The Final 403(b) Regulations: A Changing World and What Employers and Providers Need to Do About It

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Iris Meghan Stevens
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1 1 ALI-ABA Course of Study Retirement, Deferred Compensation, and Welfare Plans of Tax-Exempt and Governmental Employers September 4-6, 2008 Washington, D.C. The Final 403(b) Regulations: A Changing World and What Employers and Providers Need to Do About It By David W. Powell Groom Law Group, Chartered Washington, D.C.

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3 3 July 23, 2008 The Final 403(b) Regulations: A Changing World and What Employers and Providers Need to Do About It Some History For many years, IRS guidance on Internal Revenue Code section 403(b) plans ("403(b) plans") has been a hodge-podge of regulations, exam guidelines, revenue rulings and notices dating back to the 60's. Several years ago, the Service began to tackle the process of updating and consolidating most of this guidance into one unified set of regulations reflecting current law issued in proposed form in November 2004 and including guidance under the controlled group rules of Code section 414(c). While there were objections and concerns to many of the major changes contained in the proposal, the general thrust was to follow 401(k)-like rules to the extent possible. The restatement of the 403(b) rules also followed in the footsteps of similar IRS/Treasury efforts to update and consolidate other major pension regulations, including under section 457(b) (eligible deferred compensation plans), section 401(k), and section 415 limits. In the summer of 2007, IRS and Treasury published final rules which generally are effective January Fed. Reg (July 26, 2007). The final rules make major changes in the 403(b) world, including imposing broad written plan document and operational compliance requirements on all 403(b) programs, repealing the nondiscrimination safe harbors of IRS Notice 89-23, and imposing a set of "controlled group" rules, adding new restrictions on distributions, prohibiting the use of separate life insurance (and certain other incidental benefits) in 403(b) arrangements, restricting annuity exchanges, and allowing plan terminations (and concurrent distributions) under rules similar to those for 401(k) plans. On November 27, 2007, the IRS issued additional 403(b) plan guidance in Rev. Proc (Dec. 17 IRS Bulletin) that addresses a number of issues raised after the final 403(b) regulations were issued, including detailed guidance on "exchanges" between 403(b) contracts and custodial accounts, model plan document language for public school employers (which nonprofit employers may also be able to utilize, but without the same level of reliance), and guidance on when plan documents and amendments must be in place. GROOM LAW GROUP, CHARTERED 1701 Pennsylvania Ave., N.W. Washington, D.C Fax:

4 4 Our summary of the final rules (including the additional guidance provided in Rev. Proc ) follows. A. Plan and Contract Terms Written Plan Requirement Historically, a few 403(b) requirements have been required by statute to be in the underlying 403(b) contract (a term which in this context includes custodial account agreements and church retirement income accounts), and ERISA has always imposed a written plan document requirement on 403(b) plans subject to that law. However, the final regulations impose, for the first time, a requirement under the Code that there be a written plan containing all material terms and conditions for eligibility, benefits, limitations, the contracts available under the plan, and the time and form of distribution. In addition, any optional provisions (such as for loans and hardship distributions) must be set forth in the plan. Significantly, the final regulations do not require a single plan document the "plan" may incorporate by reference other documents, including separate contracts and related documents supplied by the annuity providers and account trustees or custodians. For example, a "wrap document" similar to the concept used in many ERISA-covered welfare plans could supplement one or more annuity contracts that contain certain terms. However, the onus is on the employer to ensure that there are no gaps and that conflicts among documents are addressed. This will be challenging in cases where there are numerous investment providers each with their own contract and custodial account terms. IRS has sought to address the potential costs associated with satisfying the written plan requirement for many employers that do not already have a written plan by promulgating the model plan document described below. The final rules also provide that a plan may allocate administrative responsibilities to the employer or another person but not participants to ease administrative burdens. Those persons responsible for compliance with the applicable Code requirements should be identified in the relevant documents. In conjunction with the final regulations, the DOL issued Field Assistance Bulletin No ("FAB") to provide additional guidance on the extent to which compliance with the final regulations would cause employers to exceed the limitations on "employer involvement" permitted under the DOL's longstanding safe harbor for tax-sheltered annuity programs. DOL Reg (f). In general, the DOL believes that complying with the final 403(b) regulations does not per se convert a salary-reduction-only plan relying on the safe harbor into a plan subject to ERISA that analysis continues to be done on a case-by-case basis. As discussed further below in our review of the FAB, this new written plan requirement may cause non- ERISA 403(b) plan sponsors relying on that regulatory exemption to look at it more closely to determine whether their plans have been or will continue to be exempt from ERISA. Church 403(b) plans which are not 403(b)(9) retirement income accounts are not subject to the written plan document, though such plans should be rare. What Must be in a 403(b) Contract The regulations indicate that certain 403(b) provisions must be in the contract, including: 2

5 5 nonforfeitability (which the final rules define by reference to the regulations under section 411 vesting rules for qualified plans, though, during the initial period the contract is unvested, the contract must at all times satisfy the 403(b) requirements), nontransferability (sec. 401(g)), limit on elective deferrals (the final regulations require a section 403(b) contract to include this limit (sec. 402(g)), minimum required distribution rules (including the incidental death benefit rule) (sec. 401(a)(9)), direct rollover rules (sec. 401(a)(31)), and limitation on incidental benefits (sec. 401(a)). It is unclear whether the plan document could include one or more of those rules instead, especially in the case of a "wrap" document, though in many cases, those wrap plan documents are likely to include such provisions as well insofar as the relate to the material terms and conditions for benefits, applicable limits, and distributions. In addition, custodial account agreements should contain the requirement that the assets be held for the exclusive benefit of participants and beneficiaries. What Must be in The Plan The final regulations require that a plan contain all the material terms and conditions for eligibility, benefits, applicable limitations and the time and form of distributions under the plan. Presumably, some of these may be addressed in documents such as the contracts. However, other 403(b) provisions not required to be in a contract, but which must be in the plan document, include: identification of the contracts and accounts available under the plan (which presumably may be done by cross-reference, as is common in 401(k) plans), coverage and contribution provisions, section 415 limits on annual additions, optional provisions (such as loans, hardships and transfers), and provisions coordinating and allocating compliance responsibilities. Model Plan Language The Rev. Proc. provides the model 403(b) plan document that satisfies the final 403(b) regulations in both form and operation. Although the model 403(b) plan is intended for use by public school employers maintaining 403(b) plans, it can also be used by other employers maintaining 403(b) plans, although certain modifications will be necessary. The IRS has attempted to assist with this process by annotating the model 403(b) document to flag certain potential issues. 3

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