403(b) Plans - Siblings, Not Twins
Kind of similar, but really different, 401(k) plans and 403(b) plans are the fraternal twins of the retirement plan universe. People think that 403(b) plans are just a funny version of a 401(k), but that is not true, says Evan Giller, a member in the New York law firm of Giller & Calhoun LLC. While the rules for the two different types of plans are similar, there are significant differences, and advisers need to know the differences, says Terry Richardson, Director of PwC Human Resources Services in Chicago. Here are five common misperceptions and misunderstandings about 403(b) plans (and how they compare with their 401(k) brethren):
The rules are exactly the same for 403(b) and 401(k) plans.
The key differences between 401(k) and 403(b) plans, says Richardson, include 1) special contribution limit rules for 403(b) plans, 2) that 403(b) plans have a special 15-year catch-up contribution rule, and 3) that 403(b) plans also have a special rule that allows contributions after someone leaves employment. There are also differences in the nondiscrimination rules and permissible funding vehicles.
For example, the rules under Internal Revenue Code 415 for the combined limit on employer and employee contributions differ between the two types of plans, says Richardson. Although the 415 rules apply to both types of plans, he says, how they apply differs. In a for-profit company, he says, 401(k) elective deferrals are combined with contributions from various other qualified retirement plans the company sponsors, and there is only one 415 limit. If a university, however, has both a 403(b) plan and a 401(a) plan with employer contributions, the university’s 401(a) plan is subject to the 415 limit, but the 403(b) plan has a separate 415 limit. The 403(b) plan and the 401(a) defined contribution plan are not combined to determine the 415 limit, says Richardson, so there are, in reality, two 415 limits.
Additionally, there is a misconception that if a 403(b) investment provider is changed, all the old money in A can be mapped over to B, explains Giller, and that is not always the case. Legacy 403(b) products are usually individual-based products, he explains, and because 403(b) plans are often funded by individual annuity contracts, the plan sponsor does not have authority under the contracts to move the money to new investments.
This means that, when 403(b) investment providers are changed, the money has to be moved over individually by each participant, says Chris Cumming, Senior Vice President of Defined Contribution Markets for Great-West Retirement Services in Greenwood Village, Colorado. This makes it difficult to move investments. “You have to roll over assets one participant at a time, and you may not get all the assets over time,” says Cumming. This is important, he says, because often the pricing for new investments is based on the assumption that all the old money will be coming over.
Additionally, notes Giller, the 403(b) plan structures differ in that they generally are funded by annuity contracts with their own terms and conditions. So, when reviewing a 403(b) plan, advisers need to look at not only the plan documents, but also the annuity contracts, to determine how to administer a plan properly.
Conversely, many advisers are not aware of how similar 403(b) and 401(k) plans are. At one time, the rules for the two types of plans were very dissimilar, says Cumming, but that has changed in the last few years. There have been a number of changes to the 403(b) rules over the last 10 years to make them more similar to 401(k) plans, says Richardson. In fact, many nonprofit entities, says Cumming, have ERISA-based plans, so there are really very few differences between the two types of plans.
Furthermore, says Cumming, some of the differences actually make 403(b) plans easier to administer. For example, 403(b) plans are not subject to the average deferral percentage (ADP) testing that 401(k) plans are.
What qualifies as a permissible investment for a 401(k) plan is permissible in a 403(b) plan.
Advisers also tend to be unaware of 403(b) investment restrictions. For the most part, says Richardson, 401(k) plans are not limited in what they can invest in. On the other hand, he says, Internal Revenue Code and ERISA rules generally limit 403(b) plans to investing in annuities or mutual funds in custodial accounts.
Additionally, under 403(b) rules, he says, investment funds are required to be a registered investment company under the 1940 Act. Many advisers are not aware of that. For example, Richardson recently worked for an adviser that had a 403(b) account. The adviser was putting the 403(b) plan into exchange-traded funds (ETFs), even though the ETFs were not mutual fund investment accounts and did not qualify under the 1940 Securities and Exchange Act. Not all ETFs are registered investment companies under the 1940 Act, though many are, Richardson explains. If the ETF is not a registered investment company, it would not be an eligible 403(b) investment; it is a misconception that all ETFs are eligible.
403(b) plans are subject to draconian contribution limits and cannot be rolled over.
It used to be the case that 403(b) plans were subjected to “draconian” contribution limits, says Richardson. However, although a “maximum exclusion allowance” still applies, the formulistic limit on amounts that can be contributed was eliminated about a decade ago, he says.
Furthermore, says Richardson, it used to be the case that 403(b) plan assets could not be rolled over to any other type of plan other than another 403(b) plan, but now you can roll 403(b) assets over to any eligible retirement plan as long as the plan will accept the rollover.
You don’t have to worry about other retirement plans from other businesses.
Not-for-profit sponsors have to ask employees who have other businesses on the side, e.g., doctors, if they have retirement plans from a side business. Many not-for-profit employees, says Richardson, think they can contribute to the 403(b) at work and maximize contributions to a retirement plan they have in their own business. The reality, however, is that where the individual 403(b) participant is also in control of an outside entity that sponsors a plan, the limit would be combined and there would only be one limit for the two plans of that individual. The 403(b) plan is combined with any 401(a) plan the employee may have.
For example, if the doctor has a 401(a) defined contribution plan for his personal practice and works at a hospital with a 403(b) plan, contributions to both plans have to be aggregated and subject to one 415 limit. There is only one combined limit in these circumstances, explains Richardson, and if the limit is violated, not only is the participant taxed on the amount over the limit as income, but there also is a 6% excise tax if the amount is invested in mutual funds. Amounts invested in annuities are not subject to this tax, he explains.
The 415 and 403(b) regulations issued several years ago make it clear that it is the 403(b) plan sponsor’s responsibility to get information on any other plans workers may have and to do combined contribution testing, says Richardson.
Conversely, says Richardson, even if an adviser never has an intention of getting into the 403(b) market, he has to be aware if any of his clients participate in 403(b) plans. For example, says Richardson, if an adviser is involved with a doctor’s practice, and the adviser sets up a 401(a) plan for that doctor’s practice without inquiring if the doctor participates in a 403(b) plan, then it could cause problems for that client.
Annuity contracts are always a bad funding vehicle.
Advisers often believe that annuity contracts are always bad as a retirement plan funding vehicle because tax-exempt retirement plans do not need the additional tax benefits of annuity contracts, says Giller. That, he says, is true to the extent that the cost of an annuity contract exceeds the cost of a mutual fund. However, he says, that is not always the case; there are times when the cost of the annuity contract is less than the cost of a mutual fund. So, the concept that annuity contracts are always bad in 403(b) plans is not really the case, says Giller. It could be true, he says, but it is not always true.
—Elayne Robertson Demby
Asking for More Time
Council recommends more audit relief for 403(b)s
The ERISA Advisory Council has recommended that the Department of Labor provide administrators of 403(b) plans with an additional year to file their 2009 Form 5500 or other annual report.
In addition, according to a report following its review of Employee Benefit Plan Auditing and Financial Reporting Models, the Council said the DoL should waive the audit requirement for 403(b) plans that have plan assets invested entirely in individual custodial contracts or individual annuity contracts. For plans containing those individual-type assets and group annuity contracts, the Council said only the group annuity contracts would be subject to the audit requirement, and for plans with only group annuity contracts, the plan would be fully subject to the audit requirement.
The DoL, the American Institute of Certified Public Accountants (AICPA), and 403(b) plan specialists all confirmed to the Council that there are problems with 403(b) plans and audits, and they relate to the nature of the sponsors, plan structure, and records. They explained that, in some plans with older individual contracts, it is very costly to try to compile plan records, and in some cases, it may be impossible. Similarly, audits of such plans can be extremely costly due to the absence of unified plan records.
Testimony was offered that many of the nonprofit and educational employers lack the resources to engage auditors and meet reporting requirements. Other witnesses asserted that audits serve no purpose in protecting plan participants where they hold individual contracts and where the employer has played no role in supporting the arrangement, other than payroll deduction. Where individual contracts are used and the participant selects them as in 403(b) arrangements, imposing an audit requirement is expensive, the witnesses claimed.
Some witnesses asserted that the cost of audits and the audit requirement itself will lead to the termination of many smaller 403(b) plans. The DoL and the Internal Revenue Service (IRS) previously granted some relief to help deal with these issues. Witnesses testified that the relief was inadequate and that there is not adequate time to transition to Employee Retirement Income Security Act (ERISA) requirements. This is characterized as an immediate “crisis” for some plan sponsors, because many filings are already due. Plans that cannot meet the requirements are subject to civil penalties and other consequences.
The DoL issued Field Assistance Bulletin (FAB) 2009-02, Annual Reporting Requirements for 403(b) Plans, and FAB 2010-01, Annual Reporting and ERISA Coverage for 403(b) Plans, to provide enforcement relief for plan administrators “that make good faith efforts to transition for the 2009 plan year to ERISA’s generally applicable annual reporting requirements.” DoL FAB 2009-02 allows the plan administrator to exclude certain pre-January 1, 2009, annuity contracts and custodial accounts for ERISA reporting purposes.
The AICPA testified that auditors cannot legally disregard incomplete financial statements because ERISA requires the audit reports to identify whether the financial statements are prepared in accordance with Generally Accepted Accounting Principles (GAAP). Therefore, if the plan administrator elects to exclude some or all of those contracts or accounts meeting the conditions of DoL FAB 2009-02 from the plan’s financial statements, or instructs the auditor not to perform procedures on certain or all pre-2009 contracts, or both, the auditor will need to consider the effect of the exclusions on the completeness of the GAAP financial statements of the plan and consider the issuance of either a qualified opinion or a disclaimer of opinion, both subjecting the Form 5500 to rejection for failing to include an unqualified accountant’s report.
—Rebecca Moore