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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.

There are only ten (or so) different provisions under SECURE 2.0 which seem to have any sort of direct relation to the provision of Lifetime Income through defined contribution plans (“LI”), and none of them seem to have the bold, systemic effects that we saw under the some of the terms under Secure 1.0. The 2.0 lifetime income terms have “headline grabbing” titles like “Remove RMD Barriers for Life Annuities;” and “Removing a Penalty on Partial Annuitization;” and the particularly catchy “Surviving Spouse Election To Be Treated As Employee.” Though there are a number of technical questions which need to be addressed under each of these sections, none of them seem to have any broad, meaningful impact on the LI market.

That is except with regard to a little noticed rule change in the handling of Qualified Longevity Annuity Contracts (QLAC) under divorce orders or separation agreements (which include both QDROs and DROs) under Section 202 of the Act. Though that Section’s increase in the QLAC limit to $200,000 (indexed) and the removal of the 25% account balance restriction have been widely reported, Section 202(b) is the term which is more likely to have widespread, institutional impact.

Sect. 202(b) actually does not make any statutory change to any of the Code’s or ERISA rules governing the distribution of a plan’s assets pursuant to divorce or separation orders, or other any such landmark modification. Instead, it instructs Treasury to amend its QLAC rules, which are obscurely found under Required Minimum Distribution applicable to DC plans which purchase annuities (Reg 1.401(a)(9)-6). The regs must be changed to reflect that if a QLAC is issued as a joint and survivor annuity (which it is required to be unless spousal consent is obtained, under plans to which such rules apply), and a divorce subsequently occurs prior to the date the annuity payments actually begin, the DRO “will not affect the permissibility of the joint and survivor annuity benefits” as long as that order:

• provides that the former spouse is entitled to the survivor benefits under the contract;
• provides that the former spouse is treated as a surviving spouse for purposes of the contract;
• does not modify the treatment of the former spouse as the beneficiary under the contract who is entitled to the survivor benefits; or
• does not modify the treatment of the former spouse as the measuring life for the survivor benefits under the contract.

There are a number of technical issues to work through in these instructions, not the least of which is discerning the meaning of the term “will not affect the permissibility of the joint and survivor annuity benefits.” Curiously enough, this change is retroactively effective to the initial effective date of the QLAC reg, July 2, 2014, which may create a few other challenges.

Technical analysis aside, however, is the potential “downstream” impact of this provision on a wide number of plan participants, legal and professionals who represent plan participants in divorce proceedings. Where there is a QLAC in a plan, this means that a wide swath of professionals of all sorts may need to be involved in sorting through this issue in resolving a domestic relations matter.

Handling QLACs in QDROs has may well force the whole idea of DC LI into the a significant number of professional “portfolios” as a matter of necessity. Particularly given the the adoption of the QLAC by the University of California Retirement Savings Program, with its 320,000 participants and $30 billion or so in assets (the second largest public sector DC in the US behind the federal government), its impact may begin to become widespread. At the very least, a significant number of non-ERISA attorneys and accountants may now need to have to some basic understanding of the QLAC, and at least a little familiarity with the manner in which DC annuities work.

Is DC Lifetime Income about to go mainstream?

Businessman Looking At Square Peg not Fitting Into Round Hole

One of the more curious circumstances under SECURE 2.0 arises from Act Section 128, which purports to permit 403(b) plan custodial accounts to invest in interests in Collective Investment Trusts (CITs), referred to as “81-100” group trusts in the Act. Prior to the Act, 403(b) custodial accounts could only invest mutual fund shares. The IRS had actually attempted earlier to open the door to group trusts in 2011 when it issued Rev Rul 2011-1, permitting 403(b) assets to be comingled with 401(a) assets in the 81-100 trusts, but that effort ran into problems because of the Code provisions which limit 403(b) plan investments.

Section 128 fixed that part of problem, as it amended the Code to permit the investment of 403(b) assets in group trusts, alongside mutual funds. But, as the Senate Finance Committee noted in its own Committee Report to the EARN Act, “In order to permit 403(b) plans to participate in a group trust, certain revisions to the securities laws will be required.” Those necessary revisions, however, never made it into SECURE 2.0

Mike Webb, 403(b) guru and senior financial adviser at CAPTRUST, astutely raised the question many are asking as to whether this even matters for certain plans-like government 403(b) plans- because of certain government plan exemptions under the Securities Laws. (He also raised the issue of church plans, some of which already can participate in CITs. The church plan securities issue is well beyond the scope of this article, as the rules for them are much different). Mike and I discussed the matter in some detail, and for those thinking about pursuing this route, you should first seek serious securities law counsel before doing so. The downside risk of getting it wrong is pretty substantial.

First some background on the problem. In a nutshell, 403(b) investments, just like 401(a) investments, are technically considered “securities” under federal Securities Laws (more specifically, the Securities Act of 1933; the Securities Exchange Law of 1934 and the Investment Company Act of 1940). Each one of these laws, however, generally (with very important exceptions) exempt the “purchase” by plan participants of “interests” in their 401(k) plans, without which each 401(k) plan would have to “register” as securities. 403(b) plans (with some church exceptions) do not enjoy these same exemptions.

One result of the workings of these various securities law exemptions is that most 401(k) plans can offer “non-registered” Collective Investment Trust (CIT) interests (which are “81-100” trusts) to their participants as part of their investment line-up without either the plan or the CIT having to register with the SEC (as is required, for example, of mutual funds), but 403(b) plans generally cannot. The same problem runs to IRAs investments, which also do not enjoy such exemptions (even though Rev Rul 2011-1 also permits, as a matter of tax law, IRA participation in a group trust).

In the end, Congress could not agree on just what the legislative securities law “fix” should be before the law was passed. Any fix would be complicated, nuanced, and involve a number of important competing trade-offs, in part because of the difference in the very nature of 403(b) and 401(k) plans. The Code still refers to 403(b) investments as individual arrangements. It calls for the “purchase for an employee by an employer” of an annuity contract. This is a fundamentally different approach than the “trusteed governed” rules which governs 401(k) plans, where 401(a) recognizes “a trust created …. forming part of a …. plan of an employer for the exclusive benefit of his employees.” Consistent with this differing language is the SEC’s historic treatment of 403(b) participant as a “shareholder,” where the trustee of a 401(k) plan is treated as the shareholder. Yes, we’ve made great strides in the past decade in order to make 403(b) and 401(k) arrangements available on very similar platforms, but there is still a significant portion of the market in which 403(b)s are still handled as individual investments.

Add to this the practical impact of granting a broad based securities law exemption to a 403(b) plan’s investment in CITs, the enabling language of which does not limit what investments in which the CIT may engage. Especially in the case of those individually based 403(b) product purchases which have no governing oversight (think most K-12 plans, for example): such an exemption may strip any sort of federal regulatory protection from many of these participants, without any serious “backup” protection at all.

So, getting back to whether certain 403(b) arrangements offered by governmental entities may be able to offer CITs because of potential securities law exemptions, extreme caution is the watchword. Those laws are complex, and the exemptions between the each of them can vary in very important ways. Consider instructive, however, that only the variable annuities which are registered have been able to be offered in this part of the 403(b) market, in spite of a wide variety of non-registered group annuities which are otherwise available to retirement plans. Similar rules will apply to the offering of CITs, as well. So, again, any decision to proceed will be complex, and will require advice of serious counsel.

Any discussion on any tax or securities law issue addressed in this blog (including any attachments or links) is NOT intended to provide legal advice, nor to create an attorney client relationship with any party.  

“Individual Annuities”-that is, annuity contracts which each cover a single person and their beneficiaries-are uncommon in 401(a) plans (403(b) plans are quite another story, to be discussed in a later writing).”Group annuities” -where a single annuity contract covers a group of participants-are, on the other hand, quite commonplace in retirement plans (yes, even 403(b) plans). The reason for this may well be both historical and technological: in a plan that, let’s say, covers 1000 employees, it has  in the past been a bit klutzy  to enter into (and administer) each one of those individual annuity contracts for each participant. Yet there are a number of elements of an individual annuity which makes them uniquely suited to address some of the more vexing logistical issues that arise in the implementation of a DC Lifetime Income program.

Enter technology, without which I don’t believe providing any sort of robust DC Lifetime Income program can really be possible. Each of the innovative programs we are seeing enter into the Lifetime Income market are heavily reliant on technology, often provided by what is commonly referred to as “middleware,” a term with which fiduciaries will become well aware. This middleware does a number of things, the most important of which is serving effectively as the “translator” between the sophisticated products providing lifetime income and the plan’s own participant records. That middleware is often used as the technological solution for the use of individual annuities where they haven’t been able to be used before.

There is an important cautionary note, however, in the use of individual annuities in plans. What has happened over time is that a large number of  insurance companies have developed two different sets of internal compliance and administrative processes, one which which applies to individual annuities (as they have been sold on a retail basis to individual consumers) and another, separate set of them which applies to group annuities (which have been largely sold to retirement plans).

Take group annuities. They can vary widely in design, from merely being a plan level investment of the plan, all the way  to the insurer establishing formal legal relationships with the participant through the issuance of a “certificate.”   There exists a very sophisticated industry established around the provisions of the group annuity in the retirement plan space, which is focused on ERISA’s fiduciary rules and matters of plan level compliance. Regardless of the particulars of any group annuity design, the one thing these contracts have in common is that they are designed to comply with the whole panoply of rules which apply when a retirement plan  purchases an insurance contract. There is, for example, an extensive set of ERISA rules which govern the use of annuities in retirement plans, from the ubiquitous PT exemption 84-24, to the Form 5500’s Schedule A, and many other requirements in between. The FINRA rules which apply to the sale  of annuities to plans are also different than those which apply to the sale of annuities to individuals, and the various anti-money laundering and OFAC rules apply in much different ways as well. Even the state laws governing the filing and approval of these contracts can be different. Insurers, though, are well skilled at these retirement plan practices.

Then there is, on the other hand, also a  very sophisticated industry established around the provisions of the individual annuity in the consumer driven  retirement income space, which is focused on ways to enhance and protect an individual’s financial well being-but outside of retirement plans. There are impressive mathematical models which continue to be developed (see, for example Wade Pfau’s and Alex Murguia’s new RISA being amongst the most prominent of them)which are designed to enable the design and implementation of personalized retirement income planning strategies aligned with individual preferences.  All of these kinds of services rely heavily upon the appropriate use of different types of guarantees provided by insurance companies, and matching them up with an individual’s own risk profile and preference. Like group annuities, individual annuities also have their own wide range of compliance requirements, which apply in different ways than to the sale of annuity products to retirement plans.  Insurers are also well skilled at these rules governing the individual annuities.

For the valuable, well established,  elements of the individual annuity retirement income space to successfully “crossover” into the DC Lifetime Income market, the group annuity “infrastructure” needs to be exported to the individual product side of things. This is where the “engineering” comes in, as aligning these products with new infrastructure is not necessarily a simple task.

Simply put, this means that most of the commonly available individual annuities sold to consumers are not suitable for the purchase by most 401(a) plans as part of their DC Lifetime Income program without changes being made to the design, administration and compensation (it is also worthwhile to note that the pricing and disclosure rules related to individual and retirement plan products can be vastly different). The differences can range from the types of disclosures being made, to the handling of money in and money out, to the manner in which it is all reported on required annual statements, along with a basketful of other sorts of requirements.

A number of insurers have made the investment necessary to accomplish this feat. It does, however, become a key fiduciary inquiry as to whether or not the annuity being purchased has been designed for use by retirement plans.  Recognize also that different products of the same insurer might be supported by different systems and processes, and the fiduciary will need to make sure it is getting to the right one.