New Rules on Employer Stock Diversification in 401(k) and KSOP Plans

On May 19, the IRS published new regulations (26 CFR Part 1, TD 9484) on required diversification of employer stock in 401(k) plans and combined ESOP/401(k) plans (KSOPs). Read them online at this link (opens in new window). Under the Pension Protection Act of 2006, publicly traded companies that do not have stand-alone ESOPs are required to allow employees to diversify out of employer stock, whether it came from employer contributions or employee investments of their own deferrals. Stand-alone ESOPs are exempt from the rules.

Under the law, a participant's right to invest in or divest employer securities cannot be any more restricted than it is for any other plan investment options. However, the final regulations modify some of the permitted restrictions. According to the IRS:

• A plan may allow transfers to and from stable value funds and out of qualified default investment alternatives more frequently than a fund invested in employer securities.
• Under the law, a plan may prohibit further investments in an employer stock fund, thereby "freezing" it. The regulations clarify that if employees are reinvesting Section 404(k) dividends on employer stock, the employer stock fund would still be considered frozen.
• Under a transitional rule, leveraged ESOPs that acquired stock in a plan year beginning before January 1, 2007, may allocate such stock as matching contributions to a frozen employer stock fund.

The IRS notes that the final regulations also:

• do not treat a multiemployer plan as holding employer securities if they are held indirectly through an investment fund managed by an independent investment manager and do not exceed 10% of the fund;
• extend the types of allowed investment companies to include certain exchange traded funds;
• state that in determining whether the value of employer securities exceeds 10% of the fund's investment's total value for a plan year, the value at the end of the preceding plan year should be used; and
• provide that if a fund that indirectly holds employer securities does not meet the "independent of the employer" requirement, it meets the diversification requirements even if the plan does not offer diversification rights to the participants for up to 90 days after it is found to hold employer securities.

In the preamble, the IRS states that an ESOP that presently has a diversification option under Section 401(a)(28) will not violate anti-cutback rules by eliminating this option in favor of the more favorable (to employees) diversification provisions of the Pension Protection Act.