The Department of Labor is currently working on final regulations regarding default investment options in tax qualified plans subject to the Employment Retirement Income Security Act of 1974.

These regulations are likely to shape the course of employee investments in coming years, including how and whether employees can benefit from the unique ability of annuities to guarantee a lifetime income from assets accumulated in 401(k) and 403(b) plans.

By way of background, ERISA section 404 imposes standards on fiduciaries of qualified plans, including those who make investment decisions affecting plan assets. A breach can result in liability for any losses to the plan and its participants.

An important exception to this comes under section 404(c)(1) for individual account plans, such as a 401(k), where the participant directs account asset investment among diversified options. Under the exception, a fiduciary is not liable for any loss resulting from a participant’s exercise of control of those assets.

The new Pension Protection Act of 2006 has now extended this exception to fiduciaries investing participant assets in default investment alternatives (in accord with DOL regulations) where a participant fails to exercise affirmative investment control. PPA says those regulations should provide guidance on the appropriateness of designating default investments that include a mix of asset classes consistent with capital preservation, long-term capital appreciation, or a blend of both.

On Sept. 27, 2006, the DOL issued proposed regulations interpreting this new exception for default investment options. The final regulations are due Feb. 17, 2007.

The proposed regulations have attracted approximately 103 comment letters, including many from life insurance people. The insurance industry letters (as well as many others) center on the proposed definition of “qualified default investment alternatives” or “QDIAs.”

In contrast to DOL’s express rejection, in the proposed regulations, of stable value and money market funds as QDIAs, the proposal is simply silent on using annuities to provide default investments.

It appears fairly clear that, under the proposal, deferred fixed annuities would not qualify as QDIAs. On the other hand, the proposed regulations are carefully drafted to refer to “investment fund products.” It may well be reasonable to conclude that an investment in a variable deferred annuity contract separate account is an “investment fund product” that may qualify as a QDIA, if all of the applicable requirements otherwise are met.

However, without a specific reference in either the preamble or the final regulations, questions may arise about whether default investments may be made through VA contracts. Therefore, the industry has urged DOL to explicitly state that variable annuity and fixed annuity contract investments may qualify as QDIAs.

Annuities have a long history in the retirement plan context. Many early employer-sponsored retirement plans involved employers making contributions to group or individual annuity contracts.

Today, annuities make even more sense in retirement plans. With increases in longevity and the shift from defined benefit plans to defined contribution plans, retirees face new challenges. They must save enough for retirement. They must also learn how to manage their savings during a retirement of uncertain length.

Annuities help with the latter by offering a guaranteed income for life. As such, they are a critical part of the retirement savings system in the United States, and it is essential that U.S. retirement policies encourage annuitization in defined contribution plans. One way to encourage annuitization is to facilitate use of annuities as default investments. Here is why:

o Unlike other investments, investments in deferred annuities work well as defaults both during the accumulation phase of a participant’s working life and during the payout phase after a participant has retired. In this sense, they are the ideal default investment because they can serve both as the accumulation and the payout default.

o Annuity defaults make sense from a policy perspective. They generally invoke the spousal consent requirements of ERISA and so create a default form of payout–a qualified joint and survivor annuity.

o Annuities send a normative message about how plan participants should behave. In this regard, automatic enrollment arrangements are good for retirement savings not just because they get participants who might not otherwise save to do so, but also because they send a message to other plan participants about the importance of savings. Annuity defaults can serve a similar function by sending a message to all plan participants that they should be considering payouts in the form of life-contingent annuities.

Given the difficult issues and policy judgments DOL is confronting in finalizing default investment regulations, the final regulations may not be issued by PPA’s deadline of February 17. However, when they are issued, the hope is that DOL will take the opportunity to send through those regulations the critical message that annuities are an option that employers and employees should consider.