From the February 2005 issue of Investment Advisor • Subscribe!

Ire Toward The IRS

The 403(b) industry is up in arms over proposed regulations issued by the Internal Revenue Service that would essentially strip 403(b)s of their unique status and turn them into qualified plans.

When Congress created 403(b) plans in the early 1960s, it gave teachers and other employees of nonprofits the ultimate control over their accounts along with their financial advisor. Industry officials argue, however, that the IRS's proposed regs usurp that authority, and would shift control of a 403(b) plan to the employer by requiring a written plan document. "The written plan requirement puts all of the administrative responsibility at the employer level--so the employer is assuming responsibility as they would in a 401(k) plan," says Ellie Lowder, an independent consultant with TSA Training and Consulting Services in Tucson, Arizona. "There is no statutory authority for a written plan requirement for non-ERISA 403(b) plans," says Lowder, a certified retirement specialist and advisor to the National Tax Sheltered Accounts Association (NTSAA), the trade group for 403(b) and 457 plans. Lowder also notes that public schools and small nonprofit companies "can't afford" to administer a written plan document because they'd have to hire more staff as well as a third-party administrator. If the plan document provision is approved, she says, "Many of [the public schools] will try to drop their 403(b) arrangements," ultimately hurting participants.

Michael Hatlee, manager of retirement services at Chemung Canal Trust Company in Elmira, New York, agrees that an employer's "costs for maintaining" a 403(b) would jump because the employer would have to find a vendor to supply the document. But, Hatlee argues, since most participants "don't understand the rules surrounding 403(b) plans," a plan document may actually be beneficial. Administering a plan will become more complex for employers. If an employer has "nine vendors that they have authorized for 403(b) investments, they may end up with nine different plan documents." This will likely prompt many employers to enlist only one vendor, he says, like 401(k)s do, which will limit participants' investment choices.

However, Hatlee believes that restricting the number of vendors will ultimately benefit both the employer and participant. With one vendor, an employer is "dealing with one plan document, the provisions are the same for every participant, and [the employer's] expenses may be reduced," he says. For "the participant, [the plan is] easier to understand because the participant will have only one person/document to deal with."

The Benefits of Limits

Scott Dauenhauer, a planner with Meridian Wealth Management in Laguna Hills, California, who specializes in 403(b) plans, agrees that limiting vendors is a good way to go. He says that many 403(b) plans are lousy because of their high fees, and hopes the IRS rules force school districts "to take an active role in the 403(b)," and lead employers to increase employees' 403(b) choices. If the schools "increase competition and get good providers, maybe we will only have four or five providers, but they will provide better products."

Many in the industry also disapprove of the IRS's proposal to eliminate revenue ruling 90-24, which permits tax-free transfers from one 403(b) plan to another. The IRS would only allow "internal transfers if there is more than one provider within a plan," Lowder explains,"or transfers from one employer to another if you're a participant in another employer's plan."

Jon Ziehl, president of PlanMember Financial Corp. in Carpinteria, California, which has nearly $1 billion in 403(b) assets under management, told the IRS in a comment letter that the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) expanded portability rights, but the IRS's rules "severely" limit a participant's ability to move from plan to plan. Furthermore, Ziehl says, the proposed rules "require that the benefits after a transfer at least equal the benefits before the transfer, but the lack of clarity and guidance regarding how benefits are to be valued for that purpose might prevent any movement to or from a contract with a surrender charge, from a contract that has additional benefits not reflected in the surrender value, or from a contract that has incurred market losses."

Annuities, Taxation, and Plan Terminations

Many in the industry are also concerned about the IRS's new requirements for establishing non-qualified annuity accounts.

The rule would "require that providers segregate amounts into non-qualified annuity accounts, which will impact product filings, prospectuses, and systems, and be extremely expensive," Lowder says. "This will impact pricing. In my opinion, participants will be hurt."

Other areas that would be affected by the rules are taxation of 403(b)s, funding vehicles, contribution limits, age 50 and other special catch-up contributions, contributions for former employees, excess contributions, non-discrimination rules, loans, rollovers, and required minimum distributions.

One bright spot in the IRS rules, however, is that participants would be able to terminate a plan. The comment period ends on February 14, but Lowder says the IRS will continue to accept comments after that date. The IRS plans to hold an open hearing to discuss the proposed rules on February 15.

The rules governing 403(b) plans haven't been touched since the IRS modified them 40 years ago. So why change the rules now? Industry officials speculate that the Bush Administration is trying to push its one-size-fits-all retirement plan, the Employer Retirement Savings Accounts (ERSAs), which President Bush included in his 2004 and 2005 budget proposals. We've yet to see if ERSAs are included in Bush's 2006 budget, which is expected out this month. ERSAs would essentially replace all other types of retirement savings vehicles--401(k)s, 403(b)s, 457s, SEPs, Simple IRAs, and SARs. Lowder believes the Administration is trying to make 403(b)s resemble other retirement plans so "there won't be as much outcry" if the government decides to eliminate the other plans.

Two bills were introduced last year calling for the adoption of the Lifetime Savings Accounts (LSAs) and Retirement Savings Accounts (RSAs)--which would replace IRAs--but neither one of the bills went anywhere.

Washington Bureau Chief Melanie Waddell can be reached at mwaddell@ia-mag.com.

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