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.