The DOL, in its final 408(b)-2 regulation, issued relief for 403(b) plans, under which information related to  certain contracts would not be subject to the the new fee disclosure rules. Though this was very helpful, it did not specifically address the 404a-5 participant disclosure regulations for the same type of contracts. This raised a degree of uncertainty with regard to whether or not that relief would be extended to the participant disclosures–causing a good  friend to comment in his inimitable NY manner, "what are the participant regs anyway, chopped liver?!?"

The DOL has saved those regs from chopped liver status, today making it clear in Question 2 to FAB 2012-2 that the 408b-2 relief for 403(b) plans also is extended to the 404a-5 requirements for said plans, on the same terms and conditions.

 

 

NOTE: I STRONGLY CAUTION READERS THAT THE FOLLOWING IS MERELY A SUGGESTED APPROACH WHICH COULD BE SENSIBLY USED BY THE IRS IF IT WERE TO CHOOSE TO RECOGNIZE THE DSTRIBUTION OF INDIVIDUAL CUSTODIAL ACCOUNTS FROM 403(b)(7) PLANS, AND TO LEAD TO FURTHER DISCUSSION. IT IS NOT REFLECTIVE OF THE IRS’S (NOR, AS FAR AS I KNOW, THE DOL’S) CURRENT POSITION, OR EVEN ONE IT IS CONSIDERING. THE FOLLOWING IS NOT INTENDED TO PROVDE LEGAL OR TAX ADVICE, AND SHOULD NOT BE USED AS A BASIS TO JUSTFY A DISTRIBUTION OF A 403(b)(7) CUSTODIAL ACCOUNT.

 

I, like many others, struggle with the notion of advocating for the ability to terminate a 403(b) retirement plan.  However, any retirement plan needs to be able to be sanely unwound -often for a number of critical, exigent reasons unrelated to the plan itself.  We now find ourselves in a growing number of difficult circumstances where the right solution is to terminate a 403(b) plan, but find ourselves unable to do so.

The IRS’s ongoing position is that an individual 403(b)(7) custodial account cannot be distributed from a 403(b) plan upon its termination, while a “fully paid” annuity contract is permitted to be distributed- as it will not deem the custodial account to be an annuity for these purposes.  This has the practical effect of preventing termination of any 403(b) plan which is funded with individual custodial accounts. As time wears on, and this position begins to get long in the tooth, its “unworkableness” becomes more and more apparent as it causes difficulties beyond the actual plan itself. 

I have never fully understood the legal concerns that the IRS has with treating the custodial account as a deemed annuity and thus a distributable asset from the plan, but will fully admit that this arises from my perspectives on these contracts bred by my particular experience with them.

Could it be that the IRS is uncomfortable with the notion of treating the custodial account as an annuity means treating the custodian contract of a plan as being, itself, a plan asset?  If so, this concern is eminently understandable. It seems counterintuitive, at best, that a part of the fundamental structure of a plan be considered a plan asset.  It makes much better sense that the underlying securities (or the cash generated from their sales) held by the custodian is the asset that can be distributed; and that its not really possible to distribute a portion of the structure of the plan. An individual custodial account cannot possibly be a financial instrument that can be recognized as an “in-kind” plan asset: its part of the plan itself.

Like many things 403(b), however, these sorts of issues are novel and of first impression when applied to such plans, requiring that we return to some very basic concepts.

I would hope that the following analysis would be useful.

Lets start with the distribution of an annuity contract from a 401(a) plan.  The tax regulations have long recognized that an annuity contract is a financial instrument (as opposed to cash) which can be distributed from a 401(a) plan (see 1.401(a)-20, Q&A 2); that it can have an account balance or a cash value (see 1.401(a)31, Q&A 17 which requires a qualified plan distributed annuity to allow a direct rollover of funds from the annuity contract to another plan or IRA); and the IRS has issued a number PLRs to that effect (see, for example PLR 200951039, which describes a variable annuity contract issued from a plan).

So it becomes a relatively straightforward proposition to permit the distribution of an individual annuity contract from a terminating 403(b) plan (putting aside for now the issue of what is a “fully paid” annuity contract). Even though it can be seen as constituting a part of the actual structure of a plan, its distribution is accorded no different legal or tax effect than is granted to annuity contracts distributed from a 401(a) plan.  And just as a qualified plan distributed annuity continues to be subject to 401(a) (as administered by the insurance company, see for example 1.401(a)-20 Q&A 17), the distributed annuity 403(b) contract continues to be subject to the terms of 403(b) (see Rev. Rul. 2011-7). 

But what of individually owned 403(b) custodial accounts which, like the annuity contracts they are deemed to be by the Code, seem to be an integral part of the plan’s structure?  Could it also be comfortably considered a financial instrument capable of being distributed by a 403(b) plan on termination in the same manner as an annuity?  

I invite consideration of the following: 

-The individually owned custodial account is a financial instrument, a legally binding contract which is signed by the participant (not the plan) and the custodian, like the individual annuity contract. It has specific terms and conditions on the exercise of the rights by the participant/owner over the underlying securities it holds. For example, the custodial accounts limit the distribution of its assets to those distributions permitted under 403(b)-11, and needed No-Act approval from the SEC to do so-as had the annuity contract. The legal right and title to those contracts under state law run to the participant (though also being subject to ERISA standards for ERISA plans), as does the rights under an individual annuity contract. It would be hard to argue that these are not ”bundle of rights” which constitutes property rights under traditional state property law analysis, as with an annuity contract. 

-The individual custodial account is fundamentally different than the traditional 401(a) custodial account, here with rights to the underlying assets themselves not only running directly to the participant, but the rights of participants can vary greatly within the same plan. 

-Given the state law property rights granted to the individual owner of the custodial accounts, and that the DOL uses ordinary notions of property law to determine whether or not something is a plan asset (see, for example AO 94-31-though the DOL has yet to take a position on this in the 403(b) custodial account context), and that annuity contracts are generally considered plan assets, it becomes hard to argue that the individually owned custodial account is not also a plan asset. And just because it is a plan asset which holds other plan assets (like annuity contracts with separate accounts), this does not disqualify its own plan asset "status."  I suspect that, if the custodial account were abused by a participant or vendor in some sort of way, the DOL would be the first to acknowledge that it is a plan asset.

-The custodial account can, and has historically has been able to, legally exist and operate independently from the existence of a plan and a plan sponsor, with the custodian acting in the same manner as an insurer under a 403(b)  annuity contract which is not related to a plan. 

-This financial instrument is recognized as a security by the SEC. The SEC’s own position recognizes the interests embodied in the 403(b) custodial account as a security owned by the participant, which further lends weight to the argument that it is an asset which can be distributed.  In Release 33-6188, it stated these interests are securities, though “as a matter of administrative practice…the staff does not require such interests to be registered."  This is not a reference to the underlying securities held by the custodial account, as those interests are specifically required to be registered. 

Admittedly, this presents a one sided view, but it is one which is both legitimate and could form the basis of permitting the distribution of the individual custodial account upon plan termination. Supporting this from a logistical view of things is that there are already a significant number of such custodial accounts described above in the marketplace which exist outside a plan. These came to be by virtue of 90-24 transfers occurring before 9/24/2007. Note that I do not address-nor advocate-the application of this approach to distributions from ongoing plans. There are a number of other complications which arise from that circumstance. Note, too, that I suggest that this analysis is only possible under 403(b) (and not under 401(a)) because of the specific language of 403(b)(7).

I would hope that this approach, recognizing the individual custodial account as the financial instrument it is, would make some sense to our regulators in deciding upon its termination distribution. 

 

 

 I have written often of the large impact of the small, the concept of  "minimum necessary change" to accomplish what needs to be done, and have noted a number of regulatory instances where this has been-and not-accomplished.

This whole idea of small rules meaning much also has relevance in the Multiple Employer Plan world, in some very key ways. Some meaningful MEP minutiae:
 
Employer responsibility. One of the ongoing concerns related to MEPs which has garnered much discussion is the level of responsibility which remains with the adopting employer, an issue noted by Ass’t Sec’y Borzi in her recent testimony before the Senate Aging Committee. Interestingly enough, the IRS Form 5330 also speaks to this point. This form, which s used to report and file prohibited transaction penalties related to the late deposit of elective deferrals into a 401(k) plan, is required to be filed and signed by the offending participating employer in the MEP, not the Lead Sponsor (though it must be reported on the 5500 by the Lead Sponsor). The 4975 penalty tax is on that participating employer which is mishandling the deferrals. 
 
An employee.  One of the more lively discussions had always been whether the lead plan sponsor of the MEP needs to have an employee covered by the plan.  Though some have legitimately taken the position that it should be possible under current law to not have an employee, a small rule seems to get in the way. A note on page 3 of the Form 5300 (used to file for an IRS determination letter for the plan) Instructions states "if an employer has no employees, the taxpayer cannot submit as the sponsor of the plan." This seems to require the Lead Sponsor of a MEP requesting the letter to have an employee as a condition of filing for the letter.
 
One bad apple.  One of the risks in adopting a MEP is that, under IRS rules, a single bad plan can disqualify the entire MEP. What minutiae is critical here, though, is Section 10.12 of EPCRS (the IRS’s correction programs): a MEP which has a violating plan sponsor is fixed by fixing only the broken portion of the MEP (of course), but the Plan Administrator may elect to have the compliance fee or sanction based only upon the offending plan, not based on the entire arrangement; while 14.03 permits similar treatment for "tainted" assets transferred into the plan from an offending plan (if the offense does not continue). As a practical matter, this means the risk of an economic catastrophe from a single employer disqualifying an entire MEP can be cost effectively managed.
 
On a personal note, an important milestone. The Toth Ft. Wayne Sourdough Starter had its 10th anniversary this past week, being cultivated from the wild yeast in our kitchen and first used by our daughter and I on April 11, 2002.  Looking, eventually, for it to be passed onto the grandkids for their eventual baking pleasure as well.  Life is good….
 
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Any discussion on any tax issue addressed in this blog (including any attachments or links) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any transaction or tax-related position addressed therein. Further, nothing contained herein is intended to provide legal advice, nor to create an attorney client relationship with any party.   
 
 
 
 
 
 
 
 
 
 
 

For those of you who do not subscribe to BNA, BNA published as an "Insight" an article I wrote on QLAC and Rev Rul 2012-3 (yes, my author agreement permits me to post it here, with attribution).  Look for Paul Hamburger’s upcoming related article, delving into a number of technical and policy issues they raise, as well as discussing the releases on transferring to a DB plan. Link here: First Steps to Modernizing DC Annuitization: QLACs and Revenue Ruling 2012-3.

I will be speaking on a panel addressing this topic with Mark Iwry, Jeff Turner and Wally Lloyd at the ABA Section of Taxation’s Employee Benefits Committee general session on May 12 in DC. 

With all of the intense activity in the marketplace related to providing the initial 408b-2 and 404a-5 disclosures in a timely manner, there is what I could only describe as a "sea change" occurring, relatively quietly, behind the scenes in financial service firms related to the ongoing responsibilities under the DOL’s new disclosure rules.  For these firms, the issue isn’t really just about disclosure. Because 408b-2, in particular, is a prohibited transaction rule, its really all about keeping the revenue generated from ERISA retirement plans. Its about being able to stay in business.

This means that financial service firms have a huge economic stake in not just making the initial disclosure, but also in making sure that permanent compliance procedures are established, implemented and audited on a routine basis. Firms should also be taking a closer look at their myriad of revenues streams to make sure that not only are they reported correctly, but that there is a Prohibited Transaction Exemption that otherwise permits the revenue. 

A firm, then, is faced with a quandary. "ERISA compliance" staffs (to the extent a firm has this function) have generally had the function to answer technical questions and provide procedural guidance to operation staff and clients. There really has been no enforcement "teeth." The only part of these financial firms that really have had to have serious "control" functions have been the securities law compliance staff. It is typically only these staffs which have the expertise necessary to establish, implement, audit, enforce and report regulatory requirements on the firms’  substantive business. And it appears that it is the securities compliance staff to whom firms are turning to institutionalize ongoing 408b-2 compliance.

I had the pleasure of being on a panel with Gigi Fuhry and Jim Downing at the National Society of Compliance Professionals meeting in Chicago on " Integrating ERISA Compliance Into the Securities Compliance Program," where we outlined the framework of an ERISA Compliance program that can built into the securities compliance practice. The NSCP itself now has training modules which are designed for the Compliance professionals who now find themselves confronted with ERISA.  I’ve linked to a compliance list the three of us developed.

Welcome, securities compliance, to our world!

 

The Treasury’s issuance of proposed regulations introducing the "Qualified Longevity Annuity Contract" is a substantial step in the efforts to better provide plan participants the ability to use their defined contribution balances to plan for retirement security. One of the QLAC’s most useful effects is that it gives us a "base," a laboratory of sorts, which permits us to look closely at the legal and practical issues in "real time" which are related to using DC plans to help fill in the gaps left by the demise of defined benefit plans.

One of the fundamental issues the proposed regulation raises is one which is beyond Treasury’s control:  what is the fiduciary’s exposure to the potential future insolvency of an insurer when choosing a QLAC provider? Absent a federal insurance system like the FDIC or the PBGC which ultimately guarantees this risk-which is likely to be a number of years off, if even possible-does this means that it will never be prudent for a fiduciary to purchase a QLAC, or any annuity, under which a single insurance company insures the risk?

Many of us have been seeking legislative and regulatory solutions to this for a number of years, to little avail. Having thought about this much, and having blogged on it on the issue on more than one occasion, I have come to the conclusion that it is unfair to expect the DOL  (and likely well beyond its mandate) to develop much more of a standard beyond what it has already published. If you read its "annuity safe harbor" standard closely,  you will see that it is comprehensive and describes the fiduciary standard well. But there still exists a queasiness about how to apply it.

I believe that the issue, however, is not as intractable as it seems, and the answer does not lie in further regulation. It lies in becoming more comfortable with the idea of risk and the commercial pooling of interests.  Fiduciaries should be able to comfortably assess an insurer without either becoming insurance experts or- at least on the narrow issue of insolvency- having to rely on an expert’s prognostication as to whether an insurer will be around decades from now.

The real issue, as made starkly clear by the SCOTUS in the oral arguments on heath care reform, is that there appears to be a serious lack of understanding in the legal, judicial and investing communities of the nature of risk and of the commercial pooling of interest.  This lack of understanding seems to be underpinned by a reluctance to accept that we, collectively as a society, share certain risks that can only be managed at a more global level.  

There are a few key (but not so obvious)  concepts, that have existed for centuries that the law (and financial advisors) should recognize, and upon which fiduciaries should be able to rely:

  1.  Risk is a natural part of life.
  2. Our individual risks often are inter-related. Thus people can, and have, well managed these risks by pooling interests with those who have similar risks.  
  3. Managing this pooling is complicated and requires specialized knowledge which has been successfully accomplished commercially (which also provides a level of financial accountability which structurally may be missing in government based programs).  
  4. Financial "scale" is necessary to make risk pooling commercially work.
  5. Such "scale"  and complexity makes it impossible for any single policyholder to protect itself against fraud and mismanagement of the pool.
  6.  Collectively acting through government provides the regulatory scale necessary to protect citizenry from insurance (pooling) mismanagement and fraud, and the regulation of pooling is significant. Making sure commercial insurance is able to fulfill the pool’s promise is an appropriate government function for protecting the well being of its citizenry.

In the end, the risk of insurer insolvency is a societal risk for which no fiduciary should be held accountable, as long as they are familiar the regulatory structure which is in place and uses it in making their decisions.

Regrettably, I believe much of the misunderstanding about pooled risk is reflected in deeply rooted political beliefs which was epitomized by the "Ownership Society" concept promoted by the Bush II administration. Though no one can deny the need for accountability, one should neither deny that longevity risk can really only be managed by acting in accordance with our common, and thus pooled, interests.

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Any discussion on any tax issue addressed in this blog (including any attachments or links) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any transaction or tax-related position addressed therein. Further, nothing contained herein is intended to provide legal advice, nor to create an attorney client relationship with any party.   

 

 

 

 

I cringed in horror as I listened to the Supreme Court debate on health care reform, and not for the reasons you may otherwise suspect. What concerned me greatly, and which is something which ultimately has an impact on the retirement industry, was the common reference by SCOTUS (Supreme Court of the Untied States)  to insurance as a "product," and without effective response from the Solicitor General. Insurance is a financial service, not a product; it is the commercial pooling of interests by policyholders to spread risk. It is no more a product than depositing funds in a brokerage account to buy stocks.

I cringed when I realized that we in the industry really have no one to blame but ourselves. 

When I first joined the insurance industry, the management consulting firms were working with insurance companies to address  insurance’s pretty bad reputation. The term "insurance" had fallen into such ill-repute that even long term industry professionals became reluctant to say that word. I  sat through a number of industry meetings where I was amazed at the seeming repulsion at using it.  What grew from all of that was an easy way out: instead of referring to insurance policies, we would just instead refer to them as "products." Or, in the retirement world, "retirement products." Even today, look hard to see how often you see reference to a "group annuity contract "or "insurance policy" in the materials where your plan may have purchased one. It has to be disclosed by state regulation, but you’ll only find it in the smallest print possible and in the most innocuous way. You are not going to see it highlighted in the midst of the marketing material, to be sure.

At first I railed against this practice. I had just come in from a manufacturing company where real, tangible product was being produced. Insurance, I insisted, was not cereal. Establishing the terms of an insurance policy is NOT "manufacturing," as the industry started to call it. It was, at best, annoying, and I believed a bit misleading.

I believe strongly in the commercial pooling of interests; it is one of those areas where good social policy and good business practices meet for the betterment of all. I ‘m afraid that, on more than one occasion, I did get on my soapbox to claim that we had nothing to be ashamed of by being in the "insurance business", as long as we did it right. It is, after all, the selling of unique knowledge. 

Over time, however, I fell prey to the same practice. You may note in my "elevator speech" description of my law practice, I discuss "retirement products and services." But now all of that is coming home to roost.

The commercial pooling of interest is a complicated matter. Just think about the number of actuaries an insurance company may have (Lincoln, at its height, had 130 of them, and a formal actuarial recruitment, training and rotation program-complete with a sort of hierarchy that only an actuary can comprehend and appreciate) and the seemingly mind-numbing work they do. Even the recent QLAC regulations required the use of an actuary, and some of the terms are difficult, at best. The complications, the risks, and the reliance as a society we have on this pooling is also the reason it is so heavily regulated, in ways no box of cereal is.

It is all about providing financial services. No tangible product is made which can be handled and sold. Instead, we are talking about providing money and knowledge to policyholders under certain defined circumstances.

In the retirement world, for example, I have often referred to distributed annuity contracts as being "in kind" distributions, as it simplifies matters greatly. But as we delve deeper into the regulation of these things, we do ourselves a great disservice-and are likely to to get the regulations wrong- if we view insurance as a product as opposed to a package of financial services; it is about the way we appropriately regulate the pooling of our financial interests.

Insurance is not a cell phone. It is not even broccoli.

 

I have expressed several times my sense that the 2007 403(b) regulations were unfortunate in a number of different ways. Though they sought to address some very real compliance issues, they did so in a heavy handed and often complicated way which virtually ignored the difficulties inherent in transitioning from a statutory and commercial system that had been operating for 3 or 4 generations under the prior set of rules.

We are very fortunate, however, that the IRS staff responsible for implementing and enforcing those regulations recognized this failing early on, and has often sought to administratively address some of the more difficult concerns that have cropped up through this transition period.

Most recently, Monika Templeman (Director of Employee Plans Examinations for the IRS’s TE/GE Division) announced in February an interim program to address an audit problem related to the IRS’s delay in updating the EPCRS program to reflect 403(b) document rule changes, and the stalled 403(b) prototype program.

This program, according to IRS staff, will not be provided in formal, published guidance, but will be implemented by the field staff during audit until such time as EPCRS and the prototype program are finalized. It will helpful to the practitioner to be familiar with how this works, because it is relief that operates within limitations of the IRS’s formal audit closing structure.

If an employer is found not to have adopted formal 403(b) plan document in a timely manner, the IRS may choose (presumably under non-abusive circumstances) to enter into a type of agreement where sanctions more resembling those available under the “Voluntary Corrections Program” (VCP) will apply, rather than those under the more expensive “Closing Agreement Program” (CAP). This should help encourage employers who still have not adopted a formal program to act as quickly as possible to adopt a formal written plan document, albiet late.

If a "document error" (as that term is used under EPCRS) has been found,  the employer may be given the option of amending the plan prospectively and fixing the past error as an operational error (either as a self correction, where applicable, or using the VCP structure); or to instead commit to adopting a prototype program (when issued) and follow the rules for the remedial amendment period under that program. It is important to note that the IRS will follow up with the employer should the "prototype choice" be selected, and one should give it serious thought before making this particular choice.

What the IRS CAN’T do under favorable terms because of the legal structure of the audit program (though some practitioners apparently insist on doing so) is to permit the retroactive amendment of the plan on audit. Insisting on this fix will cause the higher CAP sanctions to be applied.

On another note, it has come to my attention that my prior blog related to the "mis-marketing" of the 403(b) SPARK standards by some parties could have been read to imply that SPARK itself has been involved in this practice.  SPARK has not represented or suggested that its best practices are intended to serve as a DOL disclosure solution.  It was never my intent to lead any one to this conclusion, as SPARK is not engaged in such a practice. I do apologize for any misunderstanding that this may have caused.

 

 

 

The 403(b) regulations replaced the "contract exchange" rules under Revenue Ruling 90-24 (which allowed the tax free transfer of 403(b) contracts between different vendors, including that of different plans, as long as certain, minimal conditions were met) with a new scheme of exchanges and transfers. After September 24, 2007, the former "90-24 transfers" between unrelated plans could only be accomplished through a formal "transfer agreement" between plans, much in the same manner as 401(a) plans.  

The IRS also imposed new rules for exchanging contracts between vendors in the same plan. These new rules include the infamous "Information Sharing Agreement" (or "ISA") requirement, that conditions the exchange on the employer entering into an agreement with the issuer of the contract into which the funds will be exchanged. Under the ISA, the employer and the new issuer agree to, "from time to time in the future," provide each other Information necessary for the new contract, or any other contract to which contributions have been made by the employer, to satisfy section 403(b). This includes information concerning the participant’s  employment  status, eligibility for a hardship, and ability take a loan (and in what amount),  as well as Information necessary to satisfy other tax requirements.

In response to these new data exchange requirements, a number of friends and colleagues from a variety of 403(b) vendors joined together and  worked diligently and effectively over several years following the publication of the regulations to establish information standards for the exchange of this data. They are known as the SPARK 403(b) Information Sharing Data Elements Best Practices. 

Now, however, there appears to be a number of parties that are touting these ISA standards as the solution to 408(b)2 and 404a-5-compliance; that the SPARK standards will provide a solution to these new DOL disclosure rules; or that adopting the SPARK Standard suggests capability to successfully implement the disclosure rules.

Don’t be misled; nothing can be further from the truth. The SPARK standards address the basic contract information which is necessary for compliance with the ISA requirements. There is no fee data; there is no investment data; there is no description of services. Reference to the "SPARK Standard" as a solution to the DOL rules does present a very catchy marketing and sales hook, but one which is also very wrong.

As an aside, the ISA standards were well developed by dedicated professionals, many of whom are passionate about this business. They have been, in effect, a tremendously successful  "Skunk Works."   Much of the standards’ current value derives from volunteers who have moved on to other positions within and without the original organizations which were committed to the process.  So sustainability now becomes an issue. The standards were also developed under the auspices of a small organization with very limited professional and administrative staff which-in addition to attempting to establish annuity data standards along side the 403(b) standards-is very much focused on establishing its own new "brand." Sustainability, structure and support  are necessary elements for the maintenance and further development of these standards as they mature. 

Ultimately, as I’ve suggested in the past, the answer may well lie in the formation of a consortium funded in large part by user fees; supported by a well established center such as a public university; and governed by a wide variety of stakeholders-not just vendors. This is not just a pipe dream, this is how a number of standard setting organizations and consortia are run with a degree of permanence. I admit here to a bias, as a number off us had proposed and developed just such a structure in the early days of the new regs, and a number of critical parties were interested.

It will be interesting to see what happens over time.

 

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Any discussion on any tax issue addressed in this blog (including any attachments or links) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code or promoting, marketing or recommending to another person any transaction or tax-related position addressed therein. Further, nothing contained herein is intended to provide legal advice, nor to create an attorney client relationship with any party.