Plan Sponsor has a listing of tax and ERISA deadlines for 2007 at:
http://www.plansponsor.com/magazine_type1/?RECORD_ID=36118
Tuesday, January 23, 2007
Monday, January 22, 2007
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
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.
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/
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/
Thursday, January 4, 2007
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.
* 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.
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