Some of the dust is settling, in an odd sort of way, on the IRS issues related to 403(b) plans. For sure, there are many unresolved and contentious issues that remain open or poorly addressed (such as terminations and dealing with historical contracts) which will continue to to cause vendors, employers and employees all shared amounts of anguish. There is enough of a framework in place however, to now get down to the nitty gritty of running 403(b) plans.
So what are we finding as we get down to this nitty gritty of things? Most striking is the unique ways in which ERISA’s fiduciary rules will need to be used in their application to ERISA 403(b) plans. It is not that the rules were never there in the past, it is just that the new rules have forced the industry and employers to more closely define their relationships and the duties for which vendors and employers will each be responsible. This process of defining roles has caused us all to look more closely at how the rules apply, in ways we have never done in the past.
All 403(b) practitioners are painfully aware of the controversies surrounding the threshold question of whether any particular plan is governed by ERISA Title 1. Once you get past that point and attempt to, for example, draft a proper investment policy, you will see that we will not be able to apply many of the ERISA rules in the same manner in which we are used to applying them in the 401(k) context. This is particularly true where individual annuity contracts or individual custodial contracts are involved. We are all likely to find some challenging surprises as we work through the details.
Let me give you an example. Individually owned variable annuity contracts are a "staple" in the 403(b) industry. They continue to be regularly offered in 403(b) plans, even with the advent of "401(k)-like" group custodial arrangements. These variable annuity contracts offer investment accounts, called "separate accounts" or sub accounts which are treated by security laws as a type of mutual fund. Annuity contracts (for technical tax reasons) cannot offer publicly available mutual funds in their separate accounts, so these funds are often designed as "clones" to those publicly available mutual funds offered to 401(k) plans.
These separate accounts often offer large numbers of different investment sub-accounts managed by a wide variety of managers with varying styles. The management of these investment accounts are all monitored and benchmarked by the annuity companies. Occasionally, the annuity company will find it necessary to completely replace a fund (a "fund substitution") because of either performance or investment style considerations.
The fund substitution process is a lengthy one, governed by the Investment Company Act of 1940, requiring notice and proxies going to the individual participant in a 403(b) plan-not, typically, the plan sponsor.
What are the ERISA implications of a fund substitution under individual annuities for the 403(b) plan fiduciary? It is clear that the choice of an annuity carrier for an ERISA 403(b) plan is a fiduciary act, which also carries with it the ongoing obligation to periodically review the appropriateness of that choice. In a 401(k) plan, changing the investment fund made available to the participant is a fiduciary choice. Likewise, some duty will also apply to changing the investment choice by way of a substitution of an investment fund in an ERISA 403(b) annuity.
So the question becomes what is the fiduciary obligation of a 403(b) plan sponsor who has no right to vote on such a substitution, or otherwise have any authority with regard to the contract? I think its pretty clear that the plan fiduciary has an obligation to review the fund substitution, and make an independent determination as to whether the new fund is appropriate for its plan. The review is going to be quite different than the typical 401(k) review as the fiduciary really will have no control over whether or not the substitution will occur.
If the fund substitution is appropriate, the fiduciary need to take no further action other than to document its review. If the substitution is not appropriate, some very real fiduciary issues arise. It seems that the fiduciary would need to approach the carrier and ask that their employees be blocked from being able to make new deposits to the inappropriate fund. If the annuity company does not have that ability, there may be a fiduciary obligation to cease making contributions to that entire contract. With regard to the existing funds which will be substituted, where the fiduciary has no authority over the contract, little can be done. But it seems that the fiduciary is unlikely to be found in breach where it has no authority, but may have some sort of duty to inform participants of its finding.
This problem is by no means limited to annuity contracts. If an ERISA 403(b) plan funded with individual custodial accounts permits the participant to invest in any of that mutual fund family’s funds, the availability of all of those funds would be subject to fiduciary review, as well as any material changes made to the management of any of those funds.
This is all so different than the process to which we have become accustomed in the 401(a) world. What does all this mean? It means that 403(b) plan sponsors of plans funded with individual contracts will need to pay close attention to matters to which they have likely paid little attention in the past, and monitor changes in their annuity contract and custodial account offerings over which they have little control.
In a broader context, it really seems to me that a whole new line of ERISA will develop, much as it had to when 401(k) plans became popular, and how it will need to further develop as annuitization grows. The circumstances of 403(b) administration will demand unique approaches to the law.