs offered under a defined contribution plan serves 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, including that the mix of assets currently available for older participants becomes available to each younger participant as the asset mix of each TDF for younger participants changes to reflect those participants’ increasing age.
- Some of the TDFs available to participants in older age groups offer deferred annuities, and none of the deferred annuities offers a guaranteed lifetime withdrawal benefit or guaranteed minimum withdrawal benefit, both of which guarantee payments despite the fund’s performance.
- None of the TDFs holds employer securities that are not readily tradable on an established securities exchange.
- Each TDF in a series is treated in a manner consistent with the others in the series with respect to rights and features (other than mix of assets), such as whether the employer or the plan pays the fees and administrative expenses.
The notice contains an example of a TDF that satisfies these requirements.
- Notice 2014-66
By Sally P. Schreiber, J.D., a JofA senior editor.