A Good Reason to Look at Annuities

Dr. Pinar Cebar, at the American Council on Capital Formation, put out a paper early in the year encouraging greater use of annuities in the payout phase of retirement plans. The paper is available at http://www.acff.org/reports/sr-annuities0406.html. Because a significant part of this blog bewailing high costs in annuities, this report provides an opportunity to point out positives of annuities.

In writing about defined contribution retirement plans (and non-plans), the author is almost compelled to focus on the employment-based accumulation phase of retirement planning. In part this is because that phase is where the fun is, and in part it is because so few plans allow or encourage employees to leave their money in the plan. Few and far between are the sponsors who did not want to minimize involvement with former employees, and even fewer are those who want to pay for the privilege. Reduction of costs and fear of lawsuits from employees who are now former employees seem to be the basic reasons, and they are both legitimate and substantial reasons.

In addition, because the plan is about the accumulation phase, the employer/administrator has to focus on the fees between the employee and the ultimate investments, and these tend to be much higher in annuities. A non-plan environment would appear to be neutral as between annuities and other investments, but in fact is highly biased in favor of annuities because it is much, much harder to get the money needed for tax compliance from a custodial account arrangement where everything is explicit than from an annuity. This results in over-usage of annuities in situations like school districts (even setting aside the endorsed product problem) in the accumulation phase.

What Dr. Cebi's study points out is the fundamentally different issues for the participant and in the payout phase. If one has to live off of the yield from a given pool of assets, the factors that are important are very different from those that affect an employer. Specifically, the individual should be concerned about investment risk on the downside, inflation and excess (?) longevity.

This means that the tradeoffs between cost, flexibility and annuity-specific investment characteristics is fundamentally different for the payout phase. It also means that the choices to use or not to use an annuity rather than mutual funds and which annuity to buy are highly individual. The choices are completely different, for example, if you come from a long-lived family and know you are in good health rather than come from a family with a history
of lung cancer and seem to be coughing a lot lately. As a result, people at retirement ought to look carefully at annuity alternatives, and particularly those that reduce inflation and investment risks.

This does not mean that employers should be involved. Running a mutual fund-based or annuity-based retirement plan does not make one an expert in individual annuities. It also does not make one expert in the personal details and attitudes that employees ought to consider in the payout phase. At the most, the employer may want to point the participants towards the possibilities and give them starting points for information to help them make their decisions. In a plan context, or in a non-plan context of done appropriately, the employer may want to consider having a collection of names of people interested in talking to participants now receiving money from the plan or or materials offered by investment advisors of all stripes who have that interest. But not many employers will want to, or should, go beyond that.

Written Plan Requirement for 403(b) (and 457)

A major service provider in retirement plans recently issued a new advisory on 403(b) plan document requirements. This post is to disagree with most of what that advisory says. (Most of these comments apply to 457 plans as well, but with less force because they tend to be in better shape with respect to compliance issues.)

First, they say that there is no written plan requirement in 403(b), which seems right after a cursory glance. 403(b) is essentially a laundry list of requirements imposed on the "annuity" or "contract" (including custodial accounts and retirement income accounts) to get tax-deferred status for contributions to it. However, 403(b)(5) says that if 403(b) applies to more than one annuity, "such contracts shall be treated as one contract."

The effects of 403(b)(5) is not simply with respect to operational compliance; it applies to 403(b) in its entirety. The effect of this is that two annuities each including the 402(g) deferral limits are treated as one contract with twice the limit. And two contracts allowing loans are treated as one contract with an impermissible loan limitation.

You could argue that this does not matter where only one annuity can receive contributions during a year, because 403(b) is simply an element of determining tax liability for the year. However, where the requirement of 403(b) applies after the contributions are made (again, as with loan limitations), this argument is weaker. And it certainly fails in the non-plan, multi-vendor environment where there are certainly at least two options available to each employee.

And, where there is a plan and it is subject to ERISA, all of this technical tax analysis is irrelevant. ERISA has a specific written plan document requirement.

Next, the advisory says not to worry because the final regulations are not out, and won't be effective before 2008. The problem with this statement is the advisory's assumption that a writing requirement is entirely a creation of the proposed regulations, which it is not. A 403(b) that is not in compliance for 2007 because of a failure to deal with the "one contract" language of 403(b)(5) simply is not in compliance and not a 403(b) annuity.

Last, the advisory says that the Department of Labor has never been interested in seeing 403(b) documents where ERISA applies and that the DOL has never said what has to be in an ERISA 403(b) document. 29 U.S.C. 1102(a) says: "Every employee benefit plan shall be established and maintained pursuant to a written instrument." That requirement is not conditional on DOL enforcement policy or the issuance of content regulations. The fact is that people have been writing qualified plan, 457 and 409A plan documents for a long time, and the adjustments in content to make those into compliant 403(b) documents are trivial (our 403(b) documents, marked up from approved prototype 401(k) documents, took about 20 hours to modify). This argument will hold no water if a DOL auditor or a court asks for you plan document.

There is another thread running through the advisory that needs to be addressed, references to amendment deadlines. These references are an echo of the remedial amendment period rules that apply to qualified plans under 401(b). These rules apply only to qualified plans. They have no application to 403(b) or 457. The timing requirement for all 403(b) rules is, in fact, the first day of the first plan year to which the requirement applies. To the extent that the final regulations provide greater detail or liberalize the rules, the IRS can certainly delay the effective date of the regulations. But the effective dates for requirement that are clear under existing law are unaffected.

What is left of the advisory? First, what I call the "I have always relied on the kindness of strangers" defense is asserted. This says, in effect, that IRS and DOL will continue to be nicer to 403(b) employers and participants than they have to be. Given the number of 403(b) plans and arrangements in force and the fact that regulators routinely go easier on governmental and charitable organizations and their employees, there is some truth to that assertion. However, it does not help with several things. First, a lawyer cannot properly opine that the attempted 403(b) meets the requirements of 403(b). Second, nobody can certify to anyone (e.g., trustees, custodians, payroll administrators, paying agents, Form 5500 and employee return preparers, auditors, etc.) that this is a good 403(b). Third, the courts are not bound at all by IRS or DOL enforcement policy, although they do, obviously, give effect to the remedial amendment period for qualified plans. Last, if an IRS or DOL agent decides, for whatever reason, to pursue the issue (say, the employer has done bad things otherwise or the 403(b) is an element of an excess compensation arrangement), prior non-enforcement will not be a defense.

All of that is not to say that everybody should panic and scramble to get a writing in place before 2007, which is obviously not going to happen. It is simply to say that there is a business risk in not getting a writing in place soon, and that employers should be making fully-informed decisions whether or not to do so.

All of that also indicates that 403(b) documents should be reviewed and/or amended annually. This can be a problem with the current market structure because annuity and custodial account forms of contract are not modified every year. At BPS, we structure the 403(b) document service on a maintenance model, reviewing every year, and amending if needed every year.

Last, Benefit Plan Solutions has, and has had for some years, 403(b) written plans and non-plans. They follow a prototype format and are very simple to use. Please feel free to call or fax to 888-277-1017 or e-mail to geertom@gmail.com or benefitplansolutions@gmail.com for more information.

More on Plan Drafting

On September 1, the ERISA and Disability Benefits Law Blog posted and excellent write-up of Ushakova v. AIG Life Ins. Co., 2006 WL 2473473 (W.D. Wash. 8/26/06). The District Court concluded that a claim for benefits was reviewable de novo because the plan documents contained no language specifically granting discretion to the plan administrator. Instead it required that the claimant provide "due written proof of the loss."

The case is certainly another instance of courts resisting the application of the Supreme Court's "arbitrary and capricious" standard of review. There are now so many of these cases that one has to assume that a court will always look far a way to apply some lower standard.

The case is also yet another reminder that plans need to be better written than is the norm today. It is very simple to include language that the plan (to paraphrase Firestone Tire and Rubber v. Bruch, 489 U.S. 101 (1989) that the plan gives the administrator discretionary authority to determine eligibility for benefits and to construe the terms of the plan. All plans, whether they are subject to ERISA or not, should do so loudly and clearly.

What's a Plan? Gray v. Prudential

An interesting decision was made by the Eastern District of Arkansas in August. The case, Gray v. Prudential Ins. Co. of Am. (E.D. Ark. 2006) was decided under a provision in the DOL Regulations that is the counterpart of the non-plan regulations that apply to 403(b). The case is interesting for (1) how it uses a very technical analysis to find the arrangement is a plan and (2) the way it illustrates the importance of specific provisions in the DOL Regs. for 403(b) non-plans.

The insurer wanted to get the deferential review available to plans, and the employee wanted the de novo review standard that applies in insurance policy disputes. The employee argued that the plan met the requirements of DOL Regs. 1.2510.3-1(j).

DOL Regs. 1.2510.3-1(j) are met if (1) the employer does not contribute, (2) participation is completely voluntary, (3) all the employer does is permit the insurer to publicize the program to employees and collect and pay premiums over to the insurer and (4) the employer receives nothing other than reasonable compensation, without profit, for payroll administration services.

In claiming the exemption does not apply, the insurer pointed to the following: the employer's logo was on the cover page of the plan and the SPD; the formal contract holder was the employer; the employer was designated in the documents as plan administrator and agent for service of legal process; and the employer determined whether an employee was eligible. The court found that the employer's involvement with respect to the plan was more than ministerial, putting the plan outside of the exemption.

The first interesting thing to do with this case is to compare the terms of DOL Regs. 1.2510.3-2(f), which is the regulation for 403(b) non-plans. The core difference is that DOL Regs. 1.2510.3-2(f) has much more detail. The standards for welfare benefits require that “(3) The sole functions of the employer or employee organization with respect to the program are, without endorsing the program, to permit the insurer to publicize the program to employees or members, to collect premiums through payroll deductions or dues checkoffs and to remit them to the insurer; and (4) The employer or employee organization receives no consideration in the form of cash or otherwise in connection with the program, other than reasonable compensation, excluding any profit, for administrative services actually rendered in connection with payroll deductions or dues checkoffs.” The regulation for 403(b) says:

“(2) All rights under the annuity contract or custodial account are enforceable solely by the employee, by a beneficiary of such employee, or by any authorized representative of such employee or beneficiary;

(3) The sole involvement of the employer, other than pursuant to paragraph (f)(2) of this section, is limited to any of the following:

(i) Permitting annuity contractors (which term shall include any agent or broker who offers annuity contracts or who makes available custodial accounts within the meaning of section 403(b)(7) of the Code) to publicize their products to employees,

(ii) Requesting information concerning proposed funding media, products or annuity contractors;

(iii) Summarizing or otherwise compiling the information provided with respect to the proposed funding media or products which are made available, or the annuity contractors whose services are provided, in order to facilitate review and analysis by the employees;

(iv) Collecting annuity or custodial account considerations as required by salary reduction agreements or by agreements to forego salary increases, remitting such considerations to annuity contractors and maintaining records of such considerations;

(v) Holding in the employer's name one or more group annuity contracts covering its employees;

(vi) Before February 7, 1978, to have limited the funding media or products available to employees, or the annuity contractors who could approach employees, to those which, in the judgment of the employer, afforded employees appropriate investment opportunities; or

(vii) After February 6, 1978, limiting the funding media or products available to employees, or the annuity contractors who may approach employees, to a number and selection which is designed to afford employees a reasonable choice in light of all relevant circumstances. Relevant circumstances may include, but would not necessarily be limited to, the following types of factors:

(A) The number of employees affected,

(B) The number of contractors who have indicated interest in approaching employees,

(C) The variety of available products,

(D) The terms of the available arrangements,

(E) The administrative burdens and costs to the employer, and

(F) The possible interference with employee performance resulting from direct solicitation by contractors; and

(4) The employer receives no direct or indirect consideration or compensation in cash or otherwise other than reasonable compensation to cover expenses properly and actually incurred by such employer in the performance of the employer's duties pursuant to the salary reduction agreements or agreements to forego salary increases described in this paragraph (f) of this section.”

Obviously, this more detailed set of rules constitutes a better, clearer road map for non-plan 403(b) arrangements. As a result, Gray v. Prudential Ins. Co. of Am. is only strictly relevant to 403(b) determinations where a parallel requirement exists. The use of employer logos is not specifically permitted or barred under either regulation, so permitting its use may violate the “sole involvement” standard in DOL Regs. 1.2510.3-2(f)(3) even though there is no explicit non-endorsement rule. Under DOL Regs. 1.2510.3-2(f)(3)(v) the fact that the employer is the contract holder is not dispositive; however, policy holders typically have some rights under policies, which could lead to a violation of the requirement in DOL Regs. 1.2510.3-2(f)(2) that the employees hold all enforcement rights. The designation of the employer as plan administrator and agent for service of process and the preparation of a document designated as a Summary Plan Description must have been the result of using documents intended for ERISA plans and is an egregious error, but certainly possible with respect to a 403(b) arrangement and equally outside of what DOL Regs. 1.2510.3-2(f) specifically permits. As to the last item, that the employer determines eligibility, there are two issues. First, since the employer has to run contributions through its payroll system it is hard to see how the employer can be uninvolved in eligibility determinations. Second, this is not likely to be an issue for 403(b) since they typically permit any employee to sign up.

There is a pretty good argument to be made that the greater specificity of DOL Regs. 1.2510.3-2(f) can be a problem as well as an opportunity. It was by no means automatic that policy holder status of the employer was a problem for welfare plans as long as the substantive rights were vested in the employee, but the solely enforceable requirement of DOL Regs. 1.2510.3-2(f) clearly precludes any minor rights being held by the employer. The requirements of DOL Regs. 1.2510.3-2(f)(3)(ii), (iii) and (vii) have no counterparts in DOL Regs. 1.2510.3-1(j), and they are in fact a more specific, and therefore less flexible in interpretation, elaboration of the sole involvement provision of DOL Regs. 1.2510.3-1(j). Given this greater specificity of DOL Regs. 1.2510.3-2(f), it is incumbent on employers to comply literally with its terms, which certainly involves more attention to detail than was paid in Gray, and to document the reasons for denying any provider access under DOL Regs. 1.2510.3-2(f)(3)(vii).

In doing so, employers need to be careful about the specific wording of DOL Regs. 1.2510.3-2(f). In particular, note the following:

• (f)(3)(i) states that the employer may permit providers to publicize their products. It does not allow any assistance from the employer of any kind.
• (f)(3)(iii) allows the employer to summarize and compile information "to facilitate review and analysis by the employees." Unless any summary or compilation is prepared by the employer (rather than an investment provider), is prepared solely at the behest of the employer or employees, covers all material issues (including fees and costs) and is written very blandly, clever lawyers will be able to find ways to attack non-plan status.
• In turning down any investment provider under (f)(3)(vii), an employer should document each of the listed factors.
• Compensation permitted under (f)(4) only covers the costs of payroll compliance, not of any other services (internal distribution, use of facilities, and the like).
• Compensation may not be paid of costs "other than reasonable compensation to cover expenses properly and actually incurred by such employer." This should cover related payroll costs and allocable overhead (rent, depreciation, etc.) but all expenses should be carefully documented.
  

Last, the differences between the two sets of regulations are clearly intended to permit the 403(b) market to operate as it always has operated. Given the statement by the IRS when it delayed final 403(b) regulations that the subject of plans not subject to ERISA was under review, it is by no means safe to assume that DOL Regs. 1.2510.3-2(f) will not be amended at the same time. And, given that the IRS and the DOL now have their sights fixed firmly on fees, changes to DOL Regs. 1.2510.3-2(f) would be a perfect place to create an obligation to discover and disclose fees in 403(b) non-plans.

Mutual Fund Fees-Some Good News

In the United States, there has been a strong, unremitting focus on mutual fund fees for decades. This focus is now being turned to retirement plan and annuity fees, and even there, the focus in 403(b) and 457 markets is more recent and much more intense. A recent study of mutual fund fees by country has some interesting implications for that focus.

The study was conducted by Ajay Khorana of the Georgia Institute of Technology, Henri Servacs of the London School of Economics, and Peter Tufano of the Harvard Business School. The result? The United States has a relatively low fee level (and, oddly, Canada has a high level). This low fee level results from several factors, including economies of scale for larger funds and fund families, better courts, higher per capita GDP, higher education levels, separation of banking and fund management industries, higher investor protection in both general stock markets and mutual fund markets and mutual fund industry maturity.

Managing a mutual fund is different from managing a retirement plan or account. Most important is that certain fees (e.g., prospectus vs. SPD or other communications) are borne once by each fund but once by each plan or account. This is the core cause of a tension between the need to pay for the work that has to be done to get tax deferral for the investments and the human desire to get that done for free. The compliance costs are real, and somebody has to pay them. This urge is the basic reason why there are separate markets for annuities and mutual funds, with annuities having a higher expense structure that is generally advantageous for smaller accounts and smaller asset totals, and mutual funds being used more often with larger plans and larger account balances.

Of course, there are other factors operating in 403(b) and 457 markets. Employers who want to say they don't have a plan leave their employees in the position of individual investors, and they tend to hear more often from annuity providers than from mutual fund providers because of the superior profitability of annuitiew at smaller scales. The fact that mutual fund providers are fairly new to the markets is another cause, because of the dominant market position of a short list of providers offering annuities that have technical competence and an interest in the market. But the underlying economics that result from having mutual funds with relatively low fee structures reinforces these market anomalies.

All in all. though, investors in the United States are fortunate. Move north to Canada, and the fees increase by something like 175%. The fact that these fees can't carry the compliance costs for tax deferral are a lot less important than this fundamental advantage.

2007 Limitations

A reminder of the 403(b) and 457 limitations for 2007.

Overall Limit--$45,000
403(b) Deferrals--$15,500
Age 50 Catch-Up--$5,000

Primary 457 Limit--$15,000
Age 50 Catch-Up--$5,000

I Says What I Means...

The Eighth Circuit allowed a reduction in disability benefits for earnings while receiving benefits in Riddell v. Unum Life Ins. Co. of America (8th Cir. 8/10/2006), and the case contains a useful lesson for any 403(b) or 457 employer.

The policy based benefits on a monthly earnings definition that excluded bonus payments. The policy also head residual/partial disability benefit provisions, under which benefits could be reduced based on "disability earnings" that were defined to take into account bonus payments. The physician receiving benefits under the policy argued that a category of payments he received was in the nature of a bonus, and that those payments should not be used to reduce disability benefits because the two definitions were internally inconsistent. Rather than just calling the argument hogwash, the court more politely pointed out that the reduction provisions always used the "disability earnings" definition and never used the first, and more generally applicable, definition of monthly earnings.

This case may seem unglamorous, but it should remind all concerned of the need to use plan documents that are decently written. In the 403(b) and 457 markets, and retirement plan markets generally, this is not always the case because the focus of drafting is on technical compliance. Try reading your plan documents; if you don't know what they mean, you should ask for an explanation or a rewrite, because the participants won't understand it either.

In 403(b) and 457 environments, there is one particularly important issue to cover, and cover clearly - ERISA/fiduciary status. As long as the funding vehicle is not a trust and the employer or plan are not subject to ERISA (church and governmental, non-plan 403(b) and top-hat 457), the non-ERISA, non-fiduciary status should be crystal clear in the plan document. If the issue might ever come up, it will help a great deal to have a document that clearly states employer/plan status and the ramifications of that status.

McKay Hochman PPA Effective Dates

McKay Hochman has an excellent list of effective dates for PPA. You can find it at:

http://www.mhco.com/Commentary/2006/PPA_Effective_Date_083106.htm

PPA Part 2-Qualified Default Investment Alternatives

If you are concerned only about non-ERISA plans and arrangements, you can stop reading here if you want. Otherwise, you have to learn another acronym, QDIA, for Qualified Default Investment Alternatives.

Once again, the Department of Labor has chosen to make a directed investments rule too complex. This time, it is the QDIA.

Section 624 of the Pension Protection Act amended ERISA 404(c) to create the QDIA concept and required that the Department of Labor issue regulations defining a QDIA by 2/1/2007. The DOL has now issued proposed regulations.

The function of a QDIA is to solve a problem created in the overly complex existing ERISA 404(c) regulations. The protection from fiduciary duties under ERISA 404(c) applies only "if a participant or beneficiary exercises control over the assets in his account (as determined under regulations of the Secretary)". It seems clear that the parenthetical clause would have allowed a decision not to exercise after notice to be treated as an exercise, but the DOL did not do so. This meant that all the participants who got notice and did nothing were not subject to ERISA 404(c) and left the question of what to do with their accounts.

The answer seemed pretty clear, invest it how you would invest the plan that did not have a directed investments provision-de facto meaning invest it in a balanced portfolio. However, many plan sponsors decided that putting the money in a stable value or money market investment would reduce their actual risk because the participants' accounts would never show losses. And, given how people normally behave, it may have been the safest answer.

Theoretically, there were three ways to resolve this issue. The first alternative, and the cleanest, easiest one, would have been for the DOL to issue Regulations modifying the 404(c) regulations to treat inactivity after notice as an exercise of control. The second alternative was for the DOL to say that the funds had to be invested in an investment that would be appropriate for the plan as a whole, which would have in effect mandated a balanced fund in each plan. The third, and worst, option was the creation of the QDIA, because its enactment and definition have been an occasion to increase the administrative burdens on plans.

The QDIA rules have two parts. One defines the sort of investments that can be a QDIA. This part is not too complex for a 403(b) plan or arrangement. Essentially, the investment has to (1) be a mutual fund or managed by an investment manager under ERISA 3(38), and (2) be (a) a target retirement date or lifestyle fund, (b) a balanced fund, or (c) a fund managed by an investment manager taking into account, individually, the participant's age, target retirement date and life expectancy. The choice between the first and second types of mutual funds is easy, based on what funds are available and how many funds the plan wants to offer (a general balanced fund being one fund and an array of lifestyle funds being more than one). The managed fund option is a viable option only if you can find an investment manager willing to look at all the small (since those with large accounts will likely make their own decisions) accounts in the plan and take responsibility for them. My opinion has always been that every plan should have a sound, well-managed balanced fund, so my general recommendation would likely be to use that as the default investment before or after the QDIA rules become effective.

The second part of the QDIA rules is procedural, and more complex and burdensome than it needs to be. First, and pretty obvious, is that there should not be too many barriers to moving out of the QDIA; specifically, transfers out must be allowed at least quarterly and must not cost the participant more money. Second, the participant must be given an opportunity to direct investments-this will never be an issue because the QDIA rules only apply where a participant with the right to direct investments doesn't. Third, the participant has to be given a notice at least 30 days before amounts are invested in the QDIA and 30 days before each plan year; this is duplicative of the normal notices given in plans with directed investments and plans using a 401(k) safe harbor and the requirements can be met by extending the coverage of existing notices.

Fourth, the plan document must require that the plan, and the plan must in fact, send to the participant all material received by the plan relating to the QDIA or a participant's investment in the QDIA, presumably within a reasonable time. This one is potentially a problem, because of the vagueness of the word "material." All we know is that it includes account statements, any prospectus and voting proxy materials; we do not know if it includes e-mails from brokers, periodic reports by TPAs, Morningstar or other similar items, or even the contents of phone calls (unless we assume that the received "material" has to be material). You can safely bet that lawyers will be asking, sooner or later, for everything anybody involved with the plan receives from anybody any time. This requirement is not contained in the PPA, and so the ambiguity is a gratuitous part of a gratuitous requirement. In addition, since the IRS takes the position that failure to administer a plan in compliance with its terms is a qualification issue, it has the effect of adding the IRS as an enforcer of fiduciary duties in this context.

The last requirement is that the plan offer investments, including the QDIA, which meet the requirements of ERISA 404(c). Since QDIA status only matters as a fix to a hole in the 404(c) regulations, this is wholly unnecessary.

PPA Changes Affecting 403(b) and 457

The PPA made too many changes affecting 403(b) and 457 to cover in one post. This blog will, instead, cover them essentially one at a time, to allow for context and comments. This is the first such post.

The most important thing the Pension Protection Act did was to make permanent the changes in the law passed by EGTRRA. Just as a reminder, these are (as described in the PPA Blue Book and as having relevance to 403(b) or 457):

Individual retirement arrangements (“IRAs”)

• Increases in the IRA contribution limits, including the ability to make catch-up contributions (secs. 219, 408, and 408A of the Code and sec. 601 of EGTRRA); and

• Rules relating to deemed IRAs under employer plans (sec. 408(q) of the Code and sec. 602 of EGTRRA).

Expanding coverage

• Increases in the limits on contributions, benefits, and compensation under qualified retirement plans, tax-sheltered annuities, and eligible deferred compensation plans (secs. 401(a)(17), 402(g), 408(p), 414(v), 415, and 457 of the Code and sec. 611 of EGTRRA);

• Modification of the top-heavy rules (sec. 416 of the Code and sec. 613 of EGTRRA);

• Repeal of coordination requirements for deferred compensation plans of state and local governments and tax-exempt organizations (sec. 457 of the Code and sec. 615of EGTRRA);

• Option to treat elective deferrals as after-tax Roth contributions (sec. 402A of the Code and sec. 617 of EGTRRA);

and

• Certain nonresident aliens excluded in applying minimum coverage requirements (secs. 410(b)(3) and 861(a)(3) of the Code).

Enhancing fairness

• Catch-up contributions for individuals age 50 and older (sec. 414 of the Code and sec. 631 of EGTRRA);

• Equitable treatment for contributions of employees to defined contribution plans (secs. 403(b), 415, and 457 of the Code and sec. 632 of EGTRRA);

• Faster vesting of employer matching contributions (sec. 411 of the Code and sec. 633 of EGTRRA);

• Modifications to minimum distribution rules (sec. 401(a)(9) of the Code and sec. 634 of EGTRRA);

• Clarification of tax treatment of division of section 457 plan benefits upon divorce (secs. 414(p) and 457 of the Code and sec. 635 of EGTRRA);

• Provisions relating to hardship withdrawals (secs. 401(k) and 402 of the Code and sec. 636 of EGTRRA); and

Increasing portability

• Rollovers of retirement plan and IRA distributions (secs. 401, 402, 403(b), 408, 457, and 3405 of the Code and secs. 641-644 of EGTRRA);

• Treatment of forms of distribution (sec. 411(d)(6) of the Code and sec. 645 of EGTRRA);

• Rationalization of restrictions on distributions (secs. 401(k), 403(b), and 457 of the Code and sec. 646 of EGTRRA):

• Purchase of service credit under governmental pension plans (secs. 403(b) and 457 of the Code and sec. 647 of EGTRRA):

• Employers may disregard rollovers for purposes of cash-out rules (sec. 411(a)(11) of the Code and sec. 648 of EGTRRA); and

• Minimum distribution and inclusion requirements for section 457 plans (sec. 457 of the Code and sec. 649 of EGTRRA).

Strengthening pension security and enforcement

• Automatic rollovers of certain mandatory distributions (secs. 401(a)(31) and 402(f)(1) of the Code and sec. 657 of EGTRRA);

Reducing regulatory burdens

• Repeal transition rule relating to certain highly compensated employees (sec. 663 of EGTRRA);

• Treatment of employees of tax-exempt entities for purposes of nondiscrimination rules (secs. 410, 401(k), and 401(m) of the Code and sec. 664 of EGTRRA);

• Treatment of employer-provided retirement advice (sec. 132 of the Code and sec. 665 of EGTRRA).

Lest we forget, the failure to repeal these changes would have set back progress in 403(b) service markets dramatically. The effect of the changes was to make 403(b) more like 401(k), but with some nice special rules. Before, simple tasks like determining maximum contributions, was a nightmare and very few providers could handle them, which caused most TPAs to avoid 403(b) like the plague. Now, in essence, you can run a 403(b) like a 401(k), and only look at the differences if there is a problem (e.g., ADP test, annual limits, 402(g) deferral limits). This is opening up new providers to 403(b) employers and should serve to increase quality and service levels while decreasing price for all 403(b) plans or arrangements. At Benefit Plan Solutions, we are seeing a steady increase in activity helping 401(k) providers move into a new market with very soft competition.

Delay in Effective Date for Regulations Under Section 403(b)

From the IRS:

WASHINGTON —The Internal Revenue Service announced today that the general effective date for the regulations regarding section 403(b) arrangements that were proposed in 2004 (including the related controlled group regulations under section 414(c)) will be extended.

In order to provide employers, employees, insurance carriers, and mutual funds involved in section 403(b) arrangements a reasonable advance period before the regulations go into effect, the final regulations generally will not be effective earlier than January 1, 2008.

Effects of Expense Subsidies

Jeb Graham CEBS, CIMA® of CapTrust Financial Advisors has written an excellent article at 401khelpcenter.com on plan fees. The article can be read at:

http://www.401khelpcenter.com/401k/graham_stable_value.html

Preliminarily, he focuses on stable value fund economics. Stable value fund is such a loose term that different stable value funds may be invested in different asset types and may have different expense structures. Expenses may not even be fixed in amount or by a formula.

The more essential point made by Mr. Graham is that fees that are not disclosed, but are instead applied to reduce the expenses of plan administration through, e.g., sub-TA fees, are inevitably allocated unfairly.

For example, suppose two employees invest the same amounts in different funds, and one has an expense total of $100 while the other has an expense total of $200. Because the extra expense of $100 reduces the second participant's income, the plan and that participant are bearing that cost, which may or may not be reasonable. If the extra $100 is, instead, paid to the plan’s TPA, then (a) the extra is clearly not needed by the investment provider to operate the investment, (b) the use of the extra money to reduce plan administration is needed to restore fairness to the plan, and (c) the second participant, by selecting the more expensive investment, is subsidizing the operations of the plan.

If the plan’s sponsor would otherwise pay the extra $100, because the sponsor pays the plan administration fees, then there is an indirect benefit to the sponsor of $100. This may constitute a prohibited transaction under §4975 of ERISA §406, although since the effect is to pay for plan administration, and plans are allowed to defray administration expenses, it should not be a prohibited transaction, or at least not a violation of the exclusive benefit rule.

If the plan receives a subsidy from the investment provider and uses it to reduce total plan administration expenses paid by the plan, then the plan as a whole is treated fairly but there is, in effect, a subsidy of the first participant who invested in the lower-expense investment by the second participant who bore higher expenses that now reduce everyone else’s costs.

To eliminate the subsidy from one set of participants to another, the plan would have to apply the subsidy it receives to reduce the expenses only of those participants who invested in the higher-expense investment.

But look at the result of doing so. If the participant bears the higher expense through reduced investment yield, then gets it back through an expense reduction, the whole exercise is pointless. That is, the investment provide‚’s setting up of the arrangement only makes sense if it is not returned to the participant who bears the expense.

The only reason to jump through the hoops needed to create the arrangement is to use the money to influence the behavior of the plan or its advisers in the fund selection process. (To encourage use of the investment by participants, the best approach would be to eliminate the extra fee and have a higher product yield.) If the subsidy is created to encourage sales outside of employee benefit plans, and a full rebate is made, the arrangement may be defensible, although the plan needs to know about the subsidy to decide if it should be specially allocated. Otherwise, defending such an arrangement cannot be much fun.

What's Not a Top-Hat Plan

A thank you to PlanSponsor for finding Guiragoss v. Khoury, E.D. Va., No. 1:06vy187, 8/10/06, a case determining that a plan was not a top-hat plan exempt from ERISA. Unfortunately, the case is not all that useful, as is true of most cases on top-hat plan status. At least it makes clear one way to screw up top-hat status.

The plaintiff and sole participant was a clerk for the employer jewelry store, so the result is hardly surprising. Some of the language is troubling, saying "Guiragoss had no influence on the terms of the agreement and never consulted with an attorney prior to signing the agreement." Both of these statements are true of most top-hat plan participants, which is why the language is troubling. With any luck, and because this is a District Court decision, future courts will ignore that language and focus instead on the participants'' bargaining power, or lack thereof, rather than whether there was any actual bargaining.

A Reminder About Moral Hazard

There is an interesting post at http://www.bostonerisalaw.com/, the blog of Steven D. Rosenberg of the McCormack Firm in Boston relevant to reviews of claims decisions by benefit plan administrators. Those of us who do not subscribe should thank Mr. Rosenberg.

The post refers to a New York Times article that says, essentially, that some people who receive disability benefits don't go back to work when they could. No professional who has worked with plans that offer disability benefits, including LTD, STD, subsididized disability benefits under defined benefit plans or vesting up defined contribution account balances on disability, is surprised by this statement. Nor is any worker's compensation lawyer on either side. All one really has to do is notice (1) that the word "lie" exists and is frequently used, and (2) the statement that "Money is the root of all evil."

A disproportionate number of cases on reveiw standards under ERISA relate to subjective, non-verifiable symptoms, and particularly reported pain. Insurance companies are used to people who lie, but many of the cases appear to we cynics to, in essence, find some reason to reduce the deference given to the plan administrator, ignore the possibility that the, e.g., reviewing physician simply thought the claimant was lying, and take the claimant's word.

The response to this is (1) to be explicit when credibility affects a decision, and (2) to use experts and/or research to remind the court that the concept of moral hazard has always been a core component of insurance economics, not a novel way of arguing for deference to plan administrators under ERISA.

Exclusion Under §§401(k) and (m) for §403(b) Participants

The IRS on Friday issued regulations on the relationship between §§403(b) and 401(k)/(m). The regulations change was to the §410(b) definition of excludible employees, and although it technically affects only the related §401(k)/(m) plans, it clearly affects both the design and the operation of §403(b) plans and arrangements.

The change was originated by §664 of EGTRRA, which says the following:

“SEC. 664. EMPLOYEES OF TAX-EXEMPT ENTITIES.

(a) In General.--The Secretary of the Treasury shall modify Treasury Regulations section 1.410(b)-6(g) to provide that employees of an organization described in section 403(b)(1)(A)(i) of the Internal Revenue Code of 1986 who are eligible to make contributions under section 403(b) of such Code pursuant to a salary reduction agreement may be treated as excludable with respect to a plan under section 401(k) or (m) of such Code that is provided under the same general arrangement as a plan under such section 401(k), if (1) no employee of an organization described in section 403(b)(1)(A)(i) of such Code is eligible to participate in such section 401(k) plan or section 401(m) plan; and (2) 95 percent of the employees who are not employees of an organization described in section 403(b)(1)(A)(i) of such Code are eligible to participate in such plan under such section 401(k) or (m).

(b) Effective Date.--The modification required by subsection (a) shall apply as of the same date set forth in section 1426(b) of the Small Business Job Protection Act of 1996.”

A few key points here before looking at the regulation. First, it applies only to employees of §403(b)()(A)(i) organizations, not to public education employees described in §403(N)(1)(A)(ii). Second, it excludes them from §401(m) testing under the qualified plan (“the same general arrangement” acts to differentiate the qualified plan form the §403(b) arrangement, including any component subject to §401(m) testing). Second, the employees include all eligible to make deferrals into the §403(b), not just those making them. Third, there cannot be any employees of any §501(c)(3) organizations in the qualified plan. Last, 95% of the employees who are not employed by §501(c)(3) organizations have to be eligible to make deferrals into the qualified plan; the statue simply does not address whether statutory exclusions or the excludible employee definitions apply under the 95% requirement.

Now to the Final Regulations:

“Sec. 1.410(b)-6 Excludable employees.

(g) Employees of certain governmental or tax-exempt entities (1) Plans covered. For purposes of testing either a section 401(k) plan, or a section 401(m) plan that is provided under the same general arrangement as a section 401(k) plan, an employer may treat as excludable those employees described in paragraphs (g)(2) and (3) of this section.

(2) Employees of governmental entities. Employees of governmental entities who are precluded from being eligible employees under a section 401(k) plan by reason of section 401(k)(4)(B)(ii) may be treated as excludable employees if more than 95 percent of the employees of the employer who are not precluded from being eligible employees by reason of section 401(k)(4)(B)(ii) benefit under the plan for the year.

(3) Employees of tax-exempt entities. Employees of an organization described in section 403(b)(1)(A)(i) who are eligible to make salary reduction contributions under section 403(b) may be treated as excludable with respect to a section 401(k) plan, or a section 401(m) plan that is provided under the same general arrangement as a section 401(k) plan, if (i) No employee of an organization described in section 403(b)(1)(A)(i) is eligible to participate in such section 401(k) plan or section 401(m) plan; and (ii) At least 95 percent of the employees who are neither employees of an organization described in section 403(b)(1)(A)(i) nor employees of a governmental entity who are precluded from being eligible employees under a section 401(k) plan by reason of section 401(k)(4)(B)(ii) are eligible to participate in such section 401(k) plan or section 401(m) plan.”

The most obvious change is the addition of an exclusion for employees of governmental employers that cannot offer §401(k) plans. While not mandated by EGTRRA §664, this is a reasonable measure. I would argue that given the absolute inability of the §401(k)(4)(B)(ii) employer to participate maintain a §401(k) plan, the 95% coverage requirement is not appropriate here. In addition, note that subsection (2) does not explicitly exclude employees of §501(c)(3) employers at all.

Subsection (3) is, at first glance, simply parallel to subsection (2). However, note that in applying the 95% test under subsection (3), employees of governmental employers that cannot maintain §401(k) plans at all are excluded. This means that, in a very rare occurrence, the rules for nongovernmental employers are more liberal than those for governmental employers because subsection (2) does not allow exclusion of employees of charities excluded under subsection (3).

Last, there is a very problematic paragraph in the preamble, as follows: “Commentators asked whether employees of a tax-exempt organization described in section 501(c)(3) who would be eligible to make salary reduction contributions under a section 403(b) plan but for the exclusions permitted under section 403(b)(12), such as nonresident aliens and employees who normally work less than 20 hours per week, are taken into account as employees who are eligible to make salary reduction contributions for purposes of these regulations. These regulations provide that such employees are not taken into account unless they are actually eligible to make salary reduction contributions to the section 403(b) plan.” (Let’s set aside for the moment how regulation by legislative history, special provision not reflected in the Code and preambles makes for the sort of sloppiness evident here and makes the job of running plan too exciting.) This makes it that much harder for these employees to be excluded in testing the qualified plan; although at the least the §401(k) plan does not need to rewrite its entire set of exclusions to reflect both §§401(k) and 403(b) exclusions, it may mean that the calculations have to be done manually to apply §401(k) exclusions to the entire employee population minus the number of persons actually eligible within that non-excludible population.

More broadly, the paragraph in the preamble gives no hint on the application of statutory exclusions generally under the two 95% rules. Do the pre-ERISA rules apply to employees of governmental employers ineligible to maintain plans? Do the §410(b) rules for excludible employees, aggregation or disaggregation apply? And, if they do, under which plans? Governmental? ERISA? Section 403(b)? One analysis would say that these issues should be handled in parallel to the treatment of §403(b) exclusions (i.e., ignored). The second analysis would be that the IRS could have said that, so that in applying qualified plan exclusions §410(b) applies in all its glorious complexity, and by analogy to governmental plans with appropriate modifications. I, for one, have no idea which approach to use, and am hoping others will have some ideas.

Delay in 403(b) Regulations

The final 403(b) regulations are being postponed, probably until the Fall of this year. This means that they simply cannot be effective for 2007, which is a good thing. Employers can now take some time to absorb their implications and to adopt a more intelligent approach than simply calling their providers for advice.

With the increasing emphasis on fees (DOL refers to them as Enroning plans, which is not a good analogy, but is a good indicator of attitude ) and behind-the-scenes payments (see the article dated June 20th), there is likely to be a real shakeout in a market based in large part on high fees being used to make payments for endorsements.

I'm not sure I would want to handle that issue and the final regulations all at once, but may will end up doing exactly that. In any event, employers are going to have to start asking questions about fee levels and hidden payments, and this column will focus on how to do that over the next few posts. And, any employer needs to start asking now about how providers will handle issues like:

-How will the written plan document requirement be handled?
-Does a written plan always make the employer a fiduciary? If not, how not?
-How will the provided handle overall limitations when there are multiple products in place or being phased out?
-What are all of the fees and costs between employees and the ultimate investments?
-Are there funds moving around behind the scenes? If so, who is paying, who is receiving, how much are the payments and what are they for?

This is, in fact, a harder issue for plans and arrangements not subject to ERISA, for various reasons. The next entry here will cover them in more detail, but the essence is that ERISA preempts a whole host of state laws that can be applied to money moving around from place to place. Just ask the Enron and MCI/WorldCom executives, and imagine 50 state attorneys general jumping on the bandwagon with Elliott Spitzer.

Whoops! MarshMac Bites Again

This is self-explanatory. It's almost incredible to people who deal with 401(k) plans that anyobody would get a 2.85% wrap fee, and even more astounding that the NYSUT got $3,000,000 for endorsing it. It will be interesting to see the results of the class action suit that should follow.

The lesson here is that the Marsh & McClennan case sets a paradigm for dealing with all the sub-TA fees, incentives, referral fees and all other non-disclosed fees. They will, from here on out, be characterized as kickbacks and bribes paid directly with money from the pockets of participants. It is hard to imagine how a payor or payee can avoid liability, or how an employer or a fiduciary can say they have met their burden all unless of this is disclosed. And, worst of all, this is not limited to ERISA plans, since the claim can be framed as state-law fraud.

More later on this topic.

"NYSUT’S MEMBERS BENEFITS UNIT SETTLES PROBE

Settlement is Part of Ongoing Investigation of Retirement Products

Attorney General Eliot Spitzer today announced an agreement to resolve an investigation of the marketing of retirement products to members of the state’s largest teachers’ union.

Under the agreement, an arm of the New York State United Teachers (NYSUT) will adopt a series of reforms and pay $100,000 to the state to cover costs of the investigation.

The agreement follows a lengthy probe revealing that NYSUT’s Member Benefits unit accepted payments from an insurance company to promote the company’s retirement products to NYSUT members. The unit did not disclose this arrangement and, instead, took steps to conceal it.

"A simple rule that my office has enforced time and time again is that fiduciaries must place the interests of their clients first," Spitzer said. "Accordingly, an office set up to counsel union members on retirement alternatives should always provide objective advice and full disclosure of relevant facts. That did not happen in this instance. But as result of this agreement, reforms have been adopted to ensure that this standard will be met in the future."

The investigation revealed that a retirement product endorsed by the unit – a so-called 403(b) plan offered by the Dutch insurance giant ING and its predecessor, Aetna Life Insurance and Annuity Company– charged investors fees and expenses as high as 2.85 percent per year while delivering only limited benefits. The unit endorsed the plan (even though cheaper alternatives were available) in return for undisclosed payments of as much as $3 million per year.

The unit took pains to hide this "silent partnership" with ING/Aetna. The unit would urge union members to attend financial planning seminars, claiming that: "There’s no sales pitch - they [the seminars] do not promote specific products or services." But contrary to this claim, the seminars were used as a "foot in the door" to promote ING/Aetna retirement products.

In addition, the unit redirected calls it received arising from the retirement seminars to ING/Aetna employees, who answered the phones with their first names only. Callers thought they were talking to NYSUT benefits unit personnel when in fact they were talking to the insurance company’s marketing representatives.

In late 2004, after it became aware of the Attorney General’s investigation of insurance and retirement products, the unit drafted a new disclosure policy, which was described by officials in an internal e-mail as moving from a "try to hid[e] it" approach to a more open approach that included disclosing all payments from ING.

Under today’s agreement, the unit agrees to the following:

* Conduct open bidding for future retirement plan endorsements;

* Provide full disclosure of any and all payments from insurance companies;

* Allow members an opportunity to roll over savings to a new endorsed plan at no cost;

* Provide free and objective investment advice to members; and

* Hire an independent consultant to oversee reforms and report to the Attorney General’s office.

More than 50,000 New York teachers and other school district employees bought into the retirement plan without having been told by the unit of the payments it received from ING/Aetna.

The investigation underlying today’s settlement was conducted by Assistant Attorneys General Peter Dean and Harriet Rosen, under the direction of David D. Brown IV, Chief of the Attorney General’s Investment Protection Bureau.

A broad investigation of the marketing of retirement products continues."

For more detail, see the following:
http://www.oag.state.ny.us/press/2006/jun/NYSUT%20AOD.pdf
http://www.oag.state.ny.us/press/2006/jun/NYSUT%20Member%20Benefits_Exhibits.pdf

A Tale of Two Funds

Before reading the actual decision in Jenkins v. Yager & Mid America Motorworks, Inc., No. 04-4258 (7th Cir. April 16, 2006), I thought it was an unmixed positive case. Write-ups came to the conclusion like "the Seventh Circuit affirmed the decision in favor of the plan trustee." On actually reading the case, it turns out that this is not quite true. In a nutshell, the plan, which looks like a National Auto Dealers Association plan, had a profit sharing feature without directed investments and a 401(k) feature with directed investments. The decision affirmed dismissal with respect to the directed investment portion of the plan and remanded for trial on the undirected profit sharing portion.

As to the directed investment portion, the court found that ERISA 404(c) was not the only route to avoiding fiduciary claims where participants can control their own accounts. To do this, the court felt it had to find an "implied exception", which certainly doesn't jump off the page, in ERISA 403(a). However, the fundamental logic, which is that (1) if ERISA 404(c) is a safe harbor, there should be other ways that aren't as safe, and (2) the DOL Regulations specifically contemplate other routes to compliance. (See DOL Regs. 2550.404c-1(a)(2): "The standards set forth in this section are applicable solely for the purpose of determining whether a plan is an ERISA section 404(c) plan and whether a particular transaction engaged in by a participant or beneficiary of such plan is afforded relief by 404(c). Such standards, therefore, are not intended to be applied in determining whether, or to what extent, a plan which does not meet the requirements for an ERISA Section 404(c) plan or a fiduciary with respect to such a plan satisfies the fiduciary responsibility or other provisions of Title I of the Act." The real meat of the decision on this point, however, is in the recitation of how conservative the funds were, the extensive conversation with a Raymond James RIA, the ready availability to employees of investment-related materials, and the fact that the sponsor had annual meetings with employees at which the RIA made a presentation. Given that record of attention and thoroughness, the court reasonably concluded that there was no breach of duties.

So far, so good. At this point, it looks like the case is an example of what I have always called the "I have always relied on the kindness of strangers" defense. It certainly stands for the notion that if you are intelligent and attentive, and hire the right advisers, you can forget about some of the ticky-tacky stuff in the DOL regulations (e.g., statement that the plan is intended to qualify under ERISA 404(c), name address and phone number of plan fiduciary, arguably the prospectus for the investments where ordinary investors don't read it (which is pretty much every prospectus for every investment a plan would even think about making available), voting rights materials (again, where real folks don't look at them), minimum quarterly investment direction), and the standards for the array of investments and their relationships). It also makes no distinction between participants who have acted on their choices and those who have not. If there are employer securities involved, it is probably a good idea to jump through all the hoops for ERISA 404(c) compliance, because employer securities make courts justifiably nervous.

The profit sharing portion of the plan presented a very different picture. The court started citing the employer's deposition, which contained a lot of I dunno answers. The same funds were used as investments, but the employer couldn't answer questions about the mix initially set up, changes to the mix or rebalancing. The Seventh Circuit remanded for further proceedings as to the profit sharing fund.

This means two things. First, I am going to have to start distinguishing between defenses that permit or require real reliance ("I have always relied..."), such as penalty cases under the Code, and fiduciary reliance on advisers, which should be described as "I have always listened to the advice of strangers and made my own informed decisions." (Since the second one is not very snappy, I'll probably have to come up with two brand new names.) Second, always get your advisers to cover all the bases for you.

If, because the exciting issues were under the directed investment part of the plan, both parties' lawyers paid less attention to the profit sharing fund, Defendant's lawyers will probably try to get better answers from the Raymond James RIA. Then, whether they can get those better results will likely determine the outcome of the case.

One last note. Somehow or other, the DOL has decided it disagrees with the decision. It's hard to reconcile that with the language for DOL Regs. 2550.404c-1(a)(2) cited above I have no idea. Given the content of the regulations cited and the fact that thus decision is now on the books, it would seem to be too late for DOL to close this particular barn door.

Final 403(b) Regulations for 2007?

The IRS announced last week that final 403(b) regulations will be issued this month and that they will be effective for 2006.

I am willing to take the IRS at its word as to issuance, although they could be delayed a month or two. The second element, making them effective for 2007, is more problematic. For starters, the 403(b) industry is not exactly designed for efficiency. Second, both charities and governments have more cumbersome processes for taking "corporate" action. Third, lots of employers (e.g., school districts) have an array of 403(b) products from different vendors and will be getting different advice from each. Fourth, six months isn't much time anyway. Last, effective dates seem to be pushed back infinitely for governmental employers. Employers should move as quickly as possible, but the regulations will probably not go into effect until 2007.

Reports say that some providers are charging on the order of $3000 to help meet the written plan document requirement. We are hoping that our solution, which is quick, efficient, written to avoid fiduciary status and a lot less money will become popular. Employers need to be very careful about not volunteering for a fiduciary status that they do not have to assume.

I am looking forward to the 414 part of the final regulations. The IRS operates under way too many different standards for nonprofit/governmental employers. These included 414 (which appears to require an 80% board control), 415 (50% board control by the employee), the church plan and governmental plan standards in 414 and ERISA, the requirements for getting a group determination letter of tax-exempt status and the operated, supervised or controlled by or in connection with standard for determining private foundation status. It would be far preferable if one set of standards were used, even if that requires legislation. Wherever the line is drawn, a lot of analysis and hard decisions will need to be made, as multiple 415 limitations disappear or appear, as plan become or cease being multiple employer plans, among other possible effects. Any line is better than no line, so that at least people know what to do, but one line would be preferable.

Should be exciting, at least. And maybe this will help trigger the professionalism and efficiency improvements that 403(b) markets need so much.

What's a Top-Hat Plan?

There are two basic ways a court can end up deciding whther a plan is a top-hat plan or not. The first is to decide under ERISA exemption provisions, and the second is in a claim for benefits where the sponsor is bankrupt. In In re IT Group, Inc., 2006 WL 1421016 (3rd Cir. 2006), the Third Ciruit got one of the latter. The case not only looks at top-hat status, but also clearly pijnts out the downside of being "unfunded".

The claimants were participants who alleged that the plan required the establishment of rabbi trust, with all the customary disclaimers in the plan and the trust agreement. The decision also assumed that the plan was for a select group of management and highly compensated employees. so that funding was the only real issue.

The court decided that this was a case of first impression. Footnote 3 says "In previous cases involving deferred compensation plans offered to management and highly compensated employees, we have always assumed, without further examination, that ERISA’s “top hat” exemption applies. See, e.g., Goldstein v. Johnson & Johnson, 251 F.3d 433, 435 (3d Cir. 2001) (considering the proper scope of judicial review of an administrator’s decision to deny benefits owed under a top hat plan); Senior Executive Benefit Plan Participants v. New Valley Corp. (In re New Valley Corp.), 89 F.3d 143, 148 (3d Cir. 1996) (“Both plans at issue are top hat plans . . . .”); Kemmerer v. ICI Americas Inc., 70 F.3d 281, 284 (3d Cir. 1995) (“The dispute on appeal centers around [an] executive deferred compensation plan, which like all such plans is commonly referred to as a ‘top hat’ plan.”)."

However , they still manage to cite other decisions on unfunded welfare plan status, as follows: The Eighth Circuit Court of Appeals has examined this issue from both sides. In considering whether a death benefit plan supported by a life insurance policy was subject to ERISA’s substantive requirements, it stated that “[f]unding implies the existence of a res separate from the ordinary assets of the corporation.” Dependahl v. Falstaff Brewing Corp., 653 F.2d 1208, 1214 (8th Cir. 1981). The plan was “funded” because the insurance policy provided “a res separate from the corporation” to which beneficiaries could look for payment of benefits under the plan. Id. On the other hand, an excess benefit plan that specified that the rights of the beneficiary under the plan would “be solely those of an unsecured creditor” was unfunded, even though the employer had purchased an insurance policy to help it finance the plan, because the policy in that case “simply became a general, unpledged, unrestricted asset of the [employer] and those . . . assets in turn would be used to fund [the] plan.” Belsky v. First Nat’l Life Ins. Co., 818 F.2d 661, 663-64 (8th Cir. 1987). Similarly, the Second Circuit Court of Appeals has observed that a plan under which benefits were to be paid “‘solely from the general assets of the employer’” is unfunded. Demery v. Extebank Deferred Compensation Plan, 216 F.3d 283, 287 (2d Cir. 2000) (quoting Gallione v. 17 Flaherty, 70 F.3d 724, 725 (2d Cir. 1995)). More recently, it adopted a standard first articulated in Miller v. Heller, 915 F. Supp. 651 (S.D.N.Y. 1996):
the question a court must ask in determining whether a plan is unfunded is: can the beneficiary establish, through the plan documents, a legal right any greater than that of an unsecured creditor to a specific set of funds from which the employer is, under the terms of the plan, obligated to pay the deferred compensation?” Demery, 216 F.3d at 287 (quoting Miller, 915 F. Supp. at 660). Applying this test, the court found that a deferred compensation plan that was financed using life insurance contracts, the proceeds of which were kept in a separate account, was unfunded. According to the court, the plan’s terms did not “give plaintiffs a greater legal right to the funds in the Deferred Compensation Liability Account than that possessed by an unsecured creditor.” Id. Although the account was separate, it was part of the “general assets” of the corporation, and the plan was therefore “unfunded as a matter of law.” Id. The Fifth Circuit Court of Appeals employed a similar analysis, but also considered the tax treatment of the plan. In Reliable Home Health Care, Inc. v. Union Central Insurance Co., 295 F.3d 505 (5th Cir. 2002), it surveyed the decisions of the other courts of appeals, and noted that the Department of Labor had provided the following guidance: “‘[A]ny determination of the ‘unfunded’ status of an ‘excess benefit’ or ‘top hat’ plan of deferred compensation requires an
examination of the facts and circumstances, including the status of the plan under non-ERISA law.’” Id. at 513 (quoting Dep’t of Labor, Pension & Welfare Benefit Programs, Op. Ltr. 92-13A, 1992 ERISA LEXIS 14, at *7 (May 19, 1992)). More specifically, the court emphasized DOL’s advice that the tax consequences of the plan should be considered in the analysis, id. (citing DOL Op. Ltr. 92-13A, 1992 ERISA LEXIS 14, at *7), and noted a district court’s holding that “a ‘plan is more likely than not to be regarded as unfunded if the beneficiaries under the plan do not incur tax liability during the year that the contributions to the plan are made,’” id. at 514 (quoting Miller, 915 F. Supp. at 659). Combining all of this information, the court devised the following test: in determining whether a plan is “funded” or “unfunded” under ERISA, a court must first look to the surrounding facts and circumstances, including the status of the plan under non-ERISA law. Second, a court should identify whether a [plan] is funded by a res separate from the general assets of the company. Id. 4As noted above, a plan under which the beneficiaries do not incur tax liability during the year that the contributions to the plan are made is “more likely than not” an “unfunded” plan. Miller v. Heller, 915 F. Supp. 651, 659 (S.D.N.Y. 1996). This is so because the tests for taxation of deferred compensation and for funding status ovelap–deferred compensation is not taxable as current income only where the future payment of the compensation is somehow uncertain, i.e., where the assets used The Reliable court concluded, under this test, that a death benefit plan was unfunded. Like the plans at issue in Demery and Belsky, the plan was financed through the purchase of life insurance contracts on behalf of participating employees. However, those contracts belonged to the company, not the participating employees. Plan participants were prohibited from contributing to the plan, and did not treat the company’s contributions to the plan on their behalf as taxable income. Thus, the plan was unfunded and exempt from ERISA’s substantive provisions. Id. at 514-15. We agree with our fellow courts of appeals that the keys to the determination of whether a plan is “funded” or “unfunded” under ERISA are (1) whether beneficiaries of the plan can look to a res separate from the general assets of the corporation to satisfy their claims; (2) whether beneficiaries of the plan have a legal right greater than that of general, unsecured creditors to the assets of the corporation or to some specific subset of corporate assets. We may also consider the plan’s intended and actual tax treatment. We will analyze the to pay participants’ claims are also subject to other creditors’ claims. Thus, the fact that a plan qualifies for deferred taxtreatment strongly supports the conclusion that it was unfunded.
See Dep’t of Labor, Pension & Welfare Benefit Programs, Op. Ltr. 92-13A, 1992 ERISA LEXIS 14, at *7 (May 19, 1992) (noting that “the tax consequences to trust beneficiaries should be accorded significant weight” in determining whether a plan is “funded” or “unfunded”)."

Th Court then determined (1) that the plan was a top-hat plan, (2) that the employees were not entitled to a priority claim in the bakruptcy, and (3) that no one involved with the plan had breached any fiduciary duties.

This decision is not overwhelmingly important for Sections 403(b) and 457, certainly not as important as an effort to determine what constitutes a select group. Nonetheless, it points out the fact that some legalese has a purpose, and shows what language needs to be included in nongovernmental Section 457 plans.