Business of Benefits

Business of Benefits

ERISA and Mom: Sláinte!!

Posted in General Comment

We have done this post a number of years in the past as an “Almost Annual Mother’s Day” piece; our attempt to put a very personal twist to the things we do,  with a larger and hopeful light on many of the mundane tasks that make up much of our business. We now post it as a memoriam to Patti Anne Courtney, the finest of Irish Moms, who has passed early this morning. She is the inspiration of much of the work I do today.

On the rare morning when the breeze would blow in from the east, from the river, the orange dust from the prior night’s firings of the open hearth furnaces at Great Lakes Steel would settle onto the cars parked in the street. My Mom’s father worked there; my Dad’s father was a furnace brick mason at Detroit Edison; my father a tool and die maker at Ford’s Rouge Plant, not far down the road. Yes, I am a native Detroiter.

ERISA wonks such as ourselves tend to get lost in the press of details which seem to flow non-stop from our regulators and legislators in D.C. It is this background that reminds me that it is sometimes helpful to step back and see the personal impact of the things we do, even on the plant floor.

A few years back, a good friend of mine who ran the retirement plan operations of a large insurance company asked me to speak about ERISA to a meeting of his administrative processing staff. At the time, they were still struggling with some of the more difficult administrative processes related to the QJSA and QPSA rules. Here’s what I told them:

My father died at the Rouge Plant in 1970, after 20 years with the company. Back then, the normal form of benefit under a defined benefit plan was a single life annuity, covering the life of only the employee. There was no such thing yet as a qualified joint and survivor annuity or a qualified pre-retirement survivor’s annuity. This meant that my father’s pension died with him. My mother was the typical stay-at-home mother of the period who was depending on that pension benefit for the future, but was left with nothing. With my father’s wages topping at $13,000 annually and five kids at home, there was also little chance to accumulate savings.

The Retirement Equity Act of 1984 (a copy of which I still keep in my office) was designed to change all of that. By implementing the requirement of a spousal survivor annuity, a whole class of non-working spouses received protection which was desperately needed. So in that speech to my friend’s administrative staff, I asked them to take a broader view-if just for a moment- of the important task they were being asked to implement. It was valuable social policy with real, human effect which they were responsible for pulling off, and they should take a measure of pride in the work they were doing.

Things have evolved much over the years, and some of those same rules which provided such valuable protection have become the matter of great policy discussions centering on whether they are appropriately designed, and whether they can be modified in a way to accommodate new benefits like guaranteed lifetime income from defined contribution plans. But the point is that Congress sometimes gets it right, and there is very valuable social benefit often hidden in the day to day “grunge” of administering what often seems to be silly rules.

*************************

Mom lived a long and good life. She left us with, among other things, the gift of music. A song from my youth which I sang to her last night seemed fitting, written by an Irishman, no less:

Sing your way home, at the close of the day; 

sing your way home, drive the shadows away. 

Smile every mile, for wherever you roam;

it will lighten your load,

it will brighten your road,

when you sing your way home.

And we are grateful that she did go gently into the good night, for there was no dying of the light.

Sláinte!!

Bob and Conni

403(b)’s “Limitation Year” Rules Demonstrate their “Individual” Nature-and Their Potential Value of the Universal Platform of the Future

Posted in 403(b), Plan Administration

Even now, as we hear rumblings that a “universal 401(k)” arrangement may once again be in the wings under any Tax Reform package considered by the new Congress, we again are reminded on how ingrained the differences are between the various types of retirement plans. There are reasons these plans, and the differences between them, exist.   One of the most unusual differences, and hidden, differences between 403(b) plans and 401(k) plans is the striking fact that the 415 limit is an individual limit, not a plan level limit.  The reason: 403(b) plans are still fundamentally designed around an individual.

It is this sort of design which also should suggest it as a potential design of choice for the future: with the focus growing on individual portability of the retirement benefit, it’s easy to forget that these individual contracts were portable between plans. This individual control, with now-defunct Rev Rule 90-24 made it simple for the individual to transfer their funds between contracts. This is the sort of thing we are looking for plan accounts to do in the future. When you actually work through the details, you may be surprised to find that you’ll find out that the 403(b) contract (as they existed prior tenth 2007 tax regulations) actually solves for a combination of easy portability which accommodates lifetime income.

So, back to the 415 “limitation year.” It’s that time of year when we start looking to correct 415 excesses. One off the issues which inevitably comes up in any book of business is the limitation year, and whether or not it should be changed. To change it, you simply amend the plan document, and follow the regulations about the manner in which to apply it.

A 403(b) plan has no such choice. If, for any one of a number of reasons, it chooses to change its limitation years (keeping in mind that a significant number of 403(b) plans have fiscal plan years, which may drive such choices), it cannot do so by simply amending the plan. You see, the limitation year is determined on a person by person basis, it is not a plan wide rule. Only the individual can change the limitation year, and only for its contracts. To change the year, the individual must attach a statement to his or her income tax return filed for the taxable year in which the change is made. To change a plan’s limitation year, the administrator would need each employee to make that 1040 filing.

Pretty amazing. It means that the participant is actually in control, and any participant has the ability to change their own limitation year-which would, if anyone really tried to do it, make a mess of the plan’s administration. I suspect that a plan may be able to limit this right by its terms, but I would also suspect that the limitation should then be in the plan document.

The exception to the rule is those instances where the participant is “in control” of an employer (a concept used to determine when to aggregate 403(b) plans for 415 purposes). In such cases, the limitation year is the limitation years  of the employer over which the participant has control.

This rule, by the way actually makes a great deal of sense form a pure policy standpoint, especially if you are seeking a “universal account” solution to retirement plans.

Correcting the “best guesses” on 403(b) Plan terms by using the first 403(b) Remedial Amendment Period under Rev Proc 2017-18

Posted in 403(b)

The IRS has announced the end of the first remedial amendment period for 403(b) plan documents, in Revenue Procedure 2017-18.  The last day of that RAP will be March 31, 2020. Now what do you do with it?

Well, 403(b) plan documents are very curious things, as are their Remedial Amendment Periods. A written document was first required by the 2007 403(b) regulations as a condition of maintaining their favored tax status, now nearly 100 years after 403(b) plans were first put into play.  The tax statutes enabling 403(b) plans and their predecessors never required written documents other than the annuity contract or the custodial agreement. Unlike 401(a), with its extensive scheme of rules of what a plan document must contain, there has historically been nothing of the sort in 403(b).

This has been a dramatic change.  Considering there have been generations of administrators and vendor staffs which have used a variety of different methods to operate 403(b) plans, this change was bound to be a difficult one. And it has been.  The IRS exacerbated this challenge for themselves and 403(b) plan sponsors and vendors with this 2007 regulation by not publishing any  significant guidance until 6 years later. And then that guidance was only to  what terms would be required of a pre-approved plan-while announcing that ONLY pre-approved plans would be able to get a favorable Determination Letter. There are no, and it doesn’t appear there will ever be,  standards for what terms may be acceptable other than those for prototypes or volume submitter documents.

A bigger challenge for the IRS, however, is that the plan document requirement is a creature of regulations, not of the Tax Code itself. This means there is no statutory rule which lays out the time frame under which 403(b) plan documents have to be amended to meet the requirements of law changes-unlike the 401(b) remedial amendment period for 401(a) amendments (401(b) does not apply to 403(b) plans). The IRS will have to create a 403(b) Remedial Amendment Period for each and every  required plan amendment whenever there is any law or regulation change.

This is all further complicated by  the 10 year period which has passed since the 2007 regulation in which vendors and employers have written 403(b) plan documents based upon their “best guesses” of what should be in a compliant plan document. The IRS decided to handle this “best guess” period by announcing that any 403(b) document could be corrected under a new, special 403(b) Remedial Amendment Program, by that new RAP’s end date. It announced that the beginning of the RAP was the required adoption date for 403(b) plan documents (generally, January 1, 2010). The end of the RAP would be announced once the IRS approves its first set of pre-approved 403(b) documents. Once those first pre-approved documents are released, the IRS promised to announce the “end date.” It has now done that, with Rev Proc 2017-18 announcement of March 31, 2020 as the end of the RAP-which also suggests that the pre-approved documents will be released by that date.

So, as a practical matter, now what? The following summarizes what to do:

  • 403(b) written plan documents needed to be adopted by January 1, 2010 (thought there are a number of caveats to this-including when to use the “paper clip” approach to demonstrate a timely adoption).
  • If you did not adopt a written document by that date, you will need to correct with a Voluntary Compliance Program filing for a failure to timely adopt a 403(b) Plan. You cannot use this new Remedial Amendment Period to correct a late-adopter plan.
  • If you timely adopted a plan document (or adopted a new one since January 1, 2010), the terms of that document are unlikely to comply with what we think the rules are, given what we have found through the pre-approval process (remember, the IRS is still not giving us the rules for 403(b) plans, just for the pre-approved plans). This means you have one of two  choices:
    • You can restate your current plan to a vendor’s pre-approved plan by March 31, 2020, and your plan will be protected back to January 1, 2010 (remember, there is no need to goo back further, as plan documents were not a tax rule before then).
    • You can amend your plan to an individually designed plan with the terms you think meet the IRS’s non-published requirements, but you’ll never be able to have a favorable determination letter to protect you. One alternative is to adopt a volume submitter document, where you WILL have effective reliance on the plan terms that you do not alter, and only “go naked” on  those terms which are important to the sponsor but which may not be contained in the volume submitter document.

A cautionary note: a number of plan document problems which occurred in the 2008-2010 rush to complete documents may not be able to be fixed under this program. Thought the RAP is useful, it is not nirvana.

 

 

 

 

 

 

 

 

 

The Fiduciary Underpinnings of Plan Loans

Posted in Fiduciary Insurance, Fiduciary Issues

Prudence.  We often seem so focused on this one particular ERISA standard at times that it seems we do it to the exclusion of what is really ERISA’s own “prime directive”: “A fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and for the exclusive purpose of providing benefits to participants and their beneficiaries.”

Sure, prudence is critical when dealing with plan investments, as is diversifying investments to minimize loss, as is administering a plan in accordance with its documents (these are each a specific fiduciary standard contained in ERISA Section 404(a)) These rules, however, do not exist in a vacuum.

It is easy to forget that the fiduciary’s exclusive obligation is to provide retirement income from these plans. ERISA is pretty clear that even 401(k) plans and 403(b) plans are actually meant to provide retirement income. They are “employee pension benefit plans” under ERISA Section 3(2)(A) which each “provides retirement income to employees, or results in a deferral of income by employees for periods extending to the termination of covered employment or beyond.”

Sunny winter morning in the mountain forest

We spend much of our time focusing on the minutiae of fiduciary investments making sure compensation is reasonable; finding ways to comply with variable compensation under the fiduciary rule; drafting compliant 404a-5 and 408b2 documents; documenting procedures; evaluating cost and fees related to investments; and all manner of plan financial issues. In doing so, however, we cannot lose sight of the proverbial forest for all the trees.

This point becomes very real when dealing with plan loans. Yes, plan loans are investments subject to prudence. But they are also critical plan rules which have can have a major impact on the ability of the plan to provide retirement benefits which implicate that “prime directive.”  The DOL recognized that loans secured by participants’ account balances can, and do, undermine the plan’s provision of retirement benefits when they default and plans offset the retirement benefit (which data shows they regularly do).  The ERISA regs’ 50% rule is NOT designed to co-ordinate with the IRS’s statutory limit on loans. As a matter of fact, Title 1 is silent on the matter. The DOL specifically imposed this limitation by virtue of regulation in order to minimize the risk that defaulting loans cause to retirement benefits (if you are curious, the preamble to the ERISA loan regs at 54 fr 30520 are an interesting read). DOL was clearly concerned about the exclusive purpose rule.

The DOL really laid it out well when it issued Advisory Opinion 95-17, giving its opinions on 401(k) credit cards. There it laid out the exclusive purpose standard when setting the terms and conditions of a loan: “it should be emphasized that the purpose of section 408(b)(1) and the regulations thereunder is not to encourage borrowing from retirement plans, but rather to permit it in circumstances that are not likely to diminish the borrower’s retirement income or cause loss to the plan.”

In the day to day operation of a plan (without plan credit cards!), this raises a troubling issue- particularly when a plan design forces a loan default offset of a participants accrued benefit following  involuntary employment (such as a layoff, death or disability), where the retirement benefit is lost under difficult circumstances where there is little chance to recover. To add to the difficulties, a significant number of these offsets result in a 10% tax penalty being impose at a time it is most difficult to bear- a fundamental unfairness of which I have blogged in the past.

Employers  do the best they can, even as loan defaults serve to undermine one of the fundamental reasons employers provide a retirement plan. Short of not offering loans, all that really is left to do is to engage in an effort to notify plan participants of default; and often send collection letters following default. This is why the IRS asks questions about collection efforts. This is also why policymakers often propose eliminating loans from plans, because of this problem.

Loans, however, are really a necessary part of retirement plans. Without that sort of access, many employees would shy away from making deferrals, which also undermines retirement readiness.  But there remains this tension between the exclusive obligation to protect the ability to provide the retirement benefit, and the practical demand to have a loan program.

There is a potential solution in the wings, as I have been working with Custodia Financial and a number of leading practitioners throughout the country to develop a program under which plans will have the ability to protect the benefit. We will keep you posted, as it is coming into the market.

 

 

 

 

 

 

When Is an Organization a “Church” that Sponsors a Retirement Plan?

Posted in 403(b)

The recent litigation involving Church plans, and their funding (or lack thereof) of their defined benefit plans really is only a  dispute over the narrow issue of whether an affiliate of a church can sponsor a “church plan”-or whether the “church”, must itself sponsor that plan.  Central to it all is that the cases ask whether a hospital associated with a church can sponsor a church plan- but no one ever defines what a church is.

And that is a problem in the Code and ERISA: we may know what is a “Qualified Church Controlled Organization” (which we loving refer to as QCCOs), and even (or maybe even not) what is a “Non-Qualified Church Controlled Organization (or Non-QCCO), but nothing  ever defines just what qualifies as a “church.” In the 403(b) world, we often refer to them as “steeple churches,” but that seems just to beg the question as well. I do struggle when I try to define a church to anyone who may ask.

This, unfortunately, allows one to compare the definition of a church to the U.S. Supreme Court’s Justice Potter Stewart’s famous description of pornography: “I know it when I see it.”

This can actually be a problem, especially depending in how the Supreme Court finally decides the recent spate of cases.

All is not completely lost, however. The IRS has made a game try at defining it, informally (though not through regulation, God Forbid!), in its Publication 1828. If you are dealing with Churches, by the way, this is a handy publication to keep around.

So here’s characteristics the IRS says that “churches” commonly have:

  • distinct legal existence;
  • recognized creed and form of worship;
  • definite and distinct ecclesiastical government;
  • formal code of doctrine and discipline;
  • distinct religious history;
  • membership not associated with any other church or denomination;
  • organization of ordained ministers;
  • ordained ministers selected after completing prescribed courses of study;
  • literature of its own;
  • established places of worship;
  • regular congregations;
  • regular religious services;
  • Sunday schools for the religious instruction of the young; and
  • schools for the preparation of its ministers.

Note that the IRS uses all the facts and circumstances, inlcuding the above, in making a determination.  IRS disclaims any attempt to evaluate the content of whatever doctrine a particular organization claims is religious, “provided the particular beliefs of the organization are truly and sincerely held by those professing them and the practices and rites associated with the organization’s belief or creed are not illegal or contrary to clearly defined public policy.”

I guess. I know it when I see it……

The IRS Tightens Plan Examination Process With New Rules for Plan Sponsors and IRS Examiners

Posted in Regulatory Exams

An IRS’s examination of an employer’s plan has always been a bit unnerving for the plan sponsor-so much so, it seems, that many of them put off dealing with their initial notification letter. I think it’s a common experience of many professionals that they often aren’t brought in until the plan sponsors finally are forced to deal with the IRS after the examiner makes that scary call to schedule an on-site visit. The IRS, however, has been often gracious in the past with the extension of response deadlines for their document requests as long as the examiner views the sponsor as acting in good faith-especially once a professional becomes involved in the process.

This is all suddenly changing. With the IRS’s focus on “black belt” business practices, it announced on November 21, 2016 a new process for its retirement plan audits. These rules center on the timing of the “Information Document Requests” (IDR), which are central to an audit.   The IDR is the manner in which the IRS collects the plan and employer information necessary to conduct the audit.

The process has been relatively fluid in the past. The IRS would follow up on its initial notification of an examination with a series of IDRs and a response date. The response date has been, generally,  able to be reasonably negotiated after being initially set, depending on the circumstances of the plan, the employer and the examiner’s own schedule. The examiner has always had some discretion in resetting the deadlines, as they saw fit.

This is now changing, for both the plan sponsor and the examiner.

The initial IDRs will now generally come out with the first audit notification letter, triggering deadlines immediately. That initial letter (and accompanying IDR)  will be followed up by a telephone call from the examiner to review the IDR with the plan sponsor, at which time the plan sponsor is expected to agree to a response date. This will be an interesting call-most plan sponsors won’t have a clue as to whether the items on the IDR are relevant to the issues on the exam. In fact, they are likely just to agree out of a bit of intimidation-including agreeing to the response date. This is all likely to occur without involvement of the professional, as it will come from an unscheduled call.

Once that response date is agreed to, a serious clock starts ticking. If the (now agreed upon) IDR is not timely, or not complete, by the (now agreed upon) deadline, the examiner must decide within 5 days if an extension will be granted.

Only two extensions can now be granted. The examiner may grant the first one, which may be up to 15 days, AND the examiner must send an extension approval letter. The second, 15 day, extension may be granted only with the examiner’s manager’s approval, and an approval letter must be sent.

If all of the information is not received after the second extension, the examiner “will” begin the formal enforcement process, which may quickly result in the issuance of a formal delinquency notice, and eventual issuance of a formal legal summons, with all of the attendant (and unpleasant) legal ramifications.

All through this, by the way, the examiners will have the “option” to maintain an IDR log, which tracks their compliance with these new rules.

These new procedures appear to be aimed at instilling more discipline into the examination process. The problem, as tends to be the problem with many such structured business process improvement efforts, is that-as good as they may appear to the designer on paper-they often leave little room for the actual business experience. Examinations can be difficult; data can be hard to find, subject to interpretation and dispute; people can be hard to find; business conditions can be difficult; and IDRs have been a dynamic tool used throughout the examination process to establish (or even disprove) an examiners position. Discretion and flexibility in the process is necessary, to both reward and to impose accountability.

But the new, strict process is now here. And as difficult as  it will be for plan sponsors,  I can’t image these rules being well received  by IRS examiners, either.

 

A Potential Impact of the 403(b) University Lawsuits on 401(k) Self Directed Brokerage Accounts

Posted in 403(b), Fiduciary Issues

Well before there were self directed brokerage accounts in 401(k) plans, there were similar investment arrangements under 403(b) plans. Employers would permit investment vendors to make available to plan participants their full panoply of investment funds. This could be virtually all of the mutual fund types in a single fund family; in multiple fund families; or sometimes a hundred or more variable separate account investments in an annuity contract.  Employers chose to give employees free reign with regard to these investments. After all, these investments were viewed by the participants as their own funds; they received prospectuses from all of the investment companies and insurance companies related to all of their investments; they received quarterly statements, annual reports and proxy statements; and voted on materials with regard to their investments.  These investments actually provide employees with a great deal more information (and protection) than any participant who may have a similarly broad range of investment choices under a self directed brokerage account under a 401(k) plan.

The recently filed 403(b) University lawsuits are now challenging that long standing investment practice, claiming that it is a fiduciary breach to permit participants to choose from that many investments and, where the participant has chosen an expensive investment (after complete disclosure, and with no chance for the fiduciary to override that decision), claiming the plan’s fiduciary had the obligation to prevent that investment from even being available under the plan.

There are so many moving pieces in these lawsuits related to the particular structure and operational differences between 401(k) plans and 403(b) plans, that it does remind me of the expensive trap many service providers fell into after the 2007 IRS 403(b) reg changes. Those reg changes made 403(b) plans look deceiving a lot more like 401(k) plans. What those service providers (and the IRS as well) soon found out is that there are still fundamental structural and detailed differences between the two types of plans-and not recognizing those differences has been very costly.

It appears that the plaintiff law firms may have made a similar miscalculation, underestimating the differences between the two types of plans.  After all, bringing a class action lawsuit is an economic decision: it has to be worth the time and expense of the lawsuit (and class action suits are expensive and time consuming, for both plaintiffs and defendants) to bring them.  I strongly suspect that it will be difficult  to maintain a participant driven lawsuit against a fiduciary based upon a claim of the participants that they chose to purchase an expensive investment, after  disclosure which exceeds ERISA’s standards, and with more reasonably priced investments available to them. Then, even if the claim is successful, the plan fiduciaries would have no ability to force the participant-who chose the investment fund- to leave that fund.  As in all things 403(b), the details matter. I suspect the plaintiff firms will find out that this was a poor choice for them (as long as the defense firms fully understand the difference between 403(b) and 401(k) plans, which is not a given, either).

What is very striking, however, is the potential impact of these lawsuits on the ability of 401(k) plans to maintain self-directed brokerage accounts.  These 403(b) plans, with their wide variety of investments which are subject only to the control of the participants, are essentially structured in the same manner as SDBAs (without many of the security law protections that are given 403(b) participants).  Should the plaintiffs succeed in their claims that it was imprudent to permit employees the ability to invest in a wide range of securities without fiduciary oversight, this may well be the death knell of SDBAs. What fiduciary will want to be held liable for the  expensive choice of a participant under an SDBA?

We know that the DOL has cautioned for years that the fiduciary has oversight responsibilities of SDBAs, and that we have all struggled to find a way to implement that oversight into investment policies and fiduciary procedures. But a successful claim in these 403(b) lawsuits may well put an end to all of that.

 

 

The Unusual Matter of 403(b) Ethics

Posted in 403(b)
ethics

When preparing to present a webinar for the NTSA on its Professional Code of Conduct (which is shared by ASPPA and NAPA as well), I was struck by the conundrum the “mismatching” of the 403(b) rules can cause the pension professional, as well as the lawyer, registered rep and CPA, under their ethical rules.

I have long discussed the non-sensical nature of many of the rules which now apply to 403(b) plans, while also applauding the regulatory efforts of the agencies to attempt to address them. Try as they might, however, there is a fundamental problem with attempting to regulate 403(b) arrangements as employer plans: they are functionally designed under the Tax Code as individual retirement plans, much as the manner in which IRAs are designed.  Consider just a sampling: the vast majority of these contracts and accounts are actually owned by the plan participant, and only those participants can choose their investments and direct distributions from those contracts. The RMD rules are designed in the same manner as IRAs. The 402(g) limit is a personal, not plan, limit. 415 limits are combined with those of an unrelated org, if the participant controls one of the organization’s plans in which he or she participates.  Prior to the 2007 tax regulation changes, they were completely portable retirement arrangements, providing an answer to the question of retirement plan leakage which typically occurs otherwise when employees change jobs.

This is just a sampling. Those with long experience in this area can come up with quite a list, themselves.

So it really isn’t a surprise that particularly sensitive conundrums, unique to the nature of the 403(b) space,  arise when  attempting to apply professional ethics rules to often unresolvable 403(b) issues, with occassionally the result of exposing  small, charitable organizations to all manner of liabilities.

A lesson for us all is to make sure we are well familiar with our professional codes of conducts when giving advice in this difficult arena. The simple, seemingly “right” answer for the client often is not.

If you are interested, you can purchase a replay of the webinar starting August 1st at this link.  It really isn’t pretty.

403(b) Policy Loan’s Continued Form 5500 Reporting Problem

Posted in Uncategorized
Gordian Knot

One of the more intractable issues with which ERISA 403(b) plans sponsors must deal with every year arises from the “policy loans” issued by insurance carriers under the 403(b) annuity contracts held under the plans. There is simply no good way to report these loans on the Form 5500, and the newly proposed Form 5500 changes do not address this ongoing gnat of an issue.

A policy loan is a quirky financial arrangement which has existed, literally, for generations in the 403(b) market.  They are based upon the insurance industry’s historical practice of loaning money to their policyholders. How they actually work is that the insurance company makes a loan to a 403(b) contract holder in accordance with the same loan rules which apply to any other plan loan under the Code and ERISA, and then reserves an amount under the related annuity account equal to the amount of the outstanding loan. Often, for a number of practical reasons, the reserved amount may actually exceed the amount of the loan. As the loan is paid back, the corresponding amount reserved under the contract is also released. It is considered “borrowing against the policy.”

Compare this to the “plan loan,” which is typical under a 401(k) plan and has growing popularity in the 403(b) market. The plan itself makes a loan to the participant. Technically, the borrowing participant elects to invest its assets in a “loan account”, whose sole asset is the promissory note between the participant and the plan. As the loan is repaid (and funds deposited in other investment accounts of the participant), the value of the loan account decreases.

Here’s the problem: loans are required to be reported on the Form 5500 financial statement, and are carried under the Form 5500 rules as a separate asset of the plan (under the newly proposed 5500 rules, it will be carried as a receivable instead of an investment). This works well for the “plan loan,” as it just shows up as an asset of the plan on Schedule H line 1(c)(8).   However, a policy loan is reported much differently. Even though you have taken out a loan, no cash for the loan has ever come out of the plan itself. The funds have come from the insurance company’s coffers.

The reserve amount in the annuity contract related to the policy loan still shows up as an invested asset under the contract (typically reported under line 1(c)(14)). If you actually then report the amount of the outstanding “policy loans” on line 1(c)(8), the result is a double-counting of the loan amount as an asset, and your books will be sorely out of balance.

A plan can’t just ignore the loan, as such policy loans are considered plan loans under the Code. But you can’t report them on the participant loan section of the Form 5500, either, without causing serious accounting problems.

The answer is that few accounting firms know how to deal with it, and the issue is often just ignored-that is, the policy loan is just never reported. I find that the better solution is probably to footnote the loans in the audited financial statement, for large plans, and this seems to fulfill the reporting obligations. But the auditor will need to buy into this.

For small plans, the problem is not as acute. Participant loans are reported as a “specific asset” under Part 1, 3(e), a section which does need to be included in the total assets.  IT be interesting to see, however, if policy loans are actually regularly reported here, or just ignored.

It really is a Gordian Knot which we must prove every year can’t be untied.

 

Auditing Distributed 403(b) (and 401(a)) Contracts

Posted in 403(b), Lifetime Income, Plan Administration

The IRS took a significant step when it specifically  recognized the termination of a 403(b) plans as being a “distributable event” in its 2007 regulations. This then permitted, for the first time,  plans to distribute the assets of any 403(b) funds otherwise subject to distribution restrictions (like the elective deferrals in an annuity contract and any contribution to a custodial account) upon plan termination. As some of you may recall, 403(b) plan terminations were never recognized as a distributable event prior to those regulatory changes.

A 403(b) plan termination (just like a 401(k) plan termination) is not complete until all of the assets in the plan are distributed, which must be generally accomplished within 12 months of the initiation of the termination. 403(b) plans, of course, have a unique problem with this rule. How do you distribute assets where the employer has no authority to distribute the assets in that 403(b) contract, either by virtue of the contract reserving to the individual participant the right to direct a distribution or where there is no surrender value in a contract (such as in an “annualized” contract)?  The answer is a pretty straightforward one: the IRS permits the terminating plan to actually “distribute” the contract itself to the participant, instead of requiring the contract to be “cashed out.” We generally refer to this as an “in-kind” distribution.*

This is all fine and dandy until (as it seems in most things 403(b)) you pay close attention to the details: how in the world do you effectuate an in-kind distribution of an annuity contract?

From a strictly legal viewpoint, this really is a pretty straight forward task: the duly authorized officer of the organization, in proper exercise of authority granted by the organization, terminates the plan and directs the in-kind distribution of those annuity contracts. The organization then provides documentation of that corporate action to the insurer, with directions to remove the organization from its records as the plan sponsor. The insurer then deals directly with the participant in the same manner as it deals with an IRA holder.  Being a distribution,  all of the ERISA and Tax Code rules related to consents,** approvals and notices need to be followed. Many of the  large 403(b) vendors now have procedures in place to administratively handle these “in-kind” distributions.

But then along comes Bob Lavenberg and Megan Stern, of BDO,  probably one of the few auditing firms in the country with a high level of 403(b) audit sophistication. Bob, in particular, has been causing me (well deserved) heartburn for years with his insightful analysis of these quirky 403(b) issues.

Bob and Megan asked me what seems to be a simple question: how do you audit a 403(b) in-kind distribution? There is no financial transaction, no cash changes hands, there is no change in investments. It really is only a nominal change in the records of the insurer. Yet, somehow, GAAP requires that the “transaction” be verified.

Well, there is no answer, yet, to this question, which means the industries (that is, auditors, insurers, and lawyers) will be pressed for finding  a standardized approach for bringing audit certainty to this process. It even becomes a bigger issue than 403(b)s: QLACs and other distributed annuity contracts are all able to be distributed as “in-kind” distributions from 401(a) plans as well, and there is no acceptable  “recordkeeping” method to audit.

Until then, auditors will be hard pressed to validly document these sorts of distributions.

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*Note that the IRS has taken the position that only annuity contracts can be distributed “in-kind”, and not individually owned custodial accounts. The language of neither the statute or the regulations appear support this position but, until the IRS changes that position, there is some risk in attempting an “in-kind” distribution of a custodial account.

**Note there are special rules related to when spousal consents are required on annuity contract distributions. See Rev. Rul. 2012-03.

 

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