Nevin Adams, dropped another one of his gems (this one on cryptocurrency and “innovations” in self-directed brokerage accounts) while I was drafting this piece on 403(b) SDBAs, making my piece even more timely. Its a striking case in point of another unique feature showing the differences between 403(b) plans and 401(k) plans: Not only are 403(b) SDBAs not permitted to hold these “innovative” investments, including bitcoin or other crypto currency, but they cannot even hold any equities at all other than mutual funds.
403(b) SDBAs are in common use, so much so that it has become table stakes in the large 403(b) market that SDBAs be offered as a part of any RFP. However, this demand does not change the fundamental rule that the tax code requires most 403(b) plans to only be funded with annuity contracts or mutual funds held in custodial accounts. I say “most” because 403(b)(9) permits churches to have “retirement income accounts,” under which neither the mutual fund or annuity requirement are imposed-and for which, by the way, this post has no applicability.
Today’s 403(b) plans investment structures can actually be a bit misleading. We have designed these arrangements to “look and “act” like investment structures for 401(k) plans. In fact, the 403(b) arrangements are actually substantially different than their 401(k) counterparts. There is a bit of history which helps explain these unique arrangements.
Originally, 403(b) custodial accounts were designed a lot like IRAs, where they were individually owned accounts holding a single participant’s mutual fund investments under the plan. Assets under these individual custodial accounts were under the control of the participant. Some 20 years or so ago, there was a great deal of market pressure to develop new investment structures which would mimic 401(k) plans, where those assess could be held and traded by a centralized trustee and trading platform, and where the assets could be put be put under the control of the plan’s fiduciary. What we came up with was a “master custodial” 403(b)arrangement, held by a centralized “custodian,” where the mutual funds traded through a common platform. There are a number of important, but subtle, differences between the 401(k) trust and this 403(b) master custodial account, the most obvious of which (other than the fact that the custodian is technically not a “trustee”) is the need for the custodial account to do “share accounting” of the mutual funds it holds. This is unlike the 401(k) plan, which typically unitizes the mutual funds it holds. There are a number of important reasons for this distinction, which I won’t go into in this post. But among other things that these new “master custodial accounts ” did was to open the door for 403(b) self directed brokerage accounts.
The 403(b) master custodial account SDBA is structured in the same way as the 401(k) SDBA. At the direction of the individual participant, the 403(b) custodian opens a brokerage account in the custodian’s name, for the benefit of the plan participant. The purchases and redemptions in that brokerage account are conducted by the participants, but accounted for by the plan. Those accounts still have the same 404a-5 exemptions and challenges as the 401(k) accounts. However, there is one key difference between that 403(b) SDBA and the 401(k) SDBA: that 403(b) brokerage account can only be invested in mutual funds registered under the Investment Company Act of 1940. Any other investment (such as the “innovative” investments referred to by Nevin) are not permitted.
It has been my experience that the major 403(b) carriers which offer these arrangements have appropriately structured them. It seems to me, though, that the plans which are at highest risk are those serviced by providers have historically provided 401(k) services, and who began providing those same services to 403(b) plans without making the necessary changes to their systems to impose these restrictions. This happened in surprising numbers after the 2007 regulations imposed greater responsibilities on 403(b) plan sponsors. It s a similar issue to those circumstances where some platform providers failed to provide share accounting for the 403(b) mutual funds they hold, and where the shareholder rights have not been passed on to the plan participants. These all are important distinctions brought into play by 403(b) arrangements.