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

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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 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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Our blog of May 26 on "Distributed Custodial Accounts" generated a number of comments, which require a bit of a "follow-on."  Ellie Lowder, one of the grand dames  of the 403(b) world, agreed with my assessment.  She mentioned  that she had discussions with the IRS on this point. Staff  just couldn't see how distributions of custodial accounts from a terminated 403(b) plan could work under Section 72 (dealing with the taxability of distributions from plans and annuities). The IRS mentioned that Section 72 is clear on the distribution of annuities, but there is nothing about the distribution of custodial accounts.

Though I can empathize with the IRS's concerns, it actually points out the difficulty with the path it has chosen to foster greater 403(b) compliance: for over 50 years, these arrangements have been treated as individual pensions. Trying  to force them into an employer plan scheme gives rise to these kinds of  difficulties.

For the past 20 years,  custodial accounts have existed outside of a plan, with Section 72 being applied well-and being administered properly under the Code, to boot. There are a few examples  which are telling:

• Example 1:  A tax-exempt employer goes out of business in 1998, after having  sponsored an ERISA 403(b) plan funded with individual custodial accounts from a single mutual fund complex.  The plan would have terminated (for ERISA purposes) upon the employer going out of business and ceasing contributions. A former employee, age 71,  begins withdrawing his RMDs.  There is no employer to approve the distributions, or to certify to the participants age, and the investment company relies upon the employee representations.  The employee has to take distributions, or suffer penalties. What happens? The mutual fund begins the payments, and continues even today, should he still be living. The custodial account exists without a plan, and is effectively distributed. Though the plan termination was not a distributable event, the severance from employment was. But the tax effect is the same.
• Example 2:  A similarly situated employer employer goes out of business in 2010. Now what? Will the investment company ever approve payments out, bcause there is no employer? Does the IRS now view the custodial accounts of the plan participants as being immediately taxable because it is no longer associated with an employer? And why should the tax treatment be any different between the 1998 bankrupt employer and the 2010 bankrupt employer? Will the participant be penalized by a 50% tax on the failure to take an RMD when he was required to, but there was no way to do it?
• Example 3:  The plan of the employer in Example 2 was funded solely by annuity contracts of a single vendor. Two months prior to going out of business, the employer terminates its plan and distributes the annuity contracts.  We know the IRS permits this, so the contract maintains its 403(b) status. But we don't know what rules apply to the contract when an employer no longer exists. Will the annuity company permit the RMDs without employer approval? When the IRS eventually promulgates rules on how such contracts such be administered, is there any legal reason those rules should not apply to the custodial account in Example 2?

This really all points out to the unworkability of the IRS's position. The impact of forcing individual pensions into an employer mode is tough enough without having to make it more difficult on vendors, employers and employees than need be. 

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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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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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