Fiduciary Rules Applicable to "(b)" Plans

By Fred Reish and Bruce Ashton

The responsibilities of Internal Revenue Code Section 403(b) and 457(b) p/an fiduciaries are discussed here. Considerations include ERISA coverage rules, legal requirements, plan expenses, investment alternatives, and the implications of fiduciary rules.

This column has previously addressed the fiduciary rules that govern 401(k) and other qualified plans. Yet millions of American workers are covered by employer-based, participant-directed retirement plans that are not "qualified plans." We refer here to 403(b) plans and 457(b) plans. With the renewed interest in these types of plans--the IRS has recently issued extensive guidance on both--the question arises whether these plans are subject to the same fiduciary rules as are 401(k) plans.

The answer is that it depends on the type of entity sponsoring the plan. This column addresses the application of fiduciary rules to 403(b) and 457(b) plans and to the officials who oversee those plans.

Background
The entities that can sponsor 403(b) and 457(b) plans are limited. Internal Revenue Code ("Code" or "IRC") Section 403(b) plans can be sponsored by state and local governments for public school and other government employees and by organizations exempt from income taxation under Code Section 501(c)(3), such as private schools and research foundations. [IRC § 403(b)(1)(A)] Similarly, 457(b) plans can be sponsored by governmental units and agencies and by tax-exempt entities (though not limited to 501(c)(3) entities). [IRC § 457(e)(1)] The Employee Retirement Income Security Act of 1974 ("ERISA") exempts government-sponsored plans from coverage pursuant to ERISA Section 4(b), including the fiduciary and prohibited transaction provisions; thus, state law governs operations and investments of these plans. Plans sponsored by tax-exempt entities, in contrast, may or may not be subject to ERISA: The rules are not simple. (Note that plans sponsored by churches are also exempt from the provisions of ERISA under Section 4(b)(2), and are thus subject to state law fiduciary requirements.)

Under regulations of the Department of Labor (the a 403(b) plan sponsored by a tax-exempt entity may also be exempt from ERISA if the employer has little or no control over the plan. Specifically, DOL Regulation Section 2510.3-2(f) specifies that the plan will not be treated as a plan subject to Title I of ERISA if:

1. Participation is completely voluntary;
2. All rights under the annuity contract or custodial account are enforceable solely by the employee;
3. The employer receives no consideration for permitting employees to participate in the plan (other than reimbursement of reasonable expenses related to administering salary reduction instructions of the employees); and
4. The employer does no more than make information about the plan available for the employees.

On the other hand, if the employer selects the investment provider(s) or makes employer contributions, the plan will be subject to Title I of ERISA, including the fiduciary requirements of the law. [See ERISA § 3(2)(A) and DOL Reg. § 2510.3-2(f)]

Generally, a non-governmental 457(b) plan will be subject to the fiduciary provisions of Title I of ERISA unless it is a plan that provides benefits only for a select group of management or highly compensated employees. [See ERISA §401(a)(1)] As a practical matter, tax-exempt entities generally design their plans to take advantage of that exemption.

Applicable Fiduciary Rules
The fact that some 403(b) and 457(b) plans are exempt from ERISA does not mean they are free from fiduciary governance.

Private-sector 403(b) plans are subject to the ERISA fiduciary requirements unless the 403(b) plan is exempt because of limited employer involvement or the plan qualifies as a church plan. For plans that are subject to ERISA, the officials of the organization who oversee the operation of the plan and pick its investments are fiduciaries and are subject to the same fiduciary standards under ERISA as the fiduciaries of 401(k) and other qualified plans, e.g., the prudent man rule, the duty of loyalty, the exclusive purpose rule, and the prohibited transaction restrictions.

Exempt 403(b) plans and government 457(b) and 403(b) plans are also subject to legal requirements, just not ERISA's. Instead, they are subject to the laws of the states in which the plans are established. Many of the state fiduciary laws are based on principles similar to those underlying ERISA--such as modern portfolio theory, the prudent man rule, and the use of generally accepted investment principles--and a number of state statutes use language that is virtually identical to the provisions of ERISA.

For example, California, has specific fiduciary rules applicable to public school plans under the California Education Code. Section 22250 of the Education Code provides:

The board and its officers and employees of the system shall discharge their duties with respect to the system and the plan solely in the interest of the members and beneficiaries ... as follows

(a) For the exclusive purpose of the following:

(1) Providing benefits to members and beneficiaries

(2) Defraying reasonable expenses of administering the plan.

(b) With the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with those matters would use in the conduct of an enterprise of a like character and with like aims.

(c) By diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so.

(d) In accordance with the documents and instruments governing the plan and the system insofar as those documents and instruments are consistent with this part and Part 14 (commencing with Section 26000).

This language is identical to the wording of ERISA Section 404(a). The Education Code also includes provisions on prohibited transactions, conflicts of interest, breach of fiduciary duty, personal liability, and the appointment of investment managers. There are similar fiduciary rules applicable to non-school 457(b) plans under the California Government Code (as well as a specific incorporation by reference of the 404(c) rules of ERISA).

Implications of the Fiduciary Rules
These state law provisions illustrate that the fiduciaries of plans governed by ERISA and, in many cases, those that are "only" governed by state law are subject to similar legal requirements and must follow virtually identical rules and practices. That said, in the authors' experience, it is not uncommon to find that fiduciaries of 403(b) and 457(b) plans fail to live up to these standards, not because they lack the ability or desire but because they are not familiar with or even aware, in many cases, of the requirements.

Whether governed by state law or ERISA, fiduciaries of 403(b) and 457(b) plans need to take steps to comply with the applicable requirements, including, among others, the following:

1. Plans subject to Title I of ERISA (that is, nongovernmental, non-church, and non-exempt 403(b) plans) must have a written plan document under ERISA Section 402(a)(1). If the proposed Treasury regulations released in November 2004 are finalized as drafted, the plan document requirement may be extended to all 403(b) plans.
2. The fiduciaries must understand expenses related to plan administration and the available investment options and compare them with other providers to ensure that they are reasonable and appropriate. In some 403(b) arrangements, the employees must earn 3 percent, 4 percent, or even more just to cover expenses. Only after covering that expense "hurdle" do the earnings on their investments begin to fund their retirement. While some of the fault for expense-laden plans can be laid at the feet of the plan providers, much of the problem could be avoided if the fiduciaries took the same steps that their counterparts in 401(k) plans are expected to do, i.e., learn what the expenses are in the annuity contract or custodial arrangement and comparison-shop with other providers.
3. The fiduciaries must examine both the up-front and ongoing expenses, and must look at the cost of getting out of the investment. Some contracts and investments impose termination fees, surrender charges, or "contingent deferred sales charges." At the least, the fiduciaries must understand that these charges exist, how much they are, and what services are being received in return.
4. The fiduciaries must understand the provisions of the provider's contract. Among the provisions that can be problematic are ones that permit the provider (a) unilaterally to amend the contract provisions; (b) if the contract is terminated, to pay out the funds over a period of years, sometimes up to five years or more; (c) to remove investment options (e.g., mutual funds) and replace them with others without the consent of the fiduciaries; and (d) to change the expenses and fees without the consent of the fiduciaries. The fiduciaries need to understand the contracts and agreements, understand the meaning of those provisions, and not agree to them unless they conclude that the provisions are in the best interests of their participants (which may involve comparisons with other products in the marketplace).
5. Among the most important obligations is the requirement to act prudently in the selection of investment options and then to monitor them on an ongoing basis. If the officials of the plan sponsor are not aware that they are fiduciaries and that they have a legal duty to act in the best interests of participants, they will likely also fail to recognize their oversight duties in relation to the plan's investment options and the obligation to remove under-performing investments. Among the considerations for investments options are:

   a.	The expected performance in the future (based, at least partially, on how they have performed in the past, but also based on qualitative considerations about how they are managed);
   b.	Whether the investment options offer a broad range of alternatives so that the participants can develop reasonable investment portfolios in their accounts. This requires the fiduciaries to be aware of modern portfolio theory and means, therefore, that the fiduciaries may need help from an advisor or the plan provider;
   c.	Whether the investment alternatives are suitable for the employee workforce, taking into account the investment knowledge and sophistication of the employees; thus, for example, for an unsophisticated workforce, it may be appropriate to offer a limited number of identified core alternatives, accompanied by services that provide professional investment management to the participants, or vehicles such as lifestyle or lifecycle funds.

Conclusion
Officials of the institutions, whether governmental units or tax-exempt entities, that sponsor 403(b) and 457(b) plans are fiduciaries. The rules that govern their conduct are essentially the same, whether the plan is sponsored by a private-sector employer and is subject to ERISA or is a government or other exempt plan subject to state law. Regardless of which laws apply, the conduct of these officials will be governed fundamentally by the same principles: to act prudently and in the best interests of the employees whose retirement funds are invested in the plan.

© 2005 Aspen Publishers, Inc. All rights reserved. Reprinted, with permission, from Journal of Pension Benefits, Volume 12, Number 2, Winter 2005. Journal of Pension Benefits is published quarterly by Aspen Publishers, Inc. To subscribe to this publication, call 1-800-638-8437.

Learn more about R&R related practice areas:
Employee Benefits