Chapter 8

IRS’s Problem with the 403b

2004-2010

The print media, American Federation of Teachers’s AFT_Special_Report Shark ATTACK and our legislative effort highlighted 403b troubles across America. In 2004 the Internal Revenue Service (IRS) entered the fray by proposing new 403b regulations! Why? Was their update going to fix the 403b as the 2001 Economic Growth and Tax Relief Reconciliation Act did (EGTRRA, Chapter 4)? This fix aimed at a problem few could have predicted—auditing. This chapter examined the rationale and the effects of the new regs with one positive outcome.

The insurance industry in concert with the state Insurance Commissioner’s Office maintained total control of TSA products and delivery systems from day one. School district personnel misinterpreted the state’s insurance code which benefited the insurance industry. By doing nothing, districts allowed one economic opportunity after another for the industry. Something unexpected happened—as the 403b became more popular the IRS had two problems:

1. The 90-24 transfer rule allowed employees to invest in multiple 403b accounts with several companies inside and outside the official list.
2. The insane number of 403b vendors, many districts had over 100.

When the IRS audited LAUSD in the year 2000 they took a sample of 900 employees’ records. They found an insignificant $2000 worth of “over-contribution” mistakes, according to the CFO. If serious noncompliance issues were discovered, the IRS would have audited additional employees. But it was impossible to audit each of the 25,000 LAUSD active participants and one hundred fifty different 403b vendors without extensive time and commitment. With a multiple accounting environment more complicated than a Rubik’s Cube solution, how could the IRS find additional noncompliant employees among the thousands not audited?

Result of Zero Oversight

District staff had to respond to the IRS demands during audits. But apparently the IRS could not do a thorough job—the 403b was in complete systemic dysfunction well-beyond what any district with hundreds of vendors could do to provide data to the auditors. The IRS inherited a mishmash of accounts from thousands of employees, district administrators and hundreds of vendors—none with genuine responsibility to provide data the IRS needed. Something had to clear-up this unresponsive system-wide mess.

New Regs

On July 23, 2007 the IRS finalized new 403b regulations. After gradual implementation over a three-year window they went into full effect January 1, 2010. The following four points summarized the new law:

1. 403(b) programs must have a written plan document.
2. Districts must provide annual notification of eligibility (universal availability).
3. Information-sharing agreement was required between employers and vendors.
4. End to traditional 90-24 outside-of-plan transfers.

Written Plan Document

            Districts had to do the inconceivable: own their side of the 403b street by doing what 401k employers in the private sector had been doing for decades—writing a plan document. This document contains all of the plan’s terms and conditions for eligibility, benefits, distributions and hardship withdrawals etc, and the basics listed above. Districts were now on the hook to acknowledge and be responsible for their 403b plan.

Public documents are available to anybody. When I asked for the list of no-loads, LAUSD would have been required to provide a copy. When researching your employer’s 403b plan never rely on a salesperson. Always obtain what you need directly from your district or employer.

Annual Notification of Eligibility

            Employers offering 403b plans must inform employees each year their 403b exists, eligibility rules, the list of vendors and:

1. The maximum allowed to contribute in the next calendar year.
2. Employees can increase or decrease the amount contributed.
3. Ability to change companies within the plan (90-24 transfer rule is detailed below).
4. Ability to transfer money within the plan (90-24 transfer rule is detailed below).
5. All employees who work 20 or more hours a week are eligible.

Relinquishing those duties to the TSA salespeople was prohibited.

Information Sharing Agreement

The information sharing requirement reduced the number of vendors! All vendors must share with the employer information about the number of employees, their accounts and product sold (anonymously of course). About 125 vendors decided to stop doing business with LAUSD as a result. Even the insurance code with “all willing providers” could not stop the capitulation of most of the original 140 LAUSD vendors, reducing the number to 27.

This new law also puts a demand on districts. The transition from zero responsibility to taking responsibility must have been stressful. District staff had little idea how to write up a plan document, for example. Thus, the IRS allowed district staff to farm out administrative tasks to independent third-party administrators (TPA). In 2006 LAUSD hired Variable Annuity Life Insurance Company, VALIC (Details about this company will be discussed in then next Chapter).

End of 90-24 Transfers

Bad news outweighs the good news. While the Wild West of no accountability by district administrators was over, the one new restriction prevented 90-24 transfers. The new rules rescinded out-of-the-plan transfers which many teachers depended on to escape from an unwanted TSAs into sensible low-cost investments. In the 1990s, I was fortunate to transfer my two annuities to the lower cost Vanguard and Fidelity. It didn’t matter that Vanguard and Fidelity were not in the plan. The new regs forbid this out-of-the-plan transfer in order to reduce the auditing complexity.

Annuity Sales Have Not Been Slowed

The new regs did nothing to improve the 403b. The effect was the opposite of the 2001 EGTRRA law. Recall Fidelity signed on with LAUSD right after the EGTRRA law passed, but they withdrew immediately with these new regs. It’s a familiar story—low-cost companies refused to sign the information sharing agreement because of the additional cost. The usual suspects remained: annuities, TSAs, loaded or high cost mutual fund companies. Even with 125 companies now gone the steadfast options still included the largest sharks. The 27 remaining appear to be a low number, but those companies already had the most 403b assets and number of LAUSD employees contributing to TSAs or loaded mutual funds.

Double OUCH!

The fact that low cost investments such as Fidelity Investments decided to terminate their relationship with LAUSD was bad enough. Now educators were unable to transfer from horrific TSAs to Fidelity or Vanguard.  This angered many educators. Scores of participants had little choice but to abandon the 403b and invest with the lower annual max of the Roth IRA instead.

The Department of Labor (DOL) monitors the 401k plan, but public school 403bs have always been exempted from the DOL’s Employment Retirement Income Security Act requirements (ERISA, 1974 discussed in Chapter 2).ERISA requirements are the last thing the TSA companies and their reps want enforced in 403b plans—cost transparency and fiduciary responsibility.

The insurance industry’s one-to-one strategy with product information and delivery to individual educatorswas their core successful sales platform. Districts were forbidden by our industry-friendly insurance code to vet the types of products made available. If a vendor signed all requirements under the new regs districts must allow them to conduct business with their employees. Thus, insurance product 403b sales were never in jeopardy.

Not all was lost, however. The most positive unintended consequence of this 403b debacle was noteworthy—I devote the largest chapter of this book to it. The LAUSD benefits administration knew back in 2004 the new IRS regs were looming. As long as they had to hire a TPA to help, one futuristic administrator introduced a new lower cost plan. In the next two chapters, the new 457b plan will be discussed.

Summary

This was the first time the IRS updated the 403b. The IRS ended up doing the impossible, requiring school districts to take some responsibility for the 403b. Some objective information was now available. Unfortunately, the objective information never made it to each employee without the meddling of the sales force. Employees still get 100% of their information from the biased agents who roam our district turf. Sadly, other than reducing the number of vendors the economic dynamics of TSAs sold to educators was not slowed nor questioned.

How did the insurance industry escape the potential wrath of the new regs? California’s insurance code rescued the insurance industry by demanding districts continue to allow all providers who comply with the new regs. The industry strategy to end-run the new regs was so successful it made the “Miracle of Dunkirk” look like a trivial WWII skirmish. Because of the transfer rules, low-cost vendors opted out—they could not keep costs low due to the information sharing agreements. The asset heavy TSA companies with the most employees as clients were left in place. The TSA sales label and one-to-one relationship of agents with helpless educators is once again protected. Now you know why $100 plus million dollars of annuities are still being sold annually to 25,000 LAUSD educators with no end in sight.