Surrender Charges in 403(b) Plan Annuity Contracts
In our experience, participants in 403(b) plans--plans sponsored by tax exempt organizations and schools--are among those hardest hit by the fees and expenses charged by their plan's investment providers. The problem is that well-meaning but sometimes ill-informed plan fiduciaries unwittingly trap their participants in insurance contracts with significant surrender charges--or other forms of compensation to plan service providers--that substantially erode their employees' retirement accounts. Surrender charges(or "contingent deferred sales charges"), and other compensation paid to insurance carriers upon termination of group annuity contracts raise significant issues regarding ERISA's prohibited transaction and fiduciary responsibility rules which plan fiduciaries cannot overlook.
This article arises out of a number of matters we have handled for 403(b) plan clients and focuses on plans sponsored by non-governmental tax exempt entities subject to ERISA. (Plans sponsored by governmental entities are exempt from ERISA.)
When a 403(b) plan terminates its annuity contract with an insurance company, the contract may provide several different means of compensating the insurance company. Surrender charges are one common form of compensation. Typically, an annuity contract contains one of two types of surrender charges. The first is a surrender charge expressed as a declining percentage of plan assets. The longer the contract has been in force, the lower the percentage of assets that is charged -- e.g., 8% the first year, 7% the second year 7%, and so on until, in some instances, the surrender charge disappears.
A second type of common surrender charge is expressed as a percentage of the contributions paid during, for instance, the five year period leading up to the termination. Charges like this have the particular disadvantage of never going away -- the plan is essentially guaranteed to incur a surrender charge upon termination regardless of how long the contract has been in force.
Insurance companies may also insert a provision in their contracts which require that, upon the plan's termination of the annuity contract, the insurance company may pay out the plan assets in installments over a period of five or more years. The difference between the interest rate credited to the plan, and the amount the insurance company is able to earn on the plan assets during the deferred payout period represents compensation to the insurance company.
Plan fiduciaries often pay little attention to these sometimes confusing and complex contract provisions. Compounding the problem is that insurance companies often issue the contract well after the application for the contract is signed, so plan fiduciaries may not even be aware of the full range of potential expenses until after the contract has been in force for some time.
ERISA §408(b)(2) requires that plan service providers -- such as insurance companies -- receive no more than "reasonable compensation" for the services that they provide. The Department of Labor regulations interpreting this statute explain that a contract is not reasonable if the plan cannot terminate the contract without penalty to the plan on reasonably short notice to prevent the plan from being locked into an arrangement that has become disadvantageous. Charges deemed to be a penalty are per se unreasonable.
These limits on fees and expenses have significant ramifications both for investment providers -- such as insurance companies -- and for 403(b) plan fiduciaries. Any charge in excess of reasonable compensation violates ERISA's prohibited transaction provisions, and possibly, ERISA's fiduciary liability provisions.
Similarly, plan fiduciaries -- who are charged by ERISA with defraying reasonable expenses of the plan -- cannot agree to pay an investment provider excessive compensation without violating ERISA's prohibited transaction provisions. Thus, 403(b) plan fiduciaries must ask specific questions regarding the charges they can expect, and compare these charges (and the services they expect to receive in return) with those offered by competing companies. They must also determine, when terminating an annuity contract, what charges they will incur, and whether those charges are reasonable under the circumstances. If not, they should take appropriate steps to attempt to get those charges reduced - something we have worked with clients to do on a number of occasions.
Any U.S. federal income tax advice contained in this communication (including any attachments) is neither intended nor written to be used, and cannot be used, to avoid penalties under the Internal Revenue Code or to promote, market or recommend to anyone a transaction or matter addressed herein.
© 2006
Reish Luftman Reicher & Cohen. All rights reserved. Government & Tax Exempt Plan Report is published as a general informational source. Articles are general in nature and are not intended to constitute legal advice in any particular matter. Transmission of this report does not create an attorney-client relationship. Reish Luftman Reicher & Cohen does not warrant and is not responsible for errors or omissions in the content of this report.
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