Business of Benefits : Employee Benefits Lawyer & Attorney : Law Office of Robert J. Toth, Jr. : 403(b) Plans, Annuity & Insurance Law : Business of Benefits Blog

Section 939A of Dodd Frank has a very interesting mandate to federal agencies. It requires federal agencies to review their regulations to determine those which require the use of a credit-agency rating in assessing the credit-worthiness of a security and:

“Each such agency shall modify any such regulations identified by the review conducted under subsection (a) to remove any reference to or requirement of reliance on credit ratings and to substitute in such regulations such standard of credit-worthiness as each respective agency shall determine as appropriate for such regulations.….”

This mandate, to my mind, is justified.   A number of practices of financial service companies (and, apparently, governments) are often geared to obtaining the favor of the (sometimes conflicted) rating agency, sometimes even acting as a substitute for their officers' better business judgment. There is pressure to defer to the ratings agency’s thoughts about the financial company’s business, even though the agency may well not fully understand the business of the companies they assess. Those rating agencies, and their opinions, are far short of infallible- and may often be seriously flawed.

This plays out in any interesting way in the development of a fiduciary standard for the purchase of lifetime income products for defined contribution plans. In developing any annuity fiduciary regulation, the DOL will likely be unable to reference rating agency standards (even when issuing prohibited transaction exemptions, it noted that it is “cognizant…. of the Congressional intent to reduce reliance on credit ratings and is considering alternative standards for use instead of, or in addition to, existing requirements for credit ratings in granted individual prohibited transaction exemptions").

I had blogged a few months back on the development of such an annuity standard, and had suggested extensive reference to the credit ratings. Thinking it through, however, I now realize I was just using a “lazy man’s” way out to make the standard sound more legitimate.  In reality, actual ratings may or may not be relevant as, somtimes, the higher rating is not necessarily the best for the plan or the participants. A classic circumstance is where the “cost” of getting the higher rating (by means, for example, of establishing higher reserves) on the annuity product results in a higher priced annuity-without necessarily any commensurate, and real, increase in “safety.”

So, let me recast my suggestions for a safe harbor. 

The DOL could require, as part of a safe harbor, that the insurance company which provides the annuity product being purchased by the plan should be prepared to describe to the fiduciary the following, in terms the fiduciary can understand:

-Provide an explanation of any assessment of its financial condition that independent third parties have provided to it, or have been disclosed to a regulatory authority (such as the state insurance department) without reference to any rating which as been assigned to it.

-Describe any material changes in its financial condition in the past five years and describe why. Have those changes affected the interest rate upon which annuity pricing is based? 

-Explain how the state guaranty association rule would apply to the company’s product being sold.

- Describe material outcomes of the most recent state insurance exams.

-Explain the level of reserves, and why they were chosen.

-Describe the risk profile of the investment portfolio that supports the annuity contracts.

In a vacuum, the answers to these questions may mean little to the fiduciary. However, when compared to the answers of a competing insurance company, they could take on a quite a bit of relevance.

The fiduciary would use the answers using these sort of standardized questions (and a few others), focusing on the close details that are indicative of financial strength (or trouble), to arrive at a prudent decision-especially when used to compare the answers of other insurers.  It could possibly have the effect of putting insurance more into the vernacular and make it an extremely useful safe harbor. It could act to help guide fiduciaries through some of the dense and often arcane material that is related to insurance, and to help sort out what is impotent’s to what really is important. 

__________________

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In Robert Pirsig’s novel, Zen and The Art of Motorcycle Maintenance, the protagonist was a technical manual writer who went insane.  The author commented that the book had little relation to either Zen or motorcycle maintenance.  But at the core of the story was the minutiae which eventually drove him mad: to any explanation he could write in any of his manuals, he could always ask the question “why?”

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When the insurance industry began seriously developing the "living benefits" under annuity products for the retail marketplace a few years back, I dubbed them as "not your grandpa's annuity." This is because they were attempting to address the concerns that the market had about traditional annuities, which are seen as irrevocable, inaccessible, invisible and inflexible. ( I have blogged on this a few times in the past.  Click on the "401(k) Annuitization" link at the right sidebar to see the posts).

It is encouraging to see the discussion now seriously moving to the provision of these types of products from retirement plans.  

Much of this new discussion is focused only something called "guaranteed minimum withdrawal benefits," or "GMWBs." Under these sorts of arrangements, a systemic monthly withdrawal is made from the participant's account under the annuity, which will be guaranteed for the participant's lifetime-even when the account balance runs out.  This is a popular program in the non-plan marketplace, and (at the appropriate price) can be well suited as a distribution option under a 401(k) plan.

GMWBs are not the entire story, however, as there is a whole range of "living benefits" beyond GMWBs which may be appropriate for distribution under a 401(k) plan. This list includes things like:

• variable annuitization, which provides lifetime income while giving the policyholder some level of equity or "equity-like" participation;
• guaranteed minimum account value programs (GMAB), which lock in investment gains over a period of time;
• guaranteed minimum income benefits (GMIB), which insure the purchase of a minimum income stream beginning at a certain time, regardless of underlying equity performance; and
• a guaranteed lifetime withdrawal benefit (GLWB), which insures the ability to withdrawal benefits at a minimum level for a lifetime.

The legal issues in providing these benefits are all very similar, and are addressed in my newly updated article for BNA Pension & Benefits Daily, "Annuitizing From § 401(a) Defined Contribution Plans: A Technical Overview."  For those with far too much time on their hands, and wanting to read a more extensive discussion on the topic, I am reposting the Tax Management Memorandum on "Income Guarantees in Defined Contribution Plans." 

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But, first, another note of introduction......

It is with great pleasure to announce that my friend and fellow pink-shirted compatriot (many of our industry colleagues may fondly remember THAT story!) Sandy Koeppel has decided to join us as Of Counsel, and to have some fun following his illustrious career at Prudential.  Together with myself, Phil Troyer and Conni Toth, we intend to continue to contribute helping make the U.S. retirement system - which we are all so passionate about - work better. Sandy brings a tremendous wealth of experience in guaranteed lifetime income from employer plans to the marketplace (I invite you to read his bio), and intends to continue to carry this torch. Between us all, we offer substantial knowledge of the design, marketing and distribution of these products.

Sandy, as he mentions below, has also formed Plan Income Consulting & Evaluation Services, LLC (PLICES), a consulting firm which has affiliated with this firm and which provides advisors, vendors and employers consulting services related to guaranteed income products.  

Drop Sandy a note at sek@rtothlaw.com.

Now, his first blog:

The shift from Defined Benefit to Defined Contribution plans as the primary workplace retirement vehicle has eroded the confidence and jeopardized the retirement security of a vast number of American workers and their families. The recently published EBRI 2011 Retirement Confidence Survey finds that confidence among workers in their ability to have a comfortable retirement has dropped to an all-time low. According to the EBRI survey,

"the percentage of workers not at all confident about having enough money for a comfortable retirement grew from 22 percent in 2010 to 27 percent, the highest level measured in the 21 years of the RCS. At the same time, the percentage very confident shrank to the low of 13 percent." The RCS further states that "56 percent of workers expect to receive benefits from a defined benefit plan in retirement, only 37 percent report that they and/or their spouse currently have such a benefit with a current or previous employer. Therefore, up to 19 percent of workers may be expecting to receive the benefit from a future employer—a scenario that is becoming increasingly unlikely, since private-sector employers, in particular, have been cutting back on their defined benefit offerings."

These findings along with other results of this survey are disturbing and demonstrate that American workers not only are uninformed but feel challenged, concerned, and threatened about potential declines in their future lifestyle in retirement.

 With the passage of the Pension Protection Act, Congress recognized the need to instill defined benefit-like outcomes into the defined contribution plan universe. The PPA enables plan sponsors to include in their DC plans features such as automatic enrollment, automatic contribution escalation and gain fiduciary protection by offering qualified default investment alternatives deploying professional money management. These important first steps do much to replicate for workers the defined benefit plan experience in the asset accumulation stage. However, up to now, most DC plans do not offer the critical and essential missing piece to assure retirement security: guaranteed lifetime income. There are many reasons for this failure. Chief among them include: legal uncertainty about the rules and standards that apply to the choice of providers; unsettled tax issues (e.g. applicability of qualified joint and survivor annuity rules) associated with new and innovative forms of guaranteed lifetime income; cost and administrative burdens; lack of demand among participants; lack of guidance from the Department of Labor delineating between advice and education for distribution planning and the availability of out-of-plan (retail) vs in-plan (institutional) guaranteed lifetime income solutions if it is desired.    

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The seemingly obscure issue of when a payment from an annuity contract purchased under a Defined Contribution plan is considered to be a "payment from an annuity" is actually one of the most pressing tax issues that needs to be resolved in the area of DC annuitization.  Resolution of this issue determines when spousal consent rules apply and notices given.  What makes it so important to have a clear set of spousal rights rules is that the timing of the application some of the actuarial rules used in determining the level of benefit under certain kinds of products can be affected and, more universally, the actual administration of the spousal consent rules can be challenging in the best of worlds.

At issue, again, in the latest PLR from the IRS is how the spousal consent rules apply to a "hybrid" annuity of the sort which is being widely designed in the 401(k) marketplace. These hybrid products guarantee lifetime income while also maintaining a participant account account balance under which the participant remains invested in equities. These types of products tend to have complex designs, but they basically permit participants to withdraw amounts from their account balances throughout their lifetime and provide "longevity insurance" payments at a guaranteed level once the account balances reach zero or the participant reaches a certain age.  

Simply put, the IRS was asked if electing and beginning a flow of withdrawals from an account balance at actuarially determined levels, where the actual "insurance" does not kick in for a number of years, constitutes "payment as an annuity" (I won't go into here the Sect 417 differences between "payments as an annuity" and "payments NOT as an annuity").

The IRS first answered that question late in 2009 in PLR 200951039.  It ruled that the that the initial election from this sort of product was legally two different elections: it was first an election to take “payments as an annuity” at that later date, when "insurance payments" arising from the longevity insurance kicked in, which then triggers application of the 417 rules. Secondly, for any payment prior to that "longevity insurance" payment start date, it was an election to take “payments not as an annuity.” 

In the new PLR, 201048044, the IRS apparently shifted from this initial position.  A vendor introduced a new product for the 401(k) marketplace which is (from a strictly legal view) strikingly similar in key respects to the product described in In the prior PLR.  The taxpayer asked for guidance on whether the initial payments under the scenario described above would be considered "payment as annuity."

Surprisingly, and in contradiction to its earlier ruling, the IRS answered that it would be.The new PLR ruled that the initial distribution election characterizes ALL periodic payments from the contract as “payments as annuity,” beginning with the first payment. This is so even though all the payments are withdrawals from an account balance, reducing that account balance. 

Lets look at the details to see why this appears to be a shift in the IRS position.

In the new PLR, the product is a specially designed “”Guaranteed Lifetime Withdrawal Benefit,” or GLWB with a number of unique design elements, held by a plan. The product in the prior PLR was a unique version of variable annuitization, distributed from a plan. The two products, however, share common design elements  which are determinative of how to apply the "payment as an annuity" rules:

-Participant DC account balances are deposited in equity based, insurance pooled separate accounts, which balances will vary with investment performance.

-The participants elect to begin taking a monthly payment at time of retirement. Positive investment performance serves to increase the monthly benefit over time, investment losses serve to decrease the benefit. Under both products, there is a guarantee base under which the benefit will never go below, in spite of investment losses.

-Payments reduce the account balance.

-The amount of the monthly withdrawals are actuarially determined. Under the product in the prior PLR, the monthly payment is calculated based on life expectancy. In the product in the new PLR, the base payment is calculated using an average calculation from a pool of insurers.

-The death benefit while there is an account balance equals the account balance.

-The participant can withdraw all or any portion of the account balance at any time. Under the product in the prior PLR, this right ceases at the earlier of a stated age or when the account balance reaches zero. Under the product in the new PLR, that right ceases at the time the account balance becomes zero.

-The insurance company continues to pay the elected monthly benefit for the rest of the participant’s life, even after the account balance reaches zero (thought he monthly benefit is ultimately reduced by early withdrawals). This is the true income guarantee.

Of the two different positions taken by the IRS, one position is not inherently better than the other. They both have their strengths and their weaknesses (which I will not go into here). Whether one is better suited than the other is so much dependent on the specific product design and the administration and system capabilities of the insurer. This new PLR is actually more consistent with the tax treatment of similar types of payments of "non-qualified" annuities (that is, annuities not sold in relation to qualified plans). 

The problem is that the differences in these two rulings are difficult to reconcile, and muddies the waters for designing DC annuitization programs. There are a number of important differences between the products described in the two PLRs, but none of them appear to impact the determination of when payments should be characterized as "payment as an annuity." If there is a critical, minute fact difference upon which the the new rule was based, it would be helpful for the IRS to highlight it so we can use it in our design efforts  I suspect, however,  that the difference lies in process: the request for this new PLR was put in much different terms than the first, and the PLR was issued out of a different IRS group than the first.

In any event, we now have contradictory rulings. While the IRS has firmed up the position that payments from these sorts of hybrid products are (at some time or another) "payments as an annuity" subject to 417, it left us with confusion as to when that status actually occurs. An opportunity  to settle the issue has been missed. Instead, we are left with a new, self-constructed bump in the road for DC annuities- without any particular policy consideration serving as its basis. 

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The question of what the appropriate fiduciary standard should be in assessing the insurer insolvency risk when purchasing annuities by defined contribution plans continues to be a tough one.

It is also one of the  critical issues to be resolved if the efforts to encourage lifetime income from these plans is to be successful.  The recent  Lifetime Income Hearings  hosted jointly by the IRS and DOL made it clear that resolving this issue, together with portability, participant education and transparency, all need to be effectively addressed over time if there is to be widespread acceptance of DC annuitization.

I testified at those hearings, being privileged to be on the same panel as the distinguished and entertaining Professor Shlomo Bernatzi and Ben Yahr.  One of the two issues of which I spoke was the insurer solvency fiduciary issue.

A number of witnesses at the hearing testified to what I hear regularly from financial advisors as well:  plan fiduciaries don't want to be sued 15 years from now if an insurance company which issued annuity products  chosen for the plan's distribution annuities became insolvent. One of the sources for this problem is with the language that the DOL has used in its fiduciary safe harbor, which requires the fiduciary to

'"appropriately conclude(s) that, at the time of the selection, the annuity provider is financially able to make all future payments under the annuity contract...."

It is understandable that commentators and advisors who look at the above standard will take pause: If you're a fiduciary, this is pretty daunting stuff.  Without a crystal ball, how in the world can you conclude that an insurance company will be here 15 or 20 years hence?  The standard is generally being read as effectively prohibiting a fiduciary from choosing an insurance carrier, because there is no fiduciary which can foretell the future. 

I suggest that no fiduciary standard can require a conclusive prediction of the future, and that it is probably even a misapplication of the safe harbor to read it that way. The ERISA standard is not prescience, but prudence:

"with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like characterr and with like aims."

"Wizardry," is not specifically required.

But the pooling of longevity  risk (such as found in annuities) and mortality risk (such as found in life insurance) are important societal functions. No individual can-or should- solely bear the risk arising from the insolvency of the entity pooling those risks. The States have all recognized this, and the critical need of risk pooling, and have long sought to address, manage and regulate this risk. In each of the states is a substantial and integrated regulatory scheme which governs insurance company investments, reserving, contracts and sales practices. And at the tail end of it all is the guarantee associations, ultimately based on the ability to assess healthy insurers for the insolvency risk.

These state based systems can be flawed in some fundamental ways but, for now it is our "circumstances then prevailing."  Assessments based upon a biennial review, and guarantees based on assessments at the time of failure, can cause heartburn. But  It is all we have. The baby may be ugly, but the baby's ours, as they say.

Rating agencies, as flawed as they may be, may also help. They provide a good measure of current financial health. These measures provide a much more current assessments than provided by  the state's system's biennial review. But the rating agencies own no crystal bell, either. After all, Executive Life had a very high rating when it collapsed. And do not forget the potential issue of rating agency bias.

So what should a fiduciary do? 

Annuities have been being purchased by plans for a very long time. Are these, and every fiduciary choosing annuities at risk? Not necessarily so.

There are a number of different things a fiduciary can do. As an example,  I suggest that the  following acts by a fiduciary could demonstrate prudence which would provide protection:

1. Become familiar with their and their participants rights under state insurance solvency rules, should the chosen carrier become insolvent.
2. Commit, perhaps by way of the plan's Investment Policy Statement, to represent and assert participant claims upon insurer insolvency.
3. Review insurer ratings, and choose only those companies on currently sound financial footings (note, this would not require taking only those with the highest rating; many of the ratings below the highest represent soundness); and
4. When reviewing the terms of the annuity, flush things out to see if there is reason to question an insurer's solvency. So, for example, if an annuity is extraordinarily inexpensive or paying too high of a crediting rate on its accounts, the fiduciary needs to look further. If its too good to be true (such as in the Executive Life offerings) there is a duty to explore.

There are a several other acts which could demonstrate prudence, this is only one set which may work. 

So what should the DOL do?

It needs to separate "future state" from "circumstances now prevailing." Given the flawed system we have, a new, more robust, uniform and transparent system of guarantees need to be established. But while such a system is being debated, it needs to expressly recognize that fiduciaries should be able to rely upon what we now have. I know DOL staff recognizes there is no crystal ball, and that it would be silly to think that the safe harbor requires such. But the language of the safe harbor is causing great discomfort, and a slight modification to recognize that "no prescience is required" would go a long way.

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Any discussion on any tax issue addressed in this blog (including any attachments or links) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any transaction or tax-related position addressed therein. Further, nothing contained herein is intended to provide legal advice, nor to create an attorney client relationship with any party.   

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 How, one may legitimately ask, can anyone possibly write anything that makes any sense with a title like the one I've given this blog?

Easily, is my answer, as as long as one accepts the fact that our world of retirement plans and rules is not so limited as it seems at first glance, and that what we do is actually a critical component of a well functioning and relatively fair (as far as it goes...) society.  It necessarily encompass broad concepts outside of narrowly constricted regulatory compliance-even concepts raised in science fiction classics. 

I have had the pleasure of re-reading one of my all-time favorite science fiction novels, "The End of Eternity," by Isaac Asimov. Written in 1955, its a story of the "Eternals" who travel through a sort of time elevator. These Eternals time traveled in order to change events at some point in time in order to prevent major destruction (such as a nuclear holocaust) at some time in the future. It is based on the same premise as Malcolm Gladwell's book "The Tipping Point", where seemingly small events can have significant future impact .

Harlan,  the main character in Asimov's novel, was one of these "Eternals." He was instructed by the Computer of the need to travel into time and cause a malfunction in a spaceship which would kill the 12 people on that ship.  This was needed in order to prevent an earthwide catastrophe a few centuries later. Harlan struggled with this order and, through mathematical algorithms, determined that merely moving a canister on that same ship from one location to another would have the same affect on the future. Asimov labeled this the "Minimum Necessary Change," or "M.N.C."

"M.N.C." A concept which legislators and regulators often overlook when developing retirement plan rules (note I said "often," as there are some fine examples of MNC in the regulatory lore). It is the "Minimum Necessary Change" approach which I would advocate when approaching the DC annutization issue.

A prime candidate for MNC would be the seemingly intractable issue of portability: how do you allow a person to purchase lifetime guarantees in a DC plan, where the plan may want to change insurance vendors; where the employee changes employers; or when the plan terminates?

The solution for the government regulators may be to actually do as little as possible, and let those who know how to create these product figure it out. For example, the regulations could require (under both ERISA and the Code, let's not make the mistake again of making it just an ERISA rule) any company wishing to sell lifetime guarantees to a plan to provide a portability solution-such as the ability to distribute the guarantee as part of a contract to the individual.  This is not a new issue for insurers, for example, as they have addressed this one in the past with the ultimate portable product: the individual 403(b) contract. Yes, there would be costs related to doing this, but this would be taken into account in the pricing of the product to the plan. A sort of classic "internalization of costs" of which economists speak.

These "distributed annuities" are already permitted by the IRS, and a legislative rule change may be necessary to permit the in service distribution of the contract, and the manner in which they would need to be reported (perhaps by the issuing company instead of the plan).  But, as under existing law, the issuer becomes legal plan administrator of the contract, charged with making sure the "distributed annuity rules" are followed.  

Sound complicated, and nowhere near a "MNC"? Not really. Making something like this work requires insurers and regulators to "dust off" well established rules, procedures and practices which have been in place for 90 years and which were particularly effective in the 403(b) marketplace. We do NOT need to create something out of "whole cloth." 

Or, as is often said, "what is old is new again"......

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One of the most maligned and misunderstood,  yet  one of the most valuable (and one of my favorite), DC plan investments is the the insurance company general account investment-typically referred to as the "fixed fund," the "guaranteed fund," or even sometimes the "stable value fund"(in some of its iterations).  These funds guarantee principal and a certain rate of return over a stated period of time.  These funds usually (except in an inverted yield environment) provide a much higher rate of return over money market funds, while providing a measure of security of which money market funds can only dream. if the insurance company properly balances liquidity with the rate of return, it is an invaluable offering.

The downside to these funds is that the higher rate of return is often keyed to liquidity restrictions.  Dick Van Dyke, in a song from the classic movie "Mary Poppins," actually does a great  job of describing why this must be,  in "Fidelity Fiduciary Bank." He tries to describe to his employee's son, Michael, the value of these investments:

You see, Michael, you'll be part of  

Railways through Africa

Damns across the Niles

Fleets of ocean greyhounds

Majestic self, amortizing canals

Plantations of ripening tea. 

I've included the entire clip from the movie, below.

Its tough making a short term payout from an investment in an "amortized canal." You see, insurance company general accounts are truly  great  capital investment vehicles. U.S. life insurers (who offer  these investments)  held in 2008, according to the ACLI, some $4.6 trillion-12% of which are invested directly in such things as planes, trains and automobiles, and other things upon which the development of world's infrastructure seriously relies, while also purchasing (at much greater levels) the bonds which allow these infrastructure investments to be built.  Investing in these general account funds is truly taking part in an unusual sort of investment in which most plans-or even the majority of mutual funds-do not have the scale, wherewithal or structure, to partake. These are, in short, pretty cool investments.

Bur insurers have often mishandled the balance between liquidity and return, often not paying sufficiently for the long term lock up, or sometimes by the application of seemingly  mystical rules to the application of "market value adjustments" when cashing out early. The good funds still provide relatively high returns, while maintaining substantial liquidity. 

So what does 408(b)(2) have to do with all of this? Arguably, everything.  Ignoring the issue of insurer solvency for a moment,  in a world where the lack of transparency translates into higher costs to plans, and where there is concurrently serious consideration being given to increased use of insurance guarantees (including those found in general account investments) to provide greater retirement security, the regs are eerily silent on insurance transparency. With all the discussion of being concerned with things like "indirect compensation" and trying to figure just how much revenue a party to the plan is generating from the plan, an important piece is missing.

Technically, how the regs accomplish its silence is by way of 2550.408b-2(c)(1)(iii)(A), which specifically excludes investment products under which the underlying investments are not considered plan assets under 2510.3-101.  The DOL provided a good explanation on how this works in an information letter in 2004, explaining something called "guaranteed benefit policies."

This silence really is not the fault of the DOL reg writers.  It is just that the standard manner in which we have grown to evaluate equity investments over the past couple of decades just does not match up well with centuries' long, valuable practices of pooled capital investment of insurance type of entities.

We do need to devise a useful way under which plans and their fiduciaries can shop these products, to understand whether the plan is being paid sufficiently for its risk in accepting liquidity restrictions, and generally what sort of revenue (note, not profit) the insurance company expects to generate over time from the plan.  Here, the risk is not so much insurer insolvency, but being locked into a relatively poor (meaning, not competitively priced for a similar investment)  portfolio rate-yes, these general account managers do sometimes screw up, though the state regulatory structure helps minimize catastrophic errors. It is a risk for which the plan should be properly paid. Where there is not adequate consideration for that risk, the plan's contract  needs to notify the plan of changing rates, and the ability to reasonably get out of the contract if the rates go south. 

From the fiduciary side, it would seem appropriate to be paid for a long term interest rate risk. If there is insufficient return for that risk, then the contract purchased needs to provide liquidity. 

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In the following "Mary Poppins" clip, Michael opts to spend his tuppence on feeding the birds-an option that, if taken by a fiduciary,  would not likely be well received by Tim Hauser at the DOL's Solicitor's office or by Phyllis Borzi's staff.....

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Any discussion on any tax issue addressed in this blog (including any attachments or links) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any transaction or tax-related position addressed therein. Further, nothing contained herein is intended to provide legal advice, nor to create an attorney client relationship with any party.   

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BNA's  Tax Management Advisory Board published a Memorandum as an "Advisory Board Analysis" last week, "Income Guarantees in Defined Contribution Plans."   Click on the title to download a copy. It speaks in some detail of the technical issues confronting the provisions of annuities through a defined contribution plan.

I authored this paper, and have also committed to Al Lurie and NYU to do an even more detailed paper in the NYU "Review of Employee Benefits and Executive Compensation: 2010" to be published this summer. This paper will be a bit more extensive, further detailing the ERISA Title 1 issues related to these contracts, as well as a number of other points made in the BNA paper.

I look forward to your comments.

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Any discussion on any tax issue addressed in this blog (including any attachments or links) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any transaction or tax-related position addressed therein. Further, nothing contained herein is intended to provide legal advice, nor to create an attorney client relationship with any party.  

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 EBSA and the IRS issued their long promised Request For Information on annuities-or, should I say, as promised by the EBSA. We had not expected this particular piece to be a joint effort. It shows that Phyllis's and Mark's agenda is getting policy effectively done, not engaging in damning bureaucratic turf warfare. Hmm. With this and the recent DOL/ SEC activities, we may be seeing a trend here somewhere....

The RFI is extensive and well thought out (though they do reference  the GAO report I criticized in an earlier blog). There looks to be a lot of work put into the effort already, as it well identifies the key issues facing the idea of providing lifetime income streams.

Importantly, it does not make the mistake of focusing on "annuities." Instead, it focuses on how an adequate retirement policy addresses three key risks: longevity, Investment and Inflation (OK. So at least on THIS point the GAO report got it right).  I believe the recent attacks by the Investment Company Institute, as well as Jack Brennan, on "annuities" misses the point: there are solutions needed to each one of these risks, solutions which can have a critical role for mutual funds, investment managers and the insurance industry. This is NOT an industry specific effort, as one industry alone cannot address all three of these risks without the others.

As promised, the RFI focuses strongly on transparency (yes, yes, my Annuity Transparency blog is coming), relevancy for the average participant, portability and cost. But I was intrigued by the questions related to 404(c) and IB 96-1 (on participant education).  I am particularly interested in the insurer solvency issue, which to me is the key fiduciary risk (next to transparency), but you need to look closely in the RFI to find that issue.

The substance aside, one must be impressed by the process. We always thought the Borzi/Iwry combination would be an extraordinarily effective one, and this is proving to be true. Seeing these two longtime compatriots openly cooperate with the goal of effective public policy is something for which we have long waited.

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Any discussion on any tax issue addressed in this blog (including any attachments or links) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any transaction or tax-related position addressed therein. Further, nothing contained herein is intended to provide legal advice, nor to create an attorney client relationship with any party.  

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My everlasting thanks to Andrea-Ben Yousef of BNA. We were exploring annuities, and some confusion from my blog of January 6th, 2009.  We discovered that I posted the incorrect PLR number and link on that blog, where I discussed the importance of a new PLR to DC annuitization.  The link I had incorrectly provided was to a PLR on longevity insurance

The correct link and reference is PLR 200951039.   .... My apologies! It is now reading properly.

Some professional news. II have taken the exciting plunge, and have established my own firm. I now can be found at the Law Office of Robert J. Toth, Jr., rjt@rtothlaw.com.  The address and telephone numbers remain the same.I have been told that I am creating a challenge for those who still maintain a Rolodex!

Bob Toth

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Annuitization from DC plans suffers from the lack of clarity on a number of key technical rules, which need to be resolved before such annuities can be widely implemented. The IRS has taken a major step in its issuance of PLR200951039, a complex PLR which- for the first time-defines what an annuity really is for purposes of DC annuitization, and when the annuity election election occurs. This is critical for determining which RMD rule  applies, and when spousal consents will be required. It also, very importantly, recognizes the Plan Distributed Annuity (see my prior blogs)  and the qualification rules which will apply to them.

Even the informed reader is likely to get lost in trying to parse through this particular PLR.  Suffice it to say that there is a highly involved set of facts related to an insurance company's specific group and individual annuity products. The relevant features are:

• It is an annuity purchased by a DC plan for distribution to participants-either from the group annuity contract held by the plan (and not being a "plan asset", by the way) or as an individual annuity contract purchased by the plan and distributed to a participant-the classic Plan Distributed Annuity.
• The contracts have account balances within them which are invested in variable separate accounts. The retirement distributions from these contracts are actually treated by the contracts as withdrawals from the account balance. Every dollar taken out reduces the account balance by the same amount.
• At the time the participant starts taking payments, the participant elects how the amount of the withdrawals will be calculated. The  choice is that the payment will be equal that which would be paid under either a single life annuity or a joint and survivor annuity. This particular product gives the participant the right to actually choose the interest rate at which the annuity will be determined. 
• The amount of the withdrawal is adjusted every year to reflect investment performance relative to the interest rate selected. It is also adjusted for any "extra" withdrawals taken by the participant during the year. 
• At a certain age (typically age 85, but the plan can elect the age, within a range), the account balance actually disappears. All payments now come directly from the insurance company, not from the participant's account, and that payment is guaranteed for a lifetime. This particular product has an interesting twist, called "variable annuitization." This feature actually allows the participant to elect to have their annual payment adjusted in accordance with investment performance using a sort of "phantom" set of accounts.

Here's what the IRS has importantly said:

• Payment as an annuity/not as an annuity. Payments made from the contract after the account balance is "shutdown" IS annuitization. All payments before then are NOT considered annuitization, but systematic or periodic  withdrawals (let's call it the "access period"). Those "access period payments"  are also considered RMDs, but only up to up to the calculated RMD amount. (This, by the way, means that the amounts up to the RMD cannot be rolled over, but the amounts in excess of that can be). 
• Application /Timing of  spousal consent rules. Spousal consent is required at the time the participants elects distribution from the annuity- even though the payments during the access period are "non-annuity" payments. Electing the form of computing the payment at the time withdrawals begin is necessary under this product to make the systematic withdrawal "match up" with the actual annuity payments, to make it resemble a guaranteed income stream that is set for life. This then makes the election the same thing as currently electing an annuity payout at age 85 (or whatever age is elected), even if the intervening periodic payments are not paid as an annuity. This means that the spousal consent must be received  if the basis for computing the payment (and ultimate annuity payment at a later age) is other than (at least) 50% Joint and Survivor. Though one may quibble whether this is the right decision, we finally have  a rule we can use. As a practical matter, this may cause some problems if there is an intervening divorce and remarriage during the access period.
• Spousal beneficiary. The account balance during the access period will still be subject to the spousal consent rules on the naming of the beneficiary.
• RMD.  In determining the RMD, the RMD for the for payments during the access period will be determined using the account balance  under the standard DC rules. AFTER the account balance disappears, the DB method of computing the RMD will apply.

Finally, it is the overall message of the PLR which bears importance: the IRS further affirms the tax treatment of an annuity that was distributed from the plan, for an annuity that meets the requirements of 404(a)(2).

_________________

 Any discussion on any tax issue addressed in this blog (including any attachments or links) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any transaction or tax-related position addressed therein. Further, nothing contained herein is intended to provide legal advice, nor to create an attorney client relationship with any party.  

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I blogged a couple of weeks ago on the DB demise because of what I was seeing my current work on DC annuities, triggered by an interesting e-mail discussion string between fellows of the American College of Employee Benefits Counsel. 

But then the PBGC held a 35th anniversary forum shortly thereafter, extolling the idea of revitalizing the current DB system.  I thought this made it an opportune time to further the discussion.

The December 7 Forum on DB plans seem to hit it mostly right  in its calling the attention to the fundamental value of employers providing "guaranteed income for life" to employees. The National Institute on Retirement Security also reported on the meeting, noting the  critical role of Defined Benefit Plans, calling them the "Real Deal." The NIRS has also published its vision with which one can hardly argue. Under a high quality retirement system retirement system: 

• employers can offer affordable, high quality retirement benefits that help them achieve their human resources goals;
• employees can count on a secure source of retirement income that enables them to maintain a decent living standard after a lifetime of work;
• the public interest is well-served by retirement systems that are managed in ways that promote fiscal responsibility, economic growth, and responsible stewardship of retirement assets

But here's where the problem lies. Juxtapose those statements with the following quote from "The Black Swan," by Nassim Nicholas Taleb, Random House, 2007:

"Consider the following sobering statistic.Of the five hundred largest U.S, Companies in 1957, only 74 were still part of that select group, the Standard and Poors 500, forty years later. Only a few had disappeared in merger; the rest either shrank or went bust." p.22

This where the PBGC, the NIRS and Pension Rights Center (which also presented at the conference) have it all wrong: the traditional DB plan does not, and will not, meet these laudable goals if you rely upon the private employer for the financial wherewithal to insure that the funding and fund management will be adequate. Plan sponsors can be terribly conflicted, with their own corporate financial needs creating economic pressure to engage in some sort  dangerous "creative accounting" in the management of these plans- which we have all too often seen in the past.  I am tempted to argue that public plans do not have this problem, and that they should get a "bye" on this concern. But think again. Many state and local governments are in serous trouble because of a disturbing lack of financial discipline, as they have not really had to "pay as you go" when promising very expensive benefits. Are not these promises really of the most cruel kind, when we find the money to pay for them really is not, nor ever can be, there?

The current DB system is premised on the notion that a private employer can more cost effectively provide this benefit. Logically, this cannot be true because of the lack of sensible pooling even in the largest employers. Some employers will be able to do so today because of their current demographics, but many cannot-and even those who can may find themselves in a bind in a decade or two. The only potential cost savings is in the profit charge on this guarantee issued by an insurer.

In effect, the system believes that it can do a better job at longevity risk management than regulated insurance companies, and to get that insurance for, in effect, free. When all is said and done, it is likely far from free. We are seeing the effect of the fallacy today, with only 19,000 DB plans now being covered by the PBGC.

So if the system REALLY needs a guaranteed lifetime benefit based upon employer sponsorship, one under which employers have the ability to choose the benefits (and thereby control the cost),  but one under which the employees should not be exposed to the vagaries of foolish business decisions of their  employers' senior management, what IS the answer?

I truly believe the answer lies in a private insurance system which provides Annuity Transparency, in annuities purchased through the employer sponsored system.  I'll talk about this on my next blog. For now, though, its back to the ski slopes of Quebec.... 

A footnote, added 12/21: Gretchen Morgenson reports in the Sunday NY Times  on a multi-billion dollar failure in the Alaska pension system, caused in large part by the alleged error of Mercer.  Again, my point: non-regulated institutions are ill-equipped to manage DB plans, particularly large ones. Had Alaska purchased insurance, the risk of error would have be borne by a well capitalized, highly regulated expert organization.

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The private employer-sponsored defined benefit plan has had a good run of it, supporting two generations well in its goal of providing economic security  for retirees.  But the last 10 years have seen gradual though substantial decline in the number of employers sponsoring these plans, and in the percentage of employees being covered by these plans-now somewhere well south of 19% of the workforce is covered.The economic collapse has exacerbated the problem even further by exposing the weaknesses of the system, as the remaining DB plans are seeking funding relief from Congress.

You can find many sound opinions which attempt to explain this demise, from over-regulation, to difficult statutory schemes,  to the allure of defined contribution plans. If you step back, though, you can see that all of the reasons for the demise have a central theme: private employers are structurally ill-suited to bear the lifetime risk associated with providing this kind of benefit.

Think about it. Private business can, and indeed some must, fail. These companies  grow, expand and, ultimately either fail or need to be exposed to the risk of failure. There is a lot of conversation at the policy level about the evils inherent in having companies that are "too big to fail."  So what is the sense, then, to rely upon companies that we structurally need to fail from time to time to be responsible for funding a lifetime risk of their employees? One may claim that this is the function of the PBGC, but the PBGC doesn't specifically reserve for risks undertaken by plans. Its reserving system is ad hoc, at best.

Taking a close look at the current DB funding rules, you can see that they really require employers to have, or buy, sophisticated actuarial and investment expertise that you will only normally find in a regulated financial institution. We are, in effect, demanding our manufacturing base to become experts at insurance.

These employers are also seeing the changing nature of their workforce and retiree population, and they find that the DB Plan is unable to meet employee and retiree demands. DB Plans are, for the most part, proverbial “one trick ponies,” whose inflexibility has limited their usefulness in the current marketplace.

I have blogged on popular new annuity products in the marketplace, many of which are reliant upon sophisticated hedging strategies.  These innovative annuity products include features well beyond anything that could be offered in a traditional DB plan. These includes features like (but not limited to) the elective, periodic purchase of a pension guarantee with each payroll; the ability to access cash balances with minimum penalties; equity participation which will raise or lower the lifetime income guarantees; guaranteed minimum withdrawal benefits; guaranteed minimum income benefits with equity participation; and variable annuitization.  Employers who sponsor DB Plans are not in the business of developing and providing these sophisticated guarantees to meet changing employee and market needs. Additionally, plan sponsors generally have limited skills in even maintaining traditional DB benefits, much less having the resources to provide a wide variety of lifetime payout benefits which can adapt to change. They are also severely restricted by a regulatory scheme which discourages innovation. 

What is the answer? Most will agree that the former insurance schemes are sorely inadequate: inflexibility in pricing, little transparency, little portability, and irresponsible acting in some quarters has fueled the current economic mess. What the insurance industry DOES have is the necessary skills and regulatory scheme to guarantee and manage the solvency risks inherent  in guaranteeing life time income.  

Mark Iwry and Phylis Borzi both have recently noted noted their commitment (and cooperation) to providing a sensible regulatory scheme for providing annuitization from defined contribution plans, which will rely upon transparency, simplicity, relevancy and portability. To make this really work, we will need legislative relief as well, in such things as providing a "double 415" limit in such plans in order to provide the same sort of tax benefit which is available for sponsors of DB plans.

Should the insurance industry be able to answer this call, we may be able to finally have a sensible approach to providing retirement income from employer sponsored retirement plans.

For further discussion on this matter, see this link. 

Any discussion on any tax issue addressed in this blog (including any attachments or links) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any transaction or tax-related position addressed therein. Further, nothing contained herein is intended to provide legal advice, nor to create an attorney client relationship with any party.  

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A couple of months ago, I began writing about the fiduciary concerns related to the purchase of annuities as distributions from  individual account DC plans. In that Part 1, I noted that there are five elements, so called "I's", which need to be addressed by any plan annuity. In that blog I focused on  "irrevocably", the fiduciary risk of what I called the "30 year risk"-on how one gets comfortable with the inherent risk of an insurance company failing over an annuitant's lifetime.

Inflexibility and Inaccessibility

 These two "I's" are closely related, as they really point out the nature of annuity products which are purchased for annuitztion from DC plans: they are plan investments. Treating them otherwise risks turning the DC plan into a DB plan, the ultimate disaster for this kind of program. So the fiduciary focus should be on how to address these elements in choosing annuities as investments under the plan.

Lets talk about what the fiduciaries need to deal with, and about what I mean when I say say irrevocable and inflexible. Traditional annuities are inflexible. Period. You get the monthly benefit you pay for. They provide a very valuable benefit which should be part of anyone's retirement planning, but this inflexibility can be scary, as it takes away from the participant the ability to address unexpected contingencies. This fear comes from the second point: the funds used to buy the traditional annuity are gone for good. Other than payments made under a survivor annuity, the traditional annuity doesn't give the participant any access to funds to pay for contingencies, nor does it typically pay a death benefit. So what's a fiduciary to do?

It's a plan investment. Unlike a DB plan, Including the annuity in a DC plan is a fiduciary decision-not a settlor function. So plug something like this into the normal fiduciary process:

1.  Decide whether you really want this sort of traditional annuity within the plan, and whether you want to limit the purchase to a portion of the participant's account balance. Check with the annuity company. There are number companies that have a variety of features which address these issues: some have death benefits; some are "cashable," having some sort of surrender benefit; some have a guaranteed payment over time.
2. Check for annuity purchase rates. Though "fees" are the typical focus of fiduciaries, that's not not the proper inquiry for these sorts of annuities-it really is all about seeing how much benefit can be purchased for what price. Check commissions.
3. Make sure the annuity is designed for a retirement plan: make sure there are unisex mortality; that it can do the proper Schedule A reporting; that there can be appropriate valuation; and if there's a death benefit, the incidental benefit rules are met. Depending on the type of contract and features, there may be a couple of more things to check out.
4. Decide whether to hold the annuity in the plan and pay the benefit out from the plan; or issue the annuity from the plan as a plan distributed annuity. If distributing, make sure the plan document permits in-kind distributions.
5. Review the range of variable and living benefits that may be available, where, inflexibility and inaccessibility are not a problem.
6. If allowing participants a choice of annuities, if an advisor is used, and any of products are registered products, make sure the advisor follows FINRA's suitability rules.

Of course, check out the insurance company (see Part 1).

Next up: Invisibilty: the sale/advising side of annuities

Any discussion on any tax issue addressed in this blog (including any attachments or links) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any transaction or tax-related position addressed therein. Further, nothing contained herein is intended to provide legal advice, nor to create an attorney client relationship with any party.  

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The Swagger

I had the privilege to speak on a 403(b) panel at the recent DOL/ASPPA "DOL Speaks" seminar,   with Lisa Alexander and Susan Reese of the DOL.  Our own panel went very well, with Susan and Lisa both speaking directly to and recognizing the transition problems related to this new 403(b) world. As Lisa repeatedly pointed out, many of the rules causing the challenges have always been there, but not given much attention by 403(b) employers or their advisors. The audience showed some frustration, but that arises from there not being answers to a lot of the tough questions we now face.  But our take away is that the DOL is spending time and smart effort in recognizing the difficult issues now being raised, and is considering ways to approach them.  You will from time to time see in this blog me disagreeing with their chosen approach, but it will never be a criticism of the seriousness of their choices nor of the professional manner in which they are being handled.

This conference was my first serious view of the direction of the EBSA under Phylis Borzi, and it is already showing some swagger under her leadership. My first clue came from the EBSA's staff's position with regard to the material being presented. We are all very used to the typical government staff comment during most such seminars that any comments of staff in their presentations reflect their own personal opinions, not that of their employing agency.

Well, at this seminar, the DOL took accountability. None of their speakers issued this disclaimer. My own presentation material was reviewed with the view that in a seminar labeled "DOL Speaks", it couldn't very well disclaim what its staff members were saying. So the staff statements took on an import we have little seen at other such conferences. This was a rare act of bureaucratic courage.

Phylis's comments about the EBSA's priorities sounded a more hardened approach to enforcing the public policy underlying ERISA.  It reminded me some of my favorite line from one of the all time great movies, "Mr. Smith Goes to Washington". A "little bit more of looking out for the other guy" is what I recall Jimmy Stewart saying.  Plan participants have always had this kind of advocate in the EBSA, but those efforts look to clearly become more focused.

Annuities to be addressed

At long last, both the DOL and the IRS will be taking a look at the technical rules related to the offering of annuities in 40(k) plans. The DOL announced that they will be soon be publishing an RFI on annuity issues, while the IRS  announced that they will be considering auto-annuitization. This will be both challenging and fun, particularly as it comes to making annuities sensibly transparent, able to be effectively compared, and in designing programs that make sense for those with modest accumulations. 

And for those of you still looking for Part 2 of my fiduciary analysis of annuities, its on the boards and will be out shortly.

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Two recently published studies demonstrate the sort of shift in the "conventional wisdom" related to annuities for DC plans that needs to occur for those products to be successful in the marketplace.

One of the struggles the market continues to encounter is the limited  manner in which many policy wonks (with the notable exception of David John, Mark Iwry, Bill Gale and a few others) and advisors within the DC plan community continue to view annuities.  There is still a prevailing view of annuities as being simple "straight life" annuities, a view which ignores the recent development of innovative products in the individual, "non qualified" annuity marketplace.

The first study is a troubling example of this stodgy way of thinking. It is the recently issued GAO report, written for George Miller, Chair of the House of Representative's Committee on Education and Labor, called "Alternative Approaches Could Address Risks Faced By Workers But Pose Trade-Offs." It is, by all accounts, a very thorough and well done analysis of what the authors view as the current alternatives to "decumulation" from DC plans. It  ignores, however, the an entire range of "living benefits" and other sorts of guarantees which have been successfully used in the "non-qualified" marketplace. It is these sorts of guarantees which can address many of the fears of plan fiduciaries and plan participants that the purchase of an annuity is merely a bad bet made against the insurance company (see an earlier post discussing these fears).      

I encourage you to look through the GAO report, and then compare it to the second study.  Kelly Pechter wrote a recent article in his Retirement Income Journal of a study published in the Journal of Financial Planning by Gaobo Pang and Mark Warshawsky entitled "Comparing Strategies for Retirement Wealth Management: Mutual Funds and Annuities."  These two economists analyzed 6 alternative models for  for guaranteeing income out of a qualified plans, focusing on 401(k) plan accounts and IRAs. 3 of their models addressed innovative marketplace methods: the use of one of the "living benefits"-Guaranteed Minimum Withdrawal Benefits (GMWB)- as well as variable annuitization and gradual annuitization. This study does not provide all the answers, as there continues to be a number of technical/legal issues which need to be settled to make these things really work well in qualified plans (see  another, earlier post discussing these issues, referencing the CCH and BNA papers). But it finally opens the door to the sorts of discussions we need to be having in order to make DC annuities work. 

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I sat sown this morning to follow up with Part 2 of my mini-series addressing the fiduciary risks in purchasing DC annuities (link here to Part 1), when a Plan Sponsor magazine article caught my attention. It spoke of a study which linked  the lack of pensions with the risk of poverty among women and minorities. The study, by the National Institute on Retirement Security, claims that it provides hard data on the unique impact of defined benefit type of income on older Americans' economic well-being.

I do not know the Institute or the authors of the study, and the conclusions raise a while host of issues related to whether its the pensions or the type of employment related to the pensions. But the fundamental issue is one which served as a basis of my (now becoming) annual Mother's Day blog, "ERISA and Mom," . If I recall, it was studies like these which were presented to Congressional hearings leading to the passage of Retirement Equity Act of 1984. It also means that the risks may not have changed all that much over the past 25 years.

If the study holds water, it really does help answer the question of "why annuitize from a defined contribution plan?"  If there is indeed a demonstrable impact of maintaining a DB type of  program instead of just a DC type of program, annuitizing from a DC plan may be attractive to employers.

DC annuitization does some things a DB program cannot: it permits an employee to elect what percentage of his or her retirement benefit can be used to provide lifetime guarantees while permitting the choice between a wide variety of carriers with a wide variety of terms.

It may provide further impetus for employers who really do want a DB program but do  not want to deal with the risk exposure, hassle and expense of maintaining one.

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 Annuity companies have been innovative in addressing marketplace concerns in the sale of guaranteed income annuities to individuals outside of 401(k) and 403(b) plans. The recession has spurred even more interest in these products, with insurers  telling us they are seeing an increased interest in both annuitization and in other  guaranteed insurance products. A number of these annuity products for the "non-pension" markets are beginning to show up in some defined contribution plans, though awkwardly so. Those product  designs don't typically fit well with ERISA's rules, and are often administered on computer platforms which don't support ERISA compliance.

The nut that is proving the hardest to crack is finding a way make these products available to 401(k) participants in a simple, compliant and seamless way, either as a form of distribution or as a way for participants to otherwise protect their investments within the plan-and many vendors have designed products attempting to meet these criteria.

Plan Sponsor co-hosted a webinar a few weeks ago with MetLife, in which the use of annuities as distributions from defined contributions were discussed. Kent Mason, an old friend and a fine lawyer with Davis and Harman, commented that he believed that one of the key reasons annuities and other longevity products were not being used by DC plans is because of the way the RMD rules apply to them. Though I hold Kent's opinions in the highest regard, I have to disagree with him on this point. I think instead the fiduciaries' concerns lie with the fear of locking up funds for a lifetime with a single company. I would go with the view of another longtime friend, Dan Herr of Lincoln Financial Group.  Dan's experience tells him that the key obstacle to the purchase of annuities for individuals  is something he calls the "4 I's": Irrevocability, Inflexibility, Inaccessibility and Invisibility. 

In applying Dan's theory to the 401(k) marketplace, it seems to me that addressing those "4 I's" would also serve to address the concerns of fiduciaries, to which I would add a fifth "I": Immobility (or, to be more precise, portability).

Lets take a look at each one of those "I's" separately, from a fiduciary's view. In this Part 1, I'll discuss Irrevocability. The other "I's" will be covered in blogs soon to come.

 Irrevocability

The traditional annuity, one in which a set price is paid for a set amount of lifetime income, is typically irrevocable. I call this "your grandpa's annuity."  Once a participant commits a substantial payment to the insurance company, it is gone for good.  This gives both fiduciaries and participants a great deal of heart burn. It locks a participant up for a lifetime, raising some very difficult fiduciary concerns about the predictability of an insurers' solvency. It is not a new concern, as  Individuals live with that same fear when they buy any life or annuity product-a concern about what I call the "30 year risk" (my apologies to the actuaries). 

It sees to me that the first element in an adequate fiduciary review is to get at least a layman's  grasp on the nature of insurance and insurance regulation. Pooling risks with others is an uncomfortable concept that is foreign to a fiduciary with a defined contribution mindset. The pooling of risk and the undertaking of this "30 year risk" are critical societal functions, but they pose significant risks to a state's citizens whose policyholders are unable to address individually. Because of this, states have uniformly stepped in to protect their citizenry by regulating insurance in ways of no other industry:

1. Reserves are required for the risks taken (one of the big AIG failures was that large levels of risk were taken on without any reserving by a non-insurance subsidiary which was not governed by an insurance regulatory authority);
2. The manner in which the reserves are  invested are heavily regulated for investment risk and type;
3. Insurance companies are regularly and comprehensively examined by state insurance authorities and must do substantial regular reporting on their assets and the nature of them.
4. Insurance companies are required to participate in their state guarantee associations to protect the policyholders of all companies within the state. (See the NOLHGA site for further information). This is an imperfect system, and insurance companies are severally restricted by law from discussing this guarantee with their policyholders. The best solution for the future is the proposal for a sort of FDIC program for plan annuities, as described by the David John,  Bill Gale of the Retirement Security Project and Mark Iwry, Ass't Treasury Sec'y.
5. Review of marketing material of all insurance products is required.

I would think that an adequate fiduciary review would have the fiduciaries acknowledging that the task they undertake is different from the mere investment of account balances; the standard against which they will be judged has necessarily a stronger insolvency risk; and that they have addressed that risk adequately-in part-by understanding and relying upon the state's regulatory role in managing the risk.

Fiduciaries can then further manage the risks by looking closely to the terms of the annuities being purchased. They can look for products that offer terms which address their concerns. For example, they can look  well-priced "outs" in the form of cash surrender options;  for products which are funded in part with separate accounts which are protected from the insurer's creditors; or for funds and guarantees which are partially re-insured by an unrelated insurance company-thus spreading the risk.

This should then be balanced and integrated into looking at how the other 4 "I's" are addressed- a topic of soon to be published blogs.

NOTE: I have moved offices (though still with Evan and Monica), moving back downtown (yes, Fort Wayne has a very nice downtown!).  I needed to change telephone numbers in the process.

My new contact information is:

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What Happened

One of the biggest disappointments arising from the issuance of the 403(b) regs has been the inability of employers to effectively terminate their plans.  At first, the IRS caused quite a favorable stir when it announced that the regs would specifically classify the termination of a 403(b) plan as a distributable event, and would  further permit the distribution of a "fully paid individual insurance annuity contract" as a terminating distribution. This seemed almost too good to be true as employers (who were willing to pay the cost of termination, including the full vesting of employer contributions) and consultants now had another tool with which to manage the complicated changes coming out of the new 403(b) scheme. Those of us familiar with the intricacies of individual 403(b) contracts were also well familiar with the administrative methods under which an employer could actually distribute an individually owned 403(b) contract without violating the individual's contractual rights.  Life, for a moment, seemed wonkishly swell.

Reality then hit. IRS officials soon started making public statements that individually owned custodial accounts would not be honored as annuity contracts for purposes of terminating plan distributions. Some unusual comments were even made that distributing certificates under group annuity contracts (a standard method of dstribtuing annuities under terminated defined benefit plans) also would not be honored as valid terminating distributions.

These positions had the practical effect of making most 403(b) plan terminations impractical. Because all of the assets of a terminated 403(b) plan need to be distributed within 12 months of the date of termination, and because employers cannot typically force the distributions out of an individual custodial account (and often not from the certificate of a group annuity contract), any attempt at termination would have a high likelihood of failure. If an employer could not convince all of the plan's custodial account owners to take a cash distribution from their accounts, the termination would fail.  If the termination fails, then the funds of all of those who had rolled funds into an IRA from the supposedly terminating 403(b) plan or had taken a "fully paid insurance annuity contract" all becomes taxable.

 This is an absurd result. It completely eviscerates  the IRS's own termination provision and takes away a valuable planning tool from the marketplace.  

Solutions

The draconian position taken by the IRS in drawing a distinction between an individually owned annuity and a custodial account is hard to understand. From a strictly statutory view, it seems to have little support. The language of 403(b)(7) is unambiguous:

"for purposes of this tilte, amounts paid by an employer described in paragrph (1)(A) to a custodial account which satisfies the provisions of 401(f) shall be treated as amounts contributed by him for an annuity contract for his employee...."

The only 403(b) distinctions between a custodial account and an annuity contract (related to the ability to withdraw employer contributions without a "distributable event") are in 403(b)(7) itself. There seems to be little statutory authority for allowing terminating annuity distributions and not allowing custodial account distributions. For 403(b) purposes, a custodial account IS an annuity contract.  What is really interesting about the 403(b) regualtions, is that a fair reading of it doesn't seem to prevent the distribution of a custodial account as an annuity contract.

As a practical matter, the IRS's public position makes even less sense.  If you start with the proposition that 403(b) contracts have been administered for years as individual pensions and that- to many custodial account administration systems- it mattered little whether or not the account was associated with an employer. Many non-ERISA, individually owned 403(b) custodial accounts have actually been administered by mutual fund companies on the same systems that administers their IRA accounts.

It is truly hard to understand the basis for the IRS's odd position in this matter. There is no longer any potential for employer abuse, as any relationship with the employer has been terminated, and the terms of the contracts continue to regulate participant's activity.

So, now what? The Investment Company Institute has recently suggested a complex solution to the IRS to solve the IRS's "problem".  It involves waiting periods, switching the taxability of the account, issuuing deemed distribution notices and the like. All of this seems terribly complex and unnecessary, creating even more tax horror for paritcipants and administrative nightmares for vendors.

Isn't the answer really much simpler than all that?Is there any reason why a "distributed custodial account" couldn't be administered in the way non-ERISA contracts had been administered in the past, or in the manner IRAs are currently administered?  

Perhaps if there is a distaste for that past, allow the distribution of a custodial account from a terminated 403(b) plan, and treat it under the same tax rules as distributed annuity contracts. After all, those distributed annuity contracts often hold mutual funds in their variable accounts. Outline a simple set of rules for both of those types of contracts, based upon the former 403(b) rules but infused with a dose of any anti-abuse the IRS see as a risk. Require simple annual reporting as a line on the existing IRA reporting form, Form  5498.  Perhaps even allow it to be treated in the same manner as plan distributed annuities.

Does the IRS fear so much that relying upon the representations of terminated 403(b) plan participants without employer oversight will so undermine the system as to be destructive, in a system where those funds could also be transferred to a relatively unregulated IRA,  where such a vast amounts of assets are held?

I just don't get it.

Any discussion on any tax issue addressed in this blog (including any attachments or links) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any transaction or tax-related position addressed therein. Further, nothing contained herein is intended to provide legal advice, nor to create an attorney client relationship with any party.  

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 Mark Iwry, one of the principals of of the Retirement Security Project, has been appointed as  Senior Advisor to Treasury Secretary Geithner and Deputy Assistant Secretary for Retirement and Health Policy.

First and foremost, our heartfelt congratulations to Mark. This is a post well suited to him, and an appointment which will serve the nation's retirement needs well.

Mark's policy pedigree will be known to many readers of this blog: he was one of the early advocates behind the Automatic Enrollment rules under the PPA; he was instrumental (with David John) in the development of the Administration's retirement policy of mandatory employer based IRAs; and has done much work with the RSP (through writings and many presentations) on the value of annuities and lifetime guarantees in defined contribution plans.  We have mentioned his work a few times in our blog.

We have no crystal ball or any inside information, but the presence of a senior administration official who passionately believes in protecting workers' retirement income, and who sees annuities as one of the critical tools in that effort, is likely to manifest itself in the policies developed by this administration.

This appointment clearly gives a boost to an imorrtant financial tool. The challenge is for vendors  to develop a series of appropiate products and policymakers appropriate rules that address the concerns that advisors continue to raise, most particularly the transparency of an annuity's financials and addressing the fear of insurance company meltdowns.

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It has been a couple of weeks since we've last posted a blog, and with good reason. Between Evan, Monica and I, this two month span has us doing some 15 presentations and articles, whie keeping up with clients (and a couple of us squeezing in some overdue vacation time!).  Monica is speaking this week at the Plan Sponsor 403(b) Summit in Orlando; Evan will be speaking this week at a TIAA Client Forum in DC and at the CUPA Eastern Regional Conference in two weeks; and I am speaking at the IRS/ASPPA Great Lakes benefits Conference in Chicago next week and the NIPA Annual Conference in Las Vegas the week after. Come up and say hi if you see us! 

DC annuitization seems to be picking up a head of steam recently, with attention being paid to guaranteed income streams because of the effects of the recession on 401(k) and 403(b) accounts. As our good friend and fellow blogger Jerry Kalish has posted, the train is pulling out of the station. The Retirement Security Project has been espousing this for a few years; many of the major insurance have developed products specifically for this market; and even mutual fund companies are working with insurers to develop solutions. We have also blogged and published on this issue a few times.

Now Phyllis Borzi, the President's nominee for Ass't Secretary of Labor for the EBSA, is reported to hold the same conviction as well.

So, the real question is now what? Most consultants, TPAs and lawyers have only a passing familiarity with annuities, particularly the new breed of annuities which offer innovative guarantees. How does one go about deciding which annuity is right, whether the fees are appropriate, and whether the insurance company is solvent enough?  How do you explain their features to plan participants, and what part does it play in an employer's benefit program? What do you need to know about state guarantee associations, and what about rating agencies and the problems they now seem to be having?

In short, the things a plan has to look at to buy these financial guarantees creates quite a "fog" for an industry unaccustomed to them. The products are not difficult to understand, but their features, documentation and issues are much different than the typical plan investment we have been dealing with over the past few decades.

The DOL has made a first stab at things,  publishing an annuity safe harbor  designed to assist fiduciaries in their choice of annuity policies as a distribution option under their individual account plans. The insurance industry is not enamored by the safe harbor, as it seems to set some pretty high standards for fiduciary review, one which competing long term investments don't seem to have to suffer.

Imperfect as they may be, take a look at the DOL regulation. It does provide a chance to help begin to understand these products so that fiduciaries may become more comfortable with them.  We'll be addressing a number of those issues raised in the reg in the next few blogs.

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I mentioned in a posting last week that we will take some time on this blog to work through a number of the legal and technical issues related to annuitizing out of 401(k) plans. This, in effect, allows the 401(k) plan to offer the best features of the Defined Benefit and Defined Contribution plans without the huge burdens that typically are associated with DB programs.

You would think from the number of articles written in the past several years condemning the use of annuities in qualified plans that any plan sponsor would be off their rocker to even consider making this benefit available under their plan.  So I think It is well worth noting the value of these types of insurance products before we get lost in the "technical weeds" of annuitization. Annuities do something that no other financial service product in the world (other than life insurance) can do: they pool our common interests for the general benefit of all.

But most folks see the "price"of this pooling as being a bit too "salty" for their tastes-they stay away from annuities because those contracts provide a benefit which is generally inflexible, inaccessible and  invisible. Or, as my brother has put it, its just a bet against the insurance company which the insurance company will win.

That world is now changing. As an example,  Transamerica and Lincoln Financial have just finished round one in their litigation over the enforceability of a patent of an annuity design which both pools interests and gives policyholders control. Each of the major insurance carriers have been developing similar products as well, trying to address policyholder concerns over balancing liquidity with security.

So, finally, it appears that there will be annuity products available in the marketplace which serves policyholders well. The technical challlenge is to successfully fit  these new products into defined contribution plans where there is a great need for a "defined benefit" type of program. I would hope then that the value we each receive from the pooling of our common interest would get the favor it deserves.

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It is back to the future, in an odd sort of way. There is growing trade press coverage on the interests of 401(k) plans and plan participants on turning a portion of participants' account balances into a "defined benefit-like" guaranteed income stream. Follow, for example, this link to Plan Advisor.com.

There are really two ways transform that 401(k) account balance into annuity payments.  The first is to annuitize from within the 401(k) plan itself. This means that you need to

• take care that you don't turn the 401(k) plan into a defined benefit plan;
• deal with the pesky issue of handling an "outside asset" not typically held by the plan's custodian; and
• figure out how to make those guarantees portable.

The second way is to offer a distribution option from the plan of a  "plan distributed annuity." This opens up a whole world of guarantees that can be provided using a 401(k) account balance, as well as being a potential answer to the portability issue mentioned above.  

We will post over the next several weeks a number of blogs which will discuss some of the legal and technical issues related to these sorts of programs. For starters, if you're interested, take a look at the articles we published with BNA and CCH last year which discusses some of the legal issues involved: 

• BNA paper, "Annuitizing From 401(a) Defined Contribution Plans" 
• CCH paper, "Distributinfg Annuities Fom Defined Contribution Plans"

Please note that the reference in the BNA paper to my former law firm is now incorrect!

We look forward to carrying on the conversation.   

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