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Professional research and advisory firms have developed an impressive array of benchmarking tools over the years, which soundly provide guidance to plan fiduciaries on the selection and monitoring of pooled investment funds. Often using a rigorous combination qualitative and quantitative measures, fiduciaries rely heavily upon these tools to (among other things) demonstrate their compliance with fiduciary standards. The really good ones effectively integrate judgement with the use of number. This includes, for example, inclusion in their benchmarking practices a measure of qualitative assessment such as changes in management and the managers’ adherence to their own published investment goals in establishing their “scorecards.” Central to the use of most of these arrangements is the benchmarking of fees and their impact on the total performance of those funds.

There are substantial efforts underway in many parts of the industry to develop similar sorts of benchmarking tools for assessing, comparing and monitoring the growing variety of lifetime income programs for defined contribution plans. A very real challenge these developers face arises from the fundamental difference in the nature of the investments involved: existing equity based assessment tools translate poorly into critiquing programs where decumulation risks are the critical factor. Even the language used to produce these new tools is demanding a new mind set.

I attribute Matt Gray, an actuary with Allianz Life, with suggesting a new and viable route to addressing this challenge. He outlined it in the Retirement Income Consortium’s July 18 Webinar on “How to Analyze Fees Associated with Retirement Income Solutions.” I invite you to take a look at the last few slides of that presentation, as Matt succinctly lays out the case that effective benchmarking of lifetime income programs is all about “outcomes,” not fees.

Just looking at fees doesn’t tell you a lot with regard to these programs, where annuity products are a key element of the design. This is not to understate the importance of knowing where the “stated” (or “explicit”) fees lie, and who is getting compensated. However, their role in the benchmarking process is much different than it is for scoring equity investment products. The actual “costs” related to covering the variety of lifetime risks within an annuity are imbedded into the products themselves, and cannot be meaningfully compared in the same manner as we have always approached “fees.” What you really are looking at in order to conduct a comprehensive review of any product’s relative reasonableness are the “outcomes” which are being provided (which CAN be quantified) for the premiums being paid.

I would suggest that the benchmark developer’s next step, once building out the “outcomes analysis,” is then to develop and weave into these outcomes a new set of relevant qualitative tools.

Relevancy is important in the qualitative analysis. I take note that at least a few elements of the “conventional wisdom” being proposed by a number of professionals really don’t seem to pass muster. A prime example is an often misstated notion that the type of annuity used in a program does not really matter, and that each type simply provides an actuarial restatement of the same priced risk. This is not true, as each type of type of annuity provides much different “efficiencies.” A variable annuity is, structurally (because of the way insurance rules apply to them), one of the most efficient platforms under which to accumulate wealth in a plan (see, for example my blog on this point); where the fixed indexed annuity (again, because of the way in which insurance rules apply to them) appears to be very efficient at providing certain income benefits.

Another example is the use of the “spread” an insurer realizes on its general account investments in any given year, a question now often being asked by a number of advisers. Though collecting this factoid may be an interesting exercise, it has little relevance (for a number of reasons, including state reporting protocols) to a fiduciary’s quantitative or qualitative assessment of a lifetime income program.

I also wonder if an outcomes based approach may not actually help address the concerns many have expressed as to whether or not insurance products should be used in these programs, or whether even these programs should be offered in a DC plan. I suspect it will.

It also well makes my point from my previous blog that we all need to become accustomed to a whole new use of technical language.

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The growing acceptance of the idea that defined contribution plans need to provide participant access to a “DB-Like” retirement income benefit is only really possible now because of the foundational work over the past two decades by key policy thought leaders like Mark Iwry, David John, and a handful of others.

Further success of this critical policy initiative will be dependent, methinks, on a number of pieces next falling in place. Chief among these is the achieving a coherent understanding by a wide swath of fiduciaries, advisers and participants of what the notion that DC Lifetime Income programs as a part of a plan participant’s investment palate entails.

Just this idea that DC plan participants are now being more broadly offered the opportunity to choose to devote a portion of their account balances toward guaranteeing lifetime income is a sea change in employer sponsored retirement programs. This opportunity was rarely available even under some of the most “flexible” retirement programs offered in the past.

Having this valuable new and unfamiliar element available as part of a DC plan means developing support mechanisms of all sorts to actually deliver their value. Really grasping this requires understanding a new “language” (and concepts) with which we all must now become accustomed if these programs are to work. The ideas are not really complicated, but very unfamiliar to the most of us.

A classic example can be found in the investment arena. These lifetime income programs are typically part of an investment menu which utilize annuity contracts somewhere in the “offering.” Annuities are needed because many of these programs are often “risk” based, where the insurer-not the plan or the government-assume the financial risk that are inherent in providing these guarantees. Most of the well-known metrics usually used in selecting between competing equity fund investments have limited usefulness when making decision with regard to selecting these new annuity based programs (even though some of those programs have important equity elements).

One of the concepts which best demonstrates this demand arises under something called the “guaranteed lifetime withdrawal benefit,” or GLWB. A GLWB is one of a small handful of annuity features which we call “living benefits,” which is simply a class of payouts which give participants a measure of flexibility in managing their lifetime income streams. The GLWB is a core feature of many of the new programs currently available in the market.

Basic to the GLWB is something called the “benefit base,” under which the insurance company enhances the participant’s eventual retirement payout the longer the participant actually participates in the GLWB. The idea of “time” increasing an annuity benefit is a basic insurance practice, but has never played a role in the traditional DC investment vocabulary-and can almost sound a bit nefarious. It isn’t. It reflects the idea that the longer a participant holds (and doesn’t surrender) the accumulated benefit under a GLWB program, the lesser the risk the insurer bears in its actuarial calculation of the eventual lifetime guarantees it will provide. This, then, enables the insurer to guarantee the payment of an enhanced benefit over time.

With DC lifetime income programs now garnering wider acceptance, at least conceptually, their increased use and ultimate success will demand quite a shift in the “conventional wisdom” surrounding plan investments.

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Generating over 19,000 written comments, the DOL’s proposed fiduciary rule changes clearly hit a “vein.” Though the proposed changes are complex and multi-tiered, there are two of them which are particularly garnering most of the attention.

The first is the proposal to compel the application of a version of the retirement plan fiduciary rules to the retail sale of non-registered individual annuity contracts, at the point of sale, to an individual’s IRA. As substantial, expensive and potentially disruptive a change that this will introduce, these rules are still generally compatible with those which sales organizations must apply at the point of sale where “registered” investment products are sold by registered representatives.

This differs dramatically from the second of these proposed changes, that is, the proposed regulation of an annuity product’s compensation design. Abusive sales practices have been the bane of federal and state regulators, and most financial service companies, for as long as investment products have been developed and sold. However, regulating investment sales practices-whether it be by the SEC, FINRA, state regulation or even the DOL-have mostly been imposed at the point of sale.

In a departure from this regulatory norm, the DOL now seems to be attempting to regulate the design of the product the insurer builds-not just its sale. This is truly uncharted territory, especially as it is likely to widely impact the retail sale of annuities.

Like the design of any investment product, whether it be a mutual fund, annuity contracts or CIT, compensation design is an integral part of their development. These businesses produce investment products which are designed, priced and managed by very serious investment professionals (and, in the case of insurers, actuaries) which seek to profit off of their expertise. A key element of investment design is the manner in which marketing and sales compensation are actually built into the product features.

This regulatory practice may well give rise to a few issues for which to be on the watch should these rules be finalized as proposed.

Workability

DOL proposes to require that the insurer avoid certain, specific types of incentive based compensation (such as, of all things, award trips) that it builds into its products. The fundamental mandate is that any compensation design must not prioritize the financial interests of the insurer over that of the purchaser.

This seems to be a very odd requirement to impose on insurance companies-or any business, for that matter. These companies are judged by the market (and their investors or-in the case of a mutual insurer-its policyholders) by, among other things, their profitability. It seems like there may be all sorts of legal and behavioral issues which spring from such a counterintuitive demand in the regs. Among other things, it imposes this “obligation” in a competitive business environment where sales are a critical factor in the organization’s success (and survival), and where each other insurer has competing products and compensation schemes. As a result, I’m not quite sure any business has the capability of meeting this standard-especially considering that an insurer must maintain its financial viability over the policyholder’s lifetime in order to guarantee lifetime benefits. This legitimately raises the question of the rule’s workability- and whether this regulatory design can be effective at preventing abusive sales practices at the point of sale.

Note that this element is also a bit of an outlier, by its own terms: the DOL (rightfully) exempts investment companies (mutual funds) from this product compensation design requirement (and the requirement that it establish and monitor “best interest” practices), which it now seeks to impose on insurance companies.

Disjointed enforcement authority

DOL enters this uncharted territory being hobbled by ERISA’s Reorganization Plan #4. This rule gives the DOL the responsibility to promulgate conflicted advice rules under IRAs, but gives it no authority to enforce those rules. The ultimate result is that the DOL, SEC nor FINRA have the authority under federal law to enforce the imposition of this compensation design regulation as it applies to non-registered annuity contracts by non b-ds to IRAs. Though Treasury appears to have some authority regarding these sales, it seems to only have the ability to tax this behavior, not to otherwise regulate sales behavior.

That responsibility falls to the states. The states then only have the authority to enforce their own annuity design rules, not the DOL’s. This means that successful implementation of the proposed rules necessitates the coordination between some federal entity (which needs to build insurance expertise) and the states.

Dealing with enforcement practices related to the implementation of this rule is likely to be a challenge.

Conflation of IRA and retirement plan issues

In addition to the workability and enforcement issues being raised by these elements of the proposed rules, I do want to share an observation regarding the “mashing” together of IRA and retirement plan compensation rules. The announcement of the new fiduciary scheme by the White House was accompanied by a scathing (and to my mind) unfounded indictment of fixed indexed annuities-the design of which, by the way, are well suited for retirement plans. These comments actually demonstrated a much broader point: there seems to be limited awareness of the vast difference in the product design, pricing and sales practices related to annuities (including fixed indexed annuities) sold to retirement plans and of those sold to IRAs.

Think about it: the “suitability” required of the sale of annuities to IRAs under state law looks at each individual’s personal circumstances, with a correlating need to match the annuity’s terms with the individual’s needs. This takes time and expertise of a different sort than where an annuity is purchased under a retirement plan, the purchase of which is required to be “prudent” for the plan.

The ultimate goal of averting abusive sales practices may not be well-served by conflating the regulation of the processes involved in a retirement plan purchase of an annuity with those necessary for an individual purchasing an annuity for an IRA. Uniformity has its value, of course, but there is likely to be substantial value for tailored solutions in such a diverse marketplace.

Continue Reading The Fiduciary Rule’s Foray Into Uncharted Territory
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There is much to be considered under the new set fiduciary rules recently proposed by the DOL, especially as we sort through the (very extensive) details of this new regulatory regime. We are already hearing much about the impact and change which would be introduced into the market over the expansive reach of this new program, and there is little doubt that we will see litigation related to it all.

However, regardless of what your position may be with regard to the efficacy or appropriateness of these changes, there are a few striking characteristics regarding these new proposals which will, I believe, “inform” many of the discussions-pro and con-which we are going to see.

  • The first is the DOL’s discussion regarding the driving policy behind these changes of which, I suspect, you may not see much mention.  The focus will likely be, instead, on the rules’ details. Nonetheless, consider the following (found in the fiduciary proposed regs’ preamble): 

Since 1975, the retirement plan landscape has changed significantly, with a shift from defined benefit plans (in which decisions regarding investment of plan assets are primarily made by professional asset managers) to defined contribution/individual account plans such as 401(k) plans (in which decisions regarding investment of plan assets are often made by plan participants themselves). In 1975, IRAs had only recently been created (by ERISA itself), and 401(k) plans did not yet exist. Retirement assets were principally held in pension funds controlled by large employers and professional money managers. Now, IRAs and participant-directed plans, such as 401(k) plans, have become more common retirement vehicles as opposed to traditional pension plans, and rollovers of employee benefit plan assets to IRAs are commonplace. Individuals, regardless of their financial literacy, have thus become increasingly responsible for their own retirement savings.

The shift toward individual control over retirement investing (and the associated shift of risk to individuals) has been accompanied by a dramatic increase in the variety and complexity of financial products and services, which has widened the information gap between investment advice providers and their clients. Plan participants and other retirement investors may be unable to assess the quality of the advice they receive or be aware of and guard against the investment advice provider’s conflicts of interest. However, as a result of the five-part test in the 1975 rule, many investment professionals, consultants, and financial advisers have no obligation to adhere to the fiduciary standards in Title I of ERISA or to the prohibited transaction rules, despite the critical role they play in guiding plan and IRA investments.

I think few will disagree with this state of affairs, and it should be kept in mind as we discuss whether and how appropriate were the balances that have been struck.

  • This public policy seems to be serving as the basis  for proposing an approach to dealing with the growing practice of providing  lifetime income programs under defined contribution plans. These new rules recognize that lifetime income programs can be sophisticated and use annuities for which there is limited understanding in the market, and attempt to address those concerns. As noted above, where employers under DB plans were at the forefront of the fiduciary reviews of the provision of lifetime income, much of this now falls to the individual. The sponsor, however, is not off the hook, either, as these changes include the  serious regulation of the business practices related to “holy grail” of lifetime income-the sponsor’s choices which impact the portability of the guarantees which may be accumulated under a plan. 
  • Associated with this is the absolute need to now pay close attention to the IRA rules, upon which the DOL seems focused.  IRAs, in their various iterations are critical to the portability of income guarantees accumulated under DC retirement plans. These DOL proposals have a much more dramatic impact on IRAs than on retirement plans themselves, and there may be a tendency to not pay close attention to them if your focus is on the plan market. This would be a mistake, as the IRA changes may impact what a fiduciary may choose to do in its own plan-based lifetime income program.
  • The obscure has become prominent. It is necessary take note of the changes to an almost cryptic Prohibited Transaction Exemption, PTE 84-24: the proposed amendment speaks worlds of the changes to come. This exemption had previously allowed (among other things) the payment of commissions on the annuity contracts  purchased by a plan under which lifetime guarantees are provided. That prior PTE simply required notice and approval of  the commissions to and from the plan’s independent fiduciary. The changes-and their discussion-fill 91 pages, would dramatically change that, imposing PTE 2020-02 rules on commission payments. The new rule will, among other things, generally remove 84-24’s use to enable the payment of commissions paid on the purchase of annuity guarantees by ERISA covered retirement plans. So, again, for those involved in lifetime income programs, there is a serious need to pay close attention to the massive shifts implemented by this change. Whether or not you agree with the choices the DOL has made, it seems to be consistent with its stated policy goals.
  • Finally, you may also want to pay attention to the changing rules on “robo-advice.” Technology is critical to the successful operations of lifetime income programs, and the DOL is tackling that challenge in some very important and notable ways which seem, again, to be consistent with its stated policy goals.

The finalization of these new rules effectively establishes a new regulatory regime. There is much to which to pay attention.

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Revenue Ruling 2012-3; the preamble to the QLAC Regs; IRS Notice 2014-66; and the Oct. 23, 2014 DOL Information Letter to Treasury are just a few of the critical building blocks which have enabled an exciting new generation of lifetime income products which we are now seeing in the market. The three 2019 SECURE ACT provisions further enhanced the attractiveness of those guarantees, while a dozen or so SECURE ACT 2.0 provisions addressed some of the more pressing technical rules which needed to be handled as well.

With all the steps taken at the federal level to transform defined contribution plans into robust vehicles by which to provide retirement security (though acknowledging there is still much to be dome), its also worthwhile to dust off the the old hornbooks with their staid old law as well-like on how insurance works. I’m thinking of a “classic” who Jack Hunter-my general counsel at LFG-insisted we all become familiar: “Vance On Insurance.” Not up there with Corbin on Contracts or Prosser on Torts, for sure, but it has withstood the test of time. You see, once you start promising folks that you will guarantee payments for their lifetime, the notion of how you can do that with any level of confidence comes into play. For now, anyway (my apologies to the tontine folks….), this means that you need to weave these federal law enhancements in with the manner which state-based insurance laws work.

I spent a bit of time with the lawyers and actuaries at Allianz Life in testing the waters on product designs which successfully pull off this integration. One result was the following assessment: “Assessing Guaranteed Lifetime Income Programs Utilizing CITs.” I hope you find it informative-and not critical…..

Math equations and formula written in chalk on messy chalkboard

Let’s face it. Annuities generally are not well received in much of the retirement plan adviser community. From the historical impression that “annuities are sold, not bought;” to some advisers perceived baggage associated with being that ghastly “licensed insurance agent;” to the historically “salty” nature of a number of retail annuities; there is a lingering distaste in segments of the plan market to insurance products- regardless of how well suited any particular one may be for a client’s plan.

It is against this backdrop I address a little noticed feature buried deep in the last lines of the proposed 403(b) CIT statutory fix. The proposed CIT’s securities law exemptions also will permit 403(b) plans to purchase interests in non-registered annuity variable accounts. In the past, these investment accounts did not enjoy the exemptions enjoyed under 401(a) plans.

Put aside, for a moment, any anti-insurance biases you may have; the incredible politics of the CIT changes; and the question of whether or not it is sound policy to grant relief to an insurance investment product in a statute designed to promote CITs. Regardless of your view, the proposed statutory change will make available to 403(b) plans what could be the one of the most cost-effective (and flexible) equity asset pooling vehicles available to unrelated employers in the retirement plan market.

It sounds almost heretical to say that an insurance product can collectively pool the assets of unrelated plans better than most any other available investment vehicle. Given the history on how these accounts have been generally utilized (or perhaps, I suggest, under-utilized) by the insurance industry, any skepticism of my assessment is understandable. But a fascinating interaction of ERISA, the Tax Code, and the “natural” pooling nature of insurance companies makes it so.

A quick look at how these non-registered annuity variable accounts are structured may help explain my point. Note that an “annuity contract” can generally provide two features for retirement plans. The first is the provision of guarantees, in the form of protected lifetime payouts (as in your traditional pension payout); in the form of protecting and enhancing investments (as in the fixed indexed annuity); or a combination of both (as in many “Guaranteed Lifetime Withdrawal Benefit” programs). The second feature is a non-insurance one, that is, it uses the insurer’s financial resources to provide non-guaranteed, direct access and exposure to equity markets through the use of the “separate account.”

An insurance separate account is simply a non-trusteed investment account owned and managed by an insurance company. It can only be made available under an annuity contract (contrary to some of the misleading marketing material I’ve seen to the contrary) issued by the insurance company which is purchased by the retirement plan. That contract is analogous to the trust or participation agreement a plan enters into with a CIT. Like a CIT, a variable annuity contract can have any number of different investment separate accounts (often numbering in the hundreds), each operating under a different investment style and separate investment policy from which a plan sponsor or its advisers may choose. The insurer hires investment managers, and charges investment manager fees, in the same manner as CITs.

Like CIT interests, the insurance separate account investments are unitized, and are given an investment value daily; and both these separate accounts and CIT units are exempt from securities law registration if purchased by 401(a) plans. These units can be daily traded, like CIT units, through the DTCC/NSCC system. Though the “unit” in both the CIT and the separate account is considered the plan’s investment which is tracked, valued and reported, the assets within the CIT and the separate account are both considered to be plan assets. The CIT and insurer both hire investment fiduciaries to manage those investments.

The efficiencies and value of the non-registered separate account chiefly arise from the manner in which they are run. Consider that CITs require Rev Rul 81-100 trusts in order to provide pooled investment to unrelated employer plans, while separate accounts do not. They are simply insurance company accounts. As a result, insurers have the ability to pool investments at substantial “scale” in a way which other financial companies simply cannot. Consider further that insurance companies invest large sums of money on a routine basis which gives them substantial influence over investment management expenses (note, for example, the 2021 Life Insurance Fact Book of the ACLI, which reports that the total value of Prudential’s general and separate accounts exceeded $700 million).

Also noteworthy is the fact that these separate accounts can be built to be managed like mutual funds at a fraction of the costs; or be used to cobble together mutual fund investments which they purchase at scale; or to unitize a range of income producing investments; or even to invest in real estate (though that’s a quite another story….).

The CIT legislation enhances these separate account offerings for 403(b) plans by, like CIT interests, putting them on the same footing under 401(a) plans. It then avoids the registration related expenses and costly inflexibility that come from having to register those interests as securities, costs which are otherwise ultimately borne by plan participants.

Businessman Looking At Square Peg not Fitting Into Round Hole

The IRS’s 2007 403(b) regulations fundamentally altered the 403(b) marketplace. The imposition by of those regulations of greater responsibility on 403(b) plan sponsors for maintaining the continued tax favored status of their plans triggered, among other things, efforts by a number of employers, employer related groups and advisers to attempt to consolidate both the compliance services and the investment platforms for these plans. When you think about the typical 403(b) plan of the time, the vendors took on much of the responsibility for running these plans-something they could no longer do (as least to the extent they had done it in the past).

This resulted in the development of a wide arrange of what I refer to as “aggregation programs.” For example, school districts were enabled by a variety of different state and local statutes to coordinate their plans; a number of “umbrella” tax exempt organizations tried to facilitate cost effective arrangements between their constituent organizations; a number of churches engaged in efforts to assist their brethren organizations; and, yes, 403(b) Multiple Employer Plans began to become more widely used.

The 403(b) MEP is a particularly interesting arrangement. To the extent that the tax exempt organizations participating in the MEP were covered by ERISA, ERISA Section 210 (the ERISA section which covers multiple employer plans) enabled their existence- and there is a number of them now in operation. For those orgs exempt from ERISA (such as K-13 or churches), nothing in the code prevented them from combining their compliance and investment activities, even if they were not recognized as a single 403(b) plan by the Code-and many of them did.

Because the Tax Code did not make any provision for the 403(b) MEP (or other type of 403(b) “aggregation arrangement”), each of the employers participating in these arrangements are treated (for tax code compliance purposes) as each sponsoring their own 403(b) plans. This has actually worked quite well for a number of years, except for a couple of issues. The first was an annoying reporting issue: Title 1 of ERISA treats the MEP as a single plan for ERISA reporting purposes (i.e., the 5500), but the Tax Code still treated each of them as individual 403(b) plans for purposes of the IRS 5500 reporting rules. There were workarounds to meet this requirement, but it still created quite an anomaly. The second issue was always about background noise: though each of the orgs in any type of aggregation arrangement was treated as sponsoring its own 403(b) arrangement, the IRS had never really addressed publicly addressed this issue.

This is where SECURE 2.0 obliquely provided significant relief, in a couple of nice “gems.”

The first one is a section I have not seen referenced in any material on 2.0, that is, Section 106(c). This section amended the Code Section 6057 to provide that, to the extent that a 403(b) plan is “maintained by more than one employer” (eg., the plans formed under ERISA Section 210), the plan could file a single Form 5500, instead of the arrangement otherwise fulfilling the obligation that each participating employer sponsor having to individually “register” its “plan.”

The second is the provision which is designed to dispel any doubt that an employer participating in any of the of the “aggregation arrangements” still would qualify for favorable tax treatment under 403(b). Though generally viewed as the section which enabled 403(b) Pooled Employer Plans, the new Code Section 403(b)(15) (under SECURE 2.0 Section 106(a)) really was intended to have a much broader impact: it provides peace of mind that participating in a 403(b) arrangement of more than one employer (even if not a PEP) would not jeopardize their plan’s 403(b) status. Section 106(g) even provides further peace of mind to church arrangements, and how these new rules will apply to them.

403(b) MEPs really got what they needed to continue on safely. A 403(b) PEP is only necessary if the organization wants relief from the “one bad apple rule,” which-to my mind, at least- really is not a pressing need under the way 403(b) MEP rules operate.

A title like this one was bound to happen; and I was tempted to publish it on April Fool’s Day-except that its really not a joke.

Where it comes from is the simple fact that any DC Lifetime Income Program (ok, why not, lets use the acronym “DCLIP” while we’re at it) that guarantees lifetime income needs to have the ability to make an “in-kind” distribution of an annuity contract, whether that be a certificate under a group annuity contract or an actual individual annuity contract. This is because the transfer of any actual guaranteed income rights which may have been accumulated under a DCLIP must (currently) involve insurance somewhere in the chain of things, and an insurance company can only embody those rights in an insurance contract. The transfer of these insurance contract rights are accomplished by way of an “in-kind” distribution/transfer from the plan of the contractual rights under the DCLIP to an IRA of some sort, as a rollover; or by a distribution directly to the individual of those contractual rights in the form of an annuity.

These distributed annuities are generally referred to as the “Qualified Plan Distributed Annuity” (or the “QPDA”), though they may operate under various other names: Section 109 of SECURE 1.0 refers to them “qualified plan distribution annuity contracts”; 1.401(a)(31)-1 Q17 refers to them as “qualified plan distributed annuity contracts”; Rev. Run 2011-7, for 403(b) plans, refer to them as “fully paid annuity contracts.” The keys under the QPDA is that it is not a rollover to an IRA; the distributed contract retains the salient characteristics of the plan from which it was issued; and its distribution is not a taxable distribution from the plan.

Where the annuity contract had been previously purchased and (and held) by the plan as an investment, the subsequent distribution of the annuity as a QPDA is not a typical financial transaction on the books of the insurer. The ownership of the contract is merely transferred from the plan to the former plan particpant.

Therein lies the rub for the Independent Qualified Public Accountant (IQPA), which audits the books of the plan: there does not appear to be a well developed, standardized protocol in the auditing process under which the QPDA distribution can be verified as compliant with auditing standards. It is not that the insurer is not willing to certify that the distribution of the annuity contract has occurred, or that the distribution was appropriate and made in accordance with the plan’s governing documents. Instead, it becomes a point of “discussion” with the auditor as to what is an acceptable confirmation of the process. Especially as these distributions become more common, as I fully expect them to be, I would hope that the the auditing profession develops a sensible standard upon which we can all reasonably rely to document the validity of the distribution.

Businessman Looking At Square Peg not Fitting Into Round Hole

Many practitioners will point to the 2007 403(b) regs (the “new regs” as many of us often still call them, 16 years later…) as being a real seminal moment in the market, and probably rightfully so. However, an even more fundamental development occurred some 7 or 8 years earlier, which still has deep reverberations in the way these plans operate: the quirky 403(b) master custodial arrangement.

Prior to the development of the “master custodial account,” 403(b) plans were solely funded with group or individual annuity contracts issued by insurance carriers, or with individual custodial agreements entered into between the plan participant and the mutual fund company. Typically, these individual custodial contracts were funded solely with proprietary mutual funds of the “custodian, ” and under which retail priced retail mutual fund shares were widely used.

Back then, the “holy grail” of product manufacturers was to make 403(b) plans look and act like 401(k) plans. Many will recall that, at that time, there were even substantial legislative and policy efforts at creating a single, unified, all encompassing, type of defined contribution/elective deferral plan (the “RISA” anyone?). Well, the legislative efforts collapsed under their own weight, as the historical differences between the different types of tax-deferred savings plans made any sort of plausible transition to a “unified” approach virtually impossible. But that did not stop the continuing market efforts to make 403(b) and 401(k) plans look as much like each other as possible.

The route a handful of us chose to accomplish this was based on the notion that nothing in the 403(b) rules required that a custodial account be issued to an individual, as opposed to the plan sponsor. It occurred to us that, as long as the “custodial agreement” was able to be structured in such a way as to honor the SEC rules which demanded that the individual participants in that master account still be treated as the owners of the shares in that account, there was nothing in the Code or ERISA which prevented such an arrangement.

So we quietly went about our work, without there being widespread knowledge of what we were pulling off. Auditors were, and often still are, confused by these arrangements, treating them like 401(k) trusts, which they are not. In a technical ASPPA session with Bob Architect, I had mentioned to him the growing use of these vehicles, and his response was classic: he looked at me and said “and, yeah, I’ve seen Bigfoot!”

It is this vehicle which has facilitated the ability of 403(b) plan sponsors to access the favorably priced classes of mutual fund shares which generally still have very limited availability in the individual custodial account market. It also gave fiduciaries broad authority over the selection and removal of mutual fund shares, as these “master” contracts were designed to give the plan the same authority over plan investments that was exercised by 401(k) plans; and really enabled the widespread use of 3(21) and 3(38) investment fiduciaries for those plans.

There is a distinct and legal difference between the 401(k) trust and the 403(b) master custodial agreement, and I invite you to compare the two documents should you have the chance. One of the key differences is that the custodial account is technically still not a “trust” in the traditional way used in the 401(a) market-for example, the 401(a) trust is a tax exempt entity under 501(a), where the 403(b) custodial account is not. That account is merely deemed to be an “annuity purchased by section 501(c)(3) organization or public school” (to quote the Code). Though ERISA will treat the custodial account as a trust for Title 1 purposes, it still is not legally a trust. The design of the master account vehicle was even a hot topic of conversation with the IRS when it was drafting the 403(b) termination distribution guidance, and whether or not a custodian could “spinoff” an individual contract from the master. The IRS ended up covering such (I believe, non-sensical) circumstances, under Ruling 2020-23.

You’ll find that these are not distinctions without differences and, when you get down to the nitty gritty of building the processes around these accounts, you’ll find the there is much with which to be sensitive.

Engraved,National,Bank,And,Trust,Building,Facade,With,Columns.

One of the inevitable results of Congress’s failure to cobble together some sort of compromise on what the most suitable “Securities Fix” would be for the 403(b) CIT is a flurry of activity to find some way to craft a solution which would permit 403(b) plans’ investments in 81-100 trusts without a statutory fix. From a purely technical point of view, any of the three or four different possible legislative approaches being considered are not, in themselves, a heavy lift. Yet, any of the choices very much impacts different constituencies in different ways: from favoring one part of the financial services industry at the expense of another; to having to deal with newly “grandfathered” types of arrangements; to the risk of putting certain classes of consumers-like schoolteachers-at risk. Ultimately, I believe that there is a sound, well balanced compromise to be had.

In the meantime, we’ve seen a number of different proposals which would permit at least some 403(b) constituencies to utilize CITs (outside of churches, of course, who have long been able to use them). These efforts are all possible because of the incredible complexity of dealing with not only one, but three different, comprehensive securities law statutes. Each of the three applicable laws (the Securities Act of 1933, the Securities Exchange Act of 1934 and the Investment Company Act of 1940) have their own (sort of) coordinated exemptions which the investment industry has utilized successfully over the years to be able to permit certain investments by certain parties to avoid the registration rules. So it is little surprise to see the intellectual exercises we are seeing, attempting to construct acceptable methods to make the 403(b) CIT work.

What we’ve not seen much discussion of is of the risks involved in adopting any of these seemingly esoteric approaches. There is a pointed lesson taught to me by my mentor and dear friend, the late Roger Siske (though I am still convinced he shared this with me to give me sleepless nights, which, of course, it did) as we were looking at a particular plan trying to ascertain its compliance with the Securities laws: the “12 month put.” Should an institution (here, think the trustee of the 403(b) CIT) offer its interests to be purchased by 403(b) plan custodians or the participants in a 403(b) plan without complying with the terms of the ’33 Act, that purchaser is granted the right to rescind that purchase under section 12 for 12 months following the discovery of the violation. Effectively, this grants to the wronged purchaser the ability to sit and wait for a year for the market to move in its “favor” before asserting its “put.”

As I had suggested in previous postings, consider the risks before moving forward; they are substantial if you don’t get it right.