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.
