Complex Prohibited Transactions

One of the continuing confusions in how 401(a) rules apply to 403(b) plan  involves the reporting rules related to the correction and reporting on the 5500 of one of the most common errors in any elective deferral plan: the late deposit of those deferrals into the plan.  Neither non-ERISA or ERISA 403(b) will ever file a Form 5330. Ever. Even when the VFCP program is being used to correct the late deposit.

Adding to the confusion is that the Form 5500 instructions do not differentiate between 403(b) plans and 401(a) plans. It simply states that  all “defined contribution” plans need to file the Form 5330 for late deposits, and pay the penalty tax.
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State based auto-IRA programs continue to pick up steam, and may soon become prominent features of the retirement security landscape. Granted, there are a number of legal and logistical issues which need to be resolved before they can be fully implemented, but things are moving quickly.
So it is timely to discuss participant protections under these programs. A successful program must necessarily incorporate ways to protect employee deposits. The holding of employee deposits are not much of a concern, as employee deposits will be held in IRAs protected by highly regulated, commercial custody companies-as in any IRA program. The real challenge will be the protection of employees’ payroll based deposits in getting to the IRA.
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In short, a retirement plan product is really a package of financial and administrative services. This knowledge is especially important when one is tasked with understanding the reasonableness of fees related to retirement products and services. Purchasing investments through a defined contribution plan is so different than an individual making purchases for their own personal account, and it is horribly misleading to suggest otherwise.
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Pension funds and insurance companies share a little discussed attribute, one which I have mentioned from time to time on this blog: they are both great drivers of capital formation.  One of the unique aspects of capital formation through these entities is the function of time: it takes time, to quote the bankers from the movie Mary Poppins in the infamous "Fidleity Fiduciary Bank"  scene, to “build railways through Africa” (or even California, for that matter). Pension funds and insurance general accounts are of a nature uniquely suited to such investment, the commitment to which often may span decades.

Annuity contracts purchased by 401(k) plans, and other retirement plans, often offer the ability for the plan or the participant to invest in these insurer’s “general accounts” as an investment fund. They are now often marketed as “stable value funds” which, in return for time, provide guarantees of principal, some measure of guaranteed returns, and enhanced crediting rates. Though they are called "stable value funds," they are really nothing like the stable value mutual funds. They are backed (in part) by real "things" like investments in bridges, roads, equipment, factories, apartments and shopping malls.
Many of these general account investments offered under annuity contracts, however, have the hated “contingent deferred sales charges” (otherwise known as surrender charges), or “market value adjustments (MVA) ” to the stable fund investments, should these contracts be terminated or substantial amounts withdrawn before a stated time. Surrender charges are generally related to sales costs, but the MVA, as unpopular as they may be, are often necessary because of the long term capital investments backing the guarantees which may be provided. Many products today, by the way, are offered without surrender charges or MVAs, but also generally offer reduced crediting rates in return.

Which really brings us to an obscure problem the DOL has struggled with in the past under ERISA’s plan asset rules (in attempting to define a “transition guaranteed benefit policy”), and now is an issue which may well come to the forefront because of the termination rules under Reg. 1.408b-2(c)(3). 1.408b-2(c)(3)  states that a contract will not be considered reasonable if it does not permit termination “on reasonably short notice under the circumstances“ of the contract by the plan without penalty to the plan. Fortunately, the DOL noted that this should not be read to prevent long term contracts, nor contracts which “reasonably compensates the service provider” for their loss upon early termination of the contract. This exception will not apply if that recoupment is “in excess of actual loss or if it fails to require mitigation of damages.”

So the question becomes what does “without penalty” mean, under 408b-2, when you are terminating an annuity contract.  As noted, the DOL had addressed this issue in the past in an odd, and very specialized, regulation under ERISA 401(c)(1) – which may now have renewed meaning under 408b-2. Under 2550.401c–1, the DOL outlined what it meant to terminate an annuity contract "without penalty" for purposes of that reg.  It established a standard to be applied to both the surrender charge and the MVA:   ”the term penalty does not include a market value adjustment (as defined in paragraph (h)(7) of this section) or the recovery of costs actually incurred which would have been recovered by the insurer but for the termination or discontinuance of the policy, including any unliquidated acquisition expenses, to the extent not previously recovered by the insurer."
This seems consistent with the language used in 408b-2.
The challenge for regulators, insurers and the responsible plan fiduciary will be figuring out when annuity contract termination charges cross this line.  Though annuities designed for the retirement market typically are designed to meet these rules, there may be some questions related to retail annuities placed into plans.



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The disclosures related to 408()(2) are really just a precursor to the next step: the imposition of the prohibited transaction taxes and penalties related to compensation which fails to meet those standards.  It looks like the regs have the effect of shifting the application of the rules related to the "amount involved" in the transaction

Now that the initial 408(b)(2) disclosures are out, the challenge becomes understanding them. Beyond just understanding whether or not the fees disclosed are reasonable (a challenge in itself), the disclosures do something arguably more important: they take us behind the looking glass, opening a window to a world with which most are not familiar, but

The DOL continues with its sensitivity to the challenges created for 403(b) plan sponsors in the transition to an employer accountable world. In today’s release of the final 408(b)(2) regs, the DOL provided tremendously needed relief for 403(b)plans. The language from the preamble speaks for itself:

The Department was persuaded by commenters on the interim final