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DOL Finalizes Safe Harbor for Annuity Selection

Section 401(k) plans are not required to offer annuity distribution options – and most do not. Instead, participants are typically offered a lump-sum payment and, perhaps, a range of installment options. Of those few 401(k) plans that do offer annuity options, only a tiny fraction of retirees select them. Nonetheless, there is now a trend toward encouraging sponsors to offer annuity options. In this regard, both Congress and the Department of Labor have taken steps to insulate sponsors from fiduciary liability in the event the issuer of such an annuity becomes insolvent.

A 2005 report by the ERISA Advisory Council listed the following advantages of an annuity distribution option: avoiding (1) the possibility of a participant outliving his or her retirement assets, (2) investment losses associated with a lump-sum distribution, and (3) the risk of losing out to inflation by investing a lump sum in too conservative a fashion. In response to this report, Congress ordered the Department of Labor to clarify the fiduciary rules applicable to a sponsor’s selection of an annuity provider under a defined contribution plan.

In October of this year, the DOL finalized regulations it had proposed in 2007. These regulations make clear that the strict fiduciary standards applicable to the purchase of an annuity contract under a defined benefit plan do not apply to a defined contribution plan. Rather than being required to purchase the “safest available annuity,” the sponsor of a defined contribution plan need only adhere to ERISA’s general fiduciary standards (prudence, exclusive benefit, etc.).

These DOL regulations also create a “safe harbor” standard for a defined contribution plan’s purchase of an annuity. A plan fiduciary who complies with the conditions of this safe harbor will be insulated from fiduciary liability in the event the annuity provider becomes insolvent.

To take advantage of this safe harbor, a fiduciary must take all of the following steps:

  • Engage in an objective, thorough, and analytical search for an annuity provider;

  • Consider information sufficient to assess the provider’s ability to make all future annuity payments;

  • Consider the cost of the annuity (including any fees and commissions) in relation to the benefits and administrative services to be provided under the contract;

  • Conclude that, at the time of selection, the annuity provider is financially able to make all future payments; and

  • If necessary, consult with an appropriate expert.

As noted in the fourth bullet point, the safe-harbor standards apply at the “time of selection” of the annuity provider. This may be at either of two points – when an individual annuity contract is purchased on behalf of a participant or beneficiary, or when an annuity provider is selected to provide all annuity contracts that might be needed during a specified period of time. Under the latter approach, a fiduciary need not evaluate the annuity provider at the time an individual annuity contract is purchased, but must periodically review the provider’s financial status.

Sponsors of 401(k) plans who are concerned that employees may be undermining their retirement security by electing lump-sum payments may wish to amend their plans to offer annuity options, as well. Any such sponsor will want to take advantage of the safe-harbor standards for avoiding fiduciary liability associated with the purchase of an annuity contract – particularly as the solvency and stability of major annuity issuers are being called into question.