Broker Fiduciary Liability

The 401khelpcenter.com has written up a new Federal District Court case at:

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

The case involved and Edward Jones broker who helped the plan create asset allocation models. The Court found that he and Edward Jones were fiduciaries. The employer had borrowed money from the plan, booked them as "employer receivables" and then filed for bankruptcy. The broker was charged with the responsibility to question the increasing employer receivables number.

Common Remitter Functions under the Final 403(b) Regs. and FAB 2007-02

We finally have what we need to determine employer responsibilities under §403(b) and how those responsibilities have to be allocated to maintain ERISA exemption in the absence on governmental or church plan status. And it looks like all employer trying to use the special 403(b) exemption are going to have to hire somebody to provide compliance services, including payroll processing in a common remitter function.

Let’s start with the language of the exemption at DOL Regs. §2510.3-2(f):

“(f) Tax sheltered annuities. For the purpose of title I of the Act and this chapter, a program for the purchase of an annuity contract or the establishment of a custodial account described in section 403(b) of the Internal Revenue Code of 1954 (the Code), pursuant to salary reduction agreements or agreements to forego an increase in salary, which meets the requirements of 26 CFR 1.403(b)-1(b)(3) shall not be ``established or maintained by an employer'' as that phrase is used in the definition of the terms ``employee pension benefit plan'' and ``pension plan'' if

(1) Participation is completely voluntary for employees;

(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.”

The current concerns of many seem to focus on whether the existence of the plan document required under §403(b) is going to cause loss of the exemption, The answer to that is simple-NO. The quoted exemption is often called a non-plan exemption, but in fact it says that the “program” will not be treated as established or maintained by an employer.

The more interesting question is whether the operational requirement under §403(b), which are more explicit since the final regulations, are inconsistent with the exemption. Here the answer is also clear-YES.

FAB 2007-2 says, inter alia:

“The Code’s qualification requirements impose obligations directly on employers in connection with the employees’ annuity contracts and custodial accounts. If individual contracts or accounts fail to satisfy the tax qualification requirements, even if due to actions or errors of an employee or annuity contractor, the employer can be liable to the IRS for potentially substantial penalty taxes, correction fees, and employment taxes on employee salary deferrals. Accordingly, in the Department’s view, the safe harbor at section 2510.3-2(f) subsumes certain employer activities designed to ensure that a TSA program continues to be tax compliant under section 403(b) of the Code.

The Department of Labor has issued advisory opinions and other guidance on whether specific employer functions are compatible with the safe harbor. The Department believes that the safe harbor allows an employer to conduct administrative reviews of the program structure and operation for tax compliance defects. Such reviews may include discrimination testing and compliance with maximum contribution limitations under the Treasury regulations. As noted in previous guidance issued by the Department, the employer may also fashion and propose corrections; develop improvements to the plan's administrative processes that will obviate the recurrence of tax defects; obtain the cooperation of independent entities involved in the program needed to correct tax defects; and keep records of its activities.

A program could fit within the section 2510.3-2(f) safe harbor and include terms that require employers to certify to an annuity provider a state of facts within the employer's knowledge as employer, such as employee addresses, attendance records or compensation levels. The employer may also transmit to the annuity provider another party's certification as to other facts, such as a doctor's certification of the employee's physical condition. The employer could not, however, consistent with the safe harbor, have responsibility for, or make, discretionary determinations in administering the program. Examples of such discretionary determinations are authorizing plan-to-plan transfers, processing distributions, satisfying applicable qualified joint and survivor annuity requirements, and making determinations regarding hardship distributions, qualified domestic relations orders (QDROs), and eligibility for or enforcement of loans.”

The last quoted sentence puts the bunny into the hat. Clearly these functions are required to maintain §403(b) status, and clearly the employer is not allowed to do them. Implicit in this listing are multi-contract functions such as limiting aggregate loans and hardship distributions, ensuring minimum required distributions compliance and determining what investments will be allocated under QDROs. Also implicit is some amount of payroll compliance outsourcing, if only to administer loan repayments.

This need for outside assistance is reinforced by provisions of the §403(b) regulations. Regs. §1.403(b)-3(b)(3) reads as follows:

“(3) Plan in form and operation. (i) A contract does not satisfy paragraph (a) of this section unless it is maintained pursuant to a plan. For this purpose, a plan is a written defined contribution plan, which, in both form and operation, satisfies the requirements of §1.403(b)-1, §1.403(b)-2, this section, and §§1.403(b)-4 through 1.403(b)-11. For purposes of §1.403(b)-1, §1.403(b)-2, this section, and §§1.403(b)-4 through 1.403(b)-11, the plan must contain all the material terms and conditions for eligibility, benefits, applicable limitations, the contracts available under the plan, and the time and form under which benefit distributions would be made. For purposes of §1.403(b)-1, §1.403(b)-2, this section, and §§1.403(b)-4 through 1.403(b)-11, a plan may contain certain optional features that are consistent with but not required under section 403(b), such as hardship withdrawal distributions, loans, plan-to-plan or annuity contract-to-annuity contract transfers, and acceptance of rollovers to the plan. However, if a plan contains any optional provisions, the optional provisions must meet, in both form and operation, the relevant requirements under section 403(b), this section and §§1.403(b)-4 through 1.403(b)-11.

(ii) The plan may allocate responsibility for performing administrative functions, including functions to comply with the requirements of section 403(b) and other tax requirements. Any such allocation must identify responsibility for compliance with the requirements of the Internal Revenue Code that apply on the basis of the aggregated contracts issued to a participant under a plan, including loans under section 72(p) and the conditions for obtaining a hardship withdrawal under §1.403(b)-6. A plan is permitted to assign such responsibilities to parties other than the eligible employer, but not to participants (other than employees of the employer a substantial portion of whose duties are administration of the plan), and may incorporate by reference other documents, including the insurance policy or custodial account, which thereupon become part of the plan.

(iii) This paragraph (b)(3) applies to contributions to an annuity contract by a church only if the annuity is part of a retirement income account, as defined in §1.403(b)-9.”

This requires a plan document that contains all of the technical requirements of §403(b) as well as eligibility and the contracts available under the plan. The other possible subjects for coverage are not really relevant since the 403(b) exemption doesn’t permit much flexibility in design. Eligibility can of course take into account the part-time and other permitted exclusions at Regs. §1.403(b)-5(b)(4), but the plan document must reflect any exclusions the employer wants to apply.

But Regs. §1.403(b)-3(b)(1) requires that all contracts be taken into account in determining compliance with §403(b), a simple restatement of the rule at §403(b)(5). However, this reiteration makes it absolutely clear that there needs to be either (1) only one investment option, or (2) some sort of master document to set forth aggregate rules. Since the first situation is hardly normal, and in any event cannot be maintained without violating the requirements for ERISA exemption, by default the master document approach is mandated. Fortunately, the regulations permit incorporation by reference of the specific investment vehicle.

The problem that raises is how to deal with conflicting terms. This is not addressed directly in either the regulations or the FAB, but the answer is suggested in both the FAB and the preamble to the regulations. The preamble says:

“As a result, a plan may include a wide variety of documents, but it is important for the employer that adopts the plan to ensure that there is no conflict with other documents that are incorporated by reference. If a plan does incorporate other documents by reference, then, in the event of a conflict with another document, except in rare and unusual cases, the plan would govern. In the case of a plan that is funded through multiple issuers, it is expected that an employer would adopt a single plan document to coordinate administration among the issuers, rather than having a separate document for each issuer.”

And the FAB says:

“The Department of Labor expects that the written plan for a TSA program that complies with the safe harbor would consist largely of the separate contracts and related documents supplied by the annuity providers and account trustees or custodians. An employer’s development and adoption of a single document to coordinate administration among different issuers, and to address tax matters that apply, such as the universal availability requirement in Code section 403(b)(12)(A)(ii), without reference to a particular contract or account, would not put the TSA program out of compliance with the safe harbor."

From these quotes, it seems clear that both DOL and IRS expect the “normal” plan seeking the §403(b) ERISA exemption to be a wraparound document, incorporating but also limiting the terms of the underlying annuities, custodial accounts and/or retirement income accounts. This document will also have to specify what functions will be performed and by whom. Employers have essentially no capacity to prepare a compliant plan document, or to understand what they must do, what they can do and what can or must be done that they cannot do.

How exactly the coordination functions on plan language and administration will work is likely to be somewhat fluid over the next few years. For example, the employer has the responsibility for dealing with document conflicts, but the FAB makes it clear that the employer cannot negotiate with investment providers. One way to handle this is by retaining third parties to review existing and proposed investment vehicles and to communicate how the vendor is expected to fit into overall plan operations, then rejecting vendors that will not cooperate, but there may be other approaches developed over time and industry standards may evolve to effectively moot the issue. However, even with uncertainties, it is unlikely the ultimate structure will vary much from what we have been advising for some time now.

Final 403(B0 Regs.-A Ramble Through the Preamble

Well, we finally have the final regulations under §403(b). Assuming no changes are made before the projected publication date of July 26th and based on a review of the Preamble, here are what appear to be the highlights, with a focus on elements that will affect employers and the marketplace most directly.

· The final regulations are not effective until 2009. This is surprising to anyone who contemplated the chaos that would result from a 2008 effective date. There are also transitional rules for collectively bargained plans (the earlier of the termination of existing CBAs or three years from publication of the final regulations) and plans of church-related organizations (2010). Plans that rely now on Rev. Rul. 90-83 can continue to do so until 2010.

· The written plan requirement has been left in the final regulations. Again, this is not surprising, but it is likely to continue the consternation felt by sponsors who have essentially treated their employees and payroll systems as marketplaces for annuity vendors. It should not, because the simple fact of creating a plan document has absolutely no effect on whether a plan is subject to ERISA or on the responsibilities of employers with §403(b) plans or arrangements.

· The final regulations help somewhat with the process of creating a written plan by allowing incorporation by reference of things like annuities. This makes clear that the employer can create a wraparound document that lists and incorporates by reference the terms of the investment vehicles available under the plan. They also explicitly authorize the employer, in the plan, to allocate responsibilities for administration and compliance matters to others. However, there is also a requirement that documents incorporated by reference not conflict and that the plan control over the incorporated documents; this should make it routine for the employer to request copies of all §403(b)-related documents and to instruct vendors that they must subordinate their documents to the terms of the plan.

· The final regulations continue the requirement that the §403(b) plan comply “in both form and operation” with §403(b). This emphasizes further the need for employers to get a better grip on their plans, and in particular the limitations on distributions that can cause a §403(b) plan to fail even though the employer has done nothing. It is precisely “nothing” that employers can no longer do.

· The emphasis on the §403(b)(5) rule continues in place, and is actually emphasized. This rule treats all contracts as a single contract, with the result that limitations like the annual deferral and annual contribution limits and the limitations on time of distribution, loans and hardships have to be set out in the wraparound document and have to be complied with on an aggregate, plan-wide basis. This is emphasized by the new requirement for like kind exchanges out of the plan that the plan and the recipient investment vehicle exchange data to coordinate distributions. The preamble also explicitly states that investment issuers will have to look to the employer for employment-related information, in effect subordinating the issuers to the employer in compliance matters.

· The anomaly for hardship distributions from custodial accounts has been finalized. This says that although employer contributions to annuities and retirement income accounts can be distributed on hardship, employer contributions to custodial accounts cannot.

Conceptual Issues in 403(b) Documentation

With the upcoming final regulations due under 403(b), there is a definite need to re-think how 403(b) documentation is structured. For a variety of reasons, mostly historical and marketplace driven, there is no generally agreed set of practices for how to get documents in place that actually meet the requirements of 403(b) and are consistent with the complex of plan structures that has evolved over time.

The marketplace is likely to evolve in these directions over time, so this post is something of a roadmap for the future. At least, it should provide a template of issues you can raise with your provider when the final regulations come out. (And, of course, how we will be working with our clients.)

THE THREE PLAN TYPES

There are three distinct program types in the 403(b) world, as opposed to just two in the 401(k) environment. Each of these types has different documentation needs, so let's look at each separately.

ERISA Plan

A 403(b) that seeks to be or admits it is a plan subject to ERISA is, in many ways, the simplest type to figure out. These plans almost always limit investments to a single array, within the setting of a single group annuity contract or a single TPA administration structure. This means that, like an ERISA 401(k) plan, they need (1) a plan document, and (2) a funding vehicle. Group annuity contracts regularly provide both where they are the selected investment medium (subject to my concerns about whether they are amended on a timely basis). Otherwise, the plan needs a plan document and a pooled custodial account agreement that comply with 403(b)(7) (all in mutual funds, plan document controls over custodial account agreement, etc.). Given the possibility that there will be prior annuities in place with distribution restrictions, and the possibility that an employer would allow an opener to individual annuities, the plan document probably ought to permit the plan administrator to designate more than one investment vehicle or at least to grandfather existing funding arrangements.

Non-ERISA Plan

There are also 403(b) programs that are plans, but not subject to ERISA, because the employer itself is not an ERISA employer (technically, the exemption is for governmental and church plans under a bizarre and complex set of definitions). These are going to require either (1) a separate plan document that excludes ERISA rules, or (2) a master document that has provisions for ERISA and non-ERISA plans. There is no particular technical reason to pick one of these over the other. The single document is easier to draft and to draft from, but has provisions that do not apply to non-ERISA plans, while the two-document choice has less extraneous materials for non-ERISA plans. Given the implications of not having a remedial amendment period, and the better quality control inherent in a single document, we have opted for a single, combined master plan.

Oh, and don't forget church plan retirement income accounts as a third investment medium.

Non-Plan Programs

Mostly for cultural reasons, there is a genuine fear of plan status in 403(b) culture. There is good reason to attribute this mostly to fear-mongering in a marketplace where a lot of small insurance agencies make money from individual 403(b) annuities, but it is real. Setting aside all the negative effects on employees of not having any assistance from employers with, hopefully, better expertise, there it is an there it will remain for some time.

This creates an entirely new type of 403(b) program, the non-plan program or arrangement. Even ERISA-exempt employers try to maintain this status, and one of the central marketplaces, school districts, normally have to do so by state law. Otherwise, the structure tends to be fixed by the requirement of the DOL's definition of "pension plan".

Normally folks want to see these programs as simpler. For starters, they are all salary reduction-only, so there is no need to cover things like matching contributions or vesting. For another, there is no need to comply with ERISA requirements, except to the extent that analogous rules are placed in the final 403(b) regulations. However, the investment side, and the effects of the market structure, create offsetting complexities.

In this marketplace, and program type, there are multiple, unrelated investment providers, most of whom are offering single annuities. Each of these single annuities purports to comply with 403(b), although they are rarely amended on a timely basis to reflect changes in the law. However, none of them provides any of the aggregate limitations resulting from the fact that 403(b)(5) says, and has always said, that multiple contracts are treated as a single contract. Nor do they have to have common provisions about such essentially employer issues as withholding and timing of contributions.

After some hemming and hawing, we came to the conclusion that this program type needs a separate document type. Essentially, the need is for a program document that (1) says it is not a plan (ours calls itself a personnel policy), (2) includes overall limitations to be applied under all funding vehicles, in the aggregate, on contributions, loans and distributions, (3) contemplates the addition and removal of specific annuities, custodial account arrangements and retirement income accounts as funding vehicles, and (4) includes the definition of a non-plan under the DOL regulations, where applicable. Procedures under such a program would also be required, along with cooperation from investment providers, to ensure compliance with the aggregate limitations, but that should become a standard part of the "common remitter" function, as we are prepared to do.

So there we are. Reasonable minds can differ, but it is clear that the decisions we have made will keep our clients in compliance.

This is going to be an important subject, but it is unlikely that anybody will write much about it when the final regulations come out. Accordingly, I am going to pst this on my blog (403b-457plansblog.blogspot.com) for regular readers and at the 403bWise and BenefitsLink bulletin boards. My hope is that the bulletin board postings will generate discussion, and point out the flaws in this posting. At least, they will create forums where I can clarify the underlying reasons and how our system will work.

Tom Geer

A Summary of Fees from The Standard

Courtesy of the BenefitsLink Newsletter, here is a good summary of fee types and effects from The Standard.

http://www.standard.com/pensions/publications/rp-13438_fees_guide.pdf

And a reminder. If you are interested in technical issues for retirement plans, subscribe to BenefitsLink. Their newsletter is definitive.

Then, when you see a BenefitsLink source with consistent quality coverage in your area, see if you can subscribe to it.

I am particularly looking forward to the deluge of coverage when the final 403(b) regulations come out. The best way to come to an understanding of them will be (1) download and read the regulations front to back, including the preamble, before you read anything else, (2) read everything you can get, remembering that everybody has an axe to grind, (2) keep doing that for two to four weeks, (3) keep notes of open issues or ones you don't understand yet (e.g., Dewey, Cheatham & Howe law firm says you can do this, but doesn't say how), and (4) resolve your open issues by looking back and formulating your best answer. Last, feel free to send me your questions at any time, to geertom@gmail.com.

2007 Task Deadlines

Plan Sponsor has a listing of tax and ERISA deadlines for 2007 at:

http://www.plansponsor.com/magazine_type1/?RECORD_ID=36118

McKay Hochman, the PPA and 403(b)

McKay Hochman issued in October a well-done summary of the PPA provisions affecting 403(b). You can find it at:

http://www.mhco.com/Commentary/2006/PPA_403b_091406.htm

They also issued a nice summary of PPA particpant notice requirements at:

http://www.mhco.com/Commentary/2006/PPA_Disclose_Notice_083106.htm

And a terrific chart on rollovers between plan types at:

http://www.mhco.com/Charts/Rollover_011206.htm

More on Top-Hat Plans

There aren't many days when three things appear that need a comment here, but this is the day.

There is an excellent article at the Plan Sponsor web site on top-hat plan status. This is a reversal of a decision discussed here earlier (not because of its dramatic content but because there are so few cases on the issue).

The article is located at:

http://www.plansponsor.com/pi_type10/?RECORD_ID=36259

The decision reflects pretty much the traditional understanding that top-hat plans should be limited to those who have actual bargaining power. In that sense, the new result is unsurprising.

The lesson from the decision is that one bad coverage decision loses top-hat plan status, so employers and their advisers should be careful.

Settlor Function Case at Supreme Court

The Supreme Court has decided to review a case decided on the issue of what constitute settlor functions. The ERISA fiduciary duties do not apply to actions taken by the plan sponsor in its capacity as employer/sponsor, which raises the question of where the line gets drawn.

In Beck v. PACE International Union, the court will look at the dividing line in the context of of plan terminations. The Bankruptcy Court, District Court and 9th Circuit held that the employer's decision to terminate was a settlor function, but that all steps in implementing that decision were made under the fiduciary duty rules. The employer had decided to terminate the plans by buying annuities to fund the entire accrued benefit and distributing the surplus resulting from that purchase to the participants, ignoring a suggestion by the union that the plans be merged into a multiemployer plan. The holding was that the ERISA fiduciary duties required that the employer review the merger alternative and that it had failed to do so adequately.

Arguing that fiduciary duties do not apply to the implementation of settlor decisions is not for the faint of heart. However, the facts here are much more complex, and it seems pretty clear that the employer and the fiduciaries fully met their obligations, and then some. A decision from the Supreme Court may tell us more about how to do a plan termination than it does about fiduciary duties.

Since the case is going to generate a decision by the Supreme Court, a full analysis is premature. If you want more detail, you can find it at:

http://www.lawmemo.com/sct/05/Beck/

Reviewing Annuities: Don't Try This at Home

I have seen several pieces lately on what to review in a group annuity contract, and read them hoping for additional insight. There were some, but the pieces did not cover the full range of issues. This post is another contribution to those items in the 403(b) context. The same concerns, by and large, apply in the 457 and 401(k) contexts but usually in simpler forms because they usually have one insurer (if they have one at all). The focus here is on economics, and in particular unpleasant economic surprises in the form of surrender-type charges and restrictions on moving money around.

* Preliminarily, remember that annuities are not written with ease of reading in mind. My experience is that the "exciting" provisions can show up almost anywhere and that they are written in broad principals rather than in terms of "If this happens, then this happens." One way to view legal training is as a graduate course in being paranoid and suspicious. This is as useful a skill in reading annuity contracts as in any other area. And if you find yourself saying "What?" or "Hunh?" slow down and think it through.

* In a perfect world, everybody would get their annuity contracts reviewed at the beginning, before signing them. This does not happen very often, because by the time a plan gets big enough to carry the review costs at the beginning, even though there may not be problems later, it is likely to be invested in something other than annuities. However, with the increasing focus on finding and disclosing costs, there will, eventually, be increasing focus on potential costs. (In the general form of "Bad fiduciary! You should have read that annuity contract more carefully.") But at this point in the development of the retirement plan industry, the problem normally comes up only when bad things start to happen, and the review ends up being part of a scramble to find some way out.

* When you think about these issues or review an annuity contract, bear in mind two salient facts about annuities. First, the insurer is promising funds based on underlying investments that do not exactly match the promises. This is clearest when the insurer takes money into a fixed income stable value fund that annuitants can treat like a money market fund and buys long term bonds with greater price variation based in interest rate fluctuations in the fund. But it is also true when the insurer takes the annuitant's relatively small investment and makes huge asset purchases or when the contract contains any form of guarantee. The insurer then may have a legitimate need to protect itself against the possibility that annuity holder behavior will cost them more money than they expected in structuring their investments. (Although, there is a pretty good counter-argument that the insurer should hedge the risks up front rather than pass the risks through to the annuity holder. The insurer is almost by definition in a better position to assume and hedge against those risks.) Second, setting up and running an annuity account costs the insurer money that the insurer assumes initially will be recovered over time in fees within the contract, so the insurer has a legitimate interest in recovering some of these costs if the contract is terminated earlier than expected. If you keep these two issues in mind, it will help you sort through what the contract is doing because you will know what the contract is getting at. NOTE: Even when surprises have a legitimate reason, they are still no fun.

* Back-end loads. Sometimes called contingent deferred sales charges or surrender charges, these are charges for getting your money back. They come in two basic varieties. Decreasing surrender charges have a percentage rate that declines as the policy gets older; an example would be 7% one year, 6% the next, etc. Rolling surrender charges are like decreasing surrender charges except that the schedule applies separately to each deposit of new money, so that even after a long period of time there are charges on the newer money.

* You have to determine the extent to which the contract is "benefits sensitive"; that is, if the withdrawal is not simply to change investments as permitted under the plan or to pay benefits under the plan, do the surrender charges still apply? Careful review of benefits sensitivity would also look at whether, in a multi-vendor environment, the contract says that it will be first, last or pro rata vis a vis other sources of funds in payment of benefits.

* Now my favorite, market value adjustments. If you buy long-term bonds to fund a short-term investment, you get a higher yield. But the long-term bonds change value with changes in interest rates, so the underlying investments are always worth more or less than the nominal balance of the product. This is true in most short-term and GIC-type investments under annuities. The insurer, therefore, wants to avoid losses when the investments are down (and, of course, keep the gains when they are up). Thus, the market value discount or adjustment. These can come in two types. The first says the insurer will calculate its losses and apply them. The second sets up a hypothetical bond each year with some fairly long maturity (e.g., 20 years) and interest at the rate credited under the annuity, then discounts the projected cash flows back at the rate being used for new money in new, similar products. In the alternative, the insurer could use some external rate (Fed funds, LIBOR, etc.) as the basis for calculation. Market value discounts cannot be ignored--I had a client once with a 56% market value discount.

* So you look at the contract, and at the surrender charges and market value discounts, and say "Well, we'll wait them out, we'll phase them out over time." So you make all new deposits to other investments, if the contract allows a, say, 20% withdrawal per year without tripping any costs you'll take out the 20% each year, you'll make all benefits payments from this annuity, and you'll wait until the costs are phased out or all the money has trickled out. Some contracts say that the insurer can, under certain circumstances, treat the annuity contract as terminated and pay out the entire proceeds, net of surrender charges and market value discounts. The circumstances vary from contract to contract, but normal triggers are cessation of future deposits or introduction of an investment alternative that competes with one or more inside the annuity. Or, of course, the contract could say that if you want cash the insurer can force installments. This kind of clause prevents the sort of "cute" planning so loved by lawyers and consultants like me, and is extremely bad to have lying about unnoticed.

* Coordination with other investment vehicles is an important issue. It has always been true that some piece of paper with the basics of the 403(b) rules had to be in place, but the written plan document requirement in the proposed 403(b regulations has highlighted this. In a "plan" environment with one investment provider, this problem arises when the rules change and the contract doesn't or where something other than a single group annuity contract holds funds. But in a multi-vendor environment, you may have ten or twenty alternatives, each of which pretends the others don't exist. So look for language that says that contributions, loans, hardship distributions and minimum distributions will be determined taking into account such items already done under other contracts unless you have a wraparound plan document.

* The next issue is the ordering of withdrawals. (To some extent, this portion is theoretical because I have seen some but not all of these alternatives; all are at least theoretically possible.) Let me posit an example. An employee has $30,000 in each of two different annuities. In each annuity, 1/3 of the money is in a fixed income fund, 1/3 in a growth fund and 1/3 in a small cap equity fund. The participant wants to borrow or take a hardship distribution of $10,000. The previous paragraph talks about the issues that come up between the two contracts. But we still have an issue about which fund inside a contract is going to pay out the money. If the entire $10,000 comes out of one annuity, we still need to know if we can freely pick the funds. Suppose interest rates are up; will the insurer let us take the money from the fixed fund with a below-market yield? This could be barred by specific language in the contract, including any terms that give the insurer discretion. It could also be impracticable in fact because taking the full $10,000 out of one fund might trip a penalty of some sort, like the market value discount in the fixed fund or cause the insurer to use its power (if any) to wind up the contract. And, even if it does not, there is the possibility that it moves the annuity (if it's a group annuity contract) closer to the point where a market value discount or surrender charge is triggered, and therefore prejudices the next participant who needs money. And, to make it even messier, the terms of the benefits sensitivity language may, or may not, cover the specific event and may, or may not, cause the payout to be treated as a zero when the next distribution is analyzed.

* And we're not done with ordering yet. If the annuity has a rolling surrender charge, that applies anew to each deposit, which deposits are treated as withdrawn? Take the same example, and add that the equity funds have a 5 year 5% rolling surrender charge that decreases by 1% each of the five years. Can the contract holder say "I'll take the oldest $5000 from each?" Does the contract specify first-in-first-out or last-in-first-out or pro rata? Generally, the timing ordering rules will be parallel as between the fixed fund and the equity funds, so that a FIFO rule would increase potential market value discount but decrease potential surrender charges and vice versa, but they could differ (FIFO on the fixed fund and LIFO on the others being the worst potential structure).

* Last, once you figure the contract out, as well as can be done, it's a good idea to ask the insurer "What if?" The best protection against surprises is a letter, or fax, or e-mail message, or phone notes, saying nothing bad will happen. That may sound like a good enough idea to make it so you don't have to read the darn thing, but it's not, because the insurance company is not going to point out every workaround or exception for you. Remember, insurance companies make money just like everybody else, by collecting money and investing, and paying benefits is a cost more or less like any other cost.

There may well be other issues lurking out there, because you can be sure that insurance companies have lawyers and accountants and actuaries who are at least as smart as you or I thinking about this stuff. That means that annuities should be read with care and suspicion, and that the reader should always be ready to stop and say "What does that mean?" Thus the title: "Don't Try This at Home."

DISCLAIMER: This post is specifically not intended to give enough information to allow readers to fully review annuity contracts. Given the complexity of annuity contracts, any review should be done by a competent professional, preferably with experience in doing such reviews.