At $652 billion, the 403(b) retirement plan market may be dwarfed by its more familiar 401(k) cousin, which had $2.7 trillion in assets at the end of 2006. But the Internal Revenue Service overhauled the regulations for 403(b) plans last summer, and as these regulations take effect in 2008, the market will change rapidly. The changes will affect both educators and their school districts. With few experts able to advise participants and their school districts, advisors helping educators work through the new system will have a chance to build their client base as the market consolidates.
A 403(b) plan is an employer-sponsored retirement plan for public education organizations and some nonprofit companies. In the 403(b) market, participants usually choose their own investment contract. The first investment contracts in the 403(b) market were fixed annuities. Even as recently as 2003, half of all 403(b) assets were invested in fixed annuities.
Historically, a sales force of commissioned captive agents sold fixed annuities. They commonly met with educators in the teachers' lounge to educate them about tax-deferred savings. Over the past two decades, variable annuity companies have used a similar strategy to expand the 403(b) market. More recently, mutual funds have gained market share as participants have moved toward lower-cost investment choices. Now, most school districts maintain a list of approved providers that includes fixed annuity, variable annuity and mutual fund firms.
Over the years, the number of providers on this list has increased to the point where there are frequently more than 20 from which an employee can choose. Each provider has its own contract or custodial agreement, as well as its own rules, fees and surrender schedule. There is no continuity between providers, and there is limited or no communication between providers for employee hardship or loan requests.
To complicate matters, in 1990 the IRS issued a revenue ruling on trustee-to-trustee transfers of 403(b)s. Ruling 90-24 allowed 403(b) owners to transfer a current plan into another plan of their choice, even if the new plan was not approved by the employer. This ruling created an almost unlimited number of investment options, but it also created many accounts that neither the IRS nor the employer could track.
Streamlining the Process
The complicated 403(b) market needed updating in order to be more easily managed by both school districts and the IRS. Since 1964, the 403(b) rules had been updated but had not gone through a complete overhaul. In July 2007, the IRS finalized the first comprehensive 403(b) regulations in 43 years. These new rules require a written plan that will standardize each district's 403(b) providers. While providers and employers have until January 1, 2009, to be fully compliant, the changes have already begun.
In September 2007, new 403(b) regulations effectively undid the 90-24 ruling of 1990. The idea behind the 1990 revenue ruling was to allow participants more investment choices. In the late 1980s, schools had a restrictive list of approved firms, many with high fees. The 1990 ruling allowed participants the flexibility to move their investments to any account of their choice; however, there were no centralized administrators to monitor these transfers.
As 90-24 transfers became more prevalent, more variable annuity and mutual fund companies moved into the 403(b) market. This larger number of firms magnified the transfer issue. When a transfer is completed, custodians have little communication with one another. Most 403(b) providers only require the signature of a participant to certify any loan or hardship withdrawal. Compliance falls on employees, most of whom know little about the regulations.
The new regulations require multiple providers to communicate with one another and to work with school systems to set up a system of verification and information sharing. During the rest of 2008, school systems and custodians will put together the pieces to become compliant. School systems will take on more liability as the administrators of plans. Through the school systems, companies will share information on transfers, rollovers, hardship withdrawals and loans.
In December 2007, the IRS issued guidance on the new regulations and released model plan language for the written plan that must be in place by January 1, 2009. The guidance and model plan language can be found at www.irs.gov/pub/irs-drop/rp-07-71.pdf.
As a first step, many school business managers have written to the firms on their approved list to ask for an information sharing agreement and to stop further trustee-to-trustee transfers until the IRS issues guidance. Business managers have also sent out notices to employees to explain the new eligibility requirements. Many employees, like permanent substitute teachers and some hourly employees, who were not previously allowed to contribute to a 403(b) plan, are now eligible as long as they work more than 1,000 hours in a year.
The biggest changes lay ahead. Until now, school districts have played a small role in the administration of their employees' 403(b) plans. They deducted the correct amount from a teacher's salary and sent it to the right provider. Under the new regulations, the school system will take a more administrative role, monitoring transfer, hardship and loan information. This expanded role presents new challenges to school systems; they must learn about all the 403(b) products and decide which ones are best for their employees.
As with larger private companies that have one 401(k) plan for all employees, many school districts correctly believe that a smaller number of providers will simplify their administration. Therefore, providers may be weeded out in the next year. Fewer choices could bode well for school employees, as it will hopefully result in more carefully chosen options.
Going forward, the responsibility for choosing provider options will fall on the school system rather than on the participant. These options will come with an implicit approval from the district. With increased administration comes increased liability. If a school district works with its local employee unions and administrators in compiling the new approved-investment list, it may mitigate some of its liability.
With this increased focus on fewer plans, Michael Linehan, a regional director for ING in Glastonbury, Connecticut, thinks an advisor-centric model will win out. "As districts look to reduce their liability, they will need experienced 403(b) advisors to assist in the transition and to provide ongoing education," he says
If your clients invest in 403(b)s, there are some proactive steps you can take to ensure a smooth transition over the next year. Educating clients about the new regulations will give them a more personal understanding of how these changes will affect them. Since product salespeople will probably not take a proactive approach, your clients will be looking for professional guidance.
When the new regulations take effect in January 2009, there will be a lot of money sitting in 403(b) plans that are no longer approved within certain school districts. The owners of these orphaned 403(b)s will be looking for help consolidating their accounts. Advisors who alert their clients to these changes will have a better chance to play a role in the future management of these accounts.
By now, most school districts have sent letters to their employees advising them of the new regulations. Over the next year, school systems will need help reviewing prospectuses, fees, investment performance and surrender charges for the companies on their current 403(b) list. Keep yourself informed of changes as they unfold and position yourself to help your clients and their employers through the next 12 months.
Joshua B. Gottfried is a partner at Levine, Gottfried and Somberg in Glastonbury, Conn., and an investment advisor representative with Commonwealth Financial Network. He specializes in helping Connecticut educators plan for retirement. He can be reached at (860) 430-9104 or firstname.lastname@example.org.