Mastering the 403(b) Universe
With IRS rules requiring that 403(b) plans look and act more like 401(k)s, oversight committees must become experts of fiduciary compliance for higher education retirement plans. A fiduciary adviser experienced in the 403(b) world spots five trends in this evolution.
By James E. “Jeb” Graham
The 403(b) landscape has been dramatically altered during the past decade. Prompted in large part by regulations developed by the Internal Revenue Service (IRS) and the Department of Labor, changes in plan design, investments, service delivery models, and technology have been felt by plan sponsors and participants across the spectrum of health care, nonprofits, and higher education. Following an evolutionary path, today's 403(b) plans are beginning to look and feel much more like their 401(k) brethren. For most college and university plans, this is a positive step forward, moving away from proprietary investment products, allowing access to a broader universe of investments, and providing greater fee transparency.
Your institution may be facing questions like these: What are the risks of not adapting to the changes? What are other institutions doing to respond to the evolutionary nature of the 403(b), and plan governance? Where do we go from here?
To answer these questions, let's briefly explore the reasons that prompted the change, note new requirements taking effect, and identify specific trends arising from the evolution of 403(b) governance among plan sponsors in higher education.
The Need for Change
So, what prompted the IRS and the Department of Labor (DOL) to force reform on the world of 403(b) by creating new regulations? In a word: compliance. Certain statutory rules were consistently not being followed. Two particular areas of infraction stood out: maximum contributions and loan amount limits.
- Exceeding maximum contributions. The original 403(b) laws set a maximum contribution amount that was to be monitored by the company providing the investment product. The amount's calculation was based on a fairly complex formula that was not easily understood by participants. Significant problems arose when an employee had more than one plan provider accepting his or her 403(b) contributions. Typically, the companies providing the plans had no process to aggregate contributions account holders might make to any number of other companies, for purposes of monitoring the limits. Not surprisingly, contribution maximums were exceeded on a frequent and continual basis.
- Violating loan amount limits. The limits for plan loans were also consistently violated. Each plan provider monitored loan amounts, but only those loans included in accounts on its own books. Again, if an employee had accounts with two or more providers, typically no loan amount aggregation was available to monitor compliance with the loan limits under the law. Consequently, for most plans, compliance with rules for repayment of loans was practically nonexistent.
With respect to the DOL position as an advocate for plan participants, the department had growing concerns that employees' interests were not being well served. In the for-profit space, plan sponsors had fairly strict guidelines for 401(k) plan oversight, which forced employers to make decisions in the collective best interests of plan participants. For the most part, this oversight was absent in the 403(b) world, which was not yet subject to rules established by the Employee Retirement Income Security Act (ERISA) of 1974 that established explicit requirements for employer-sponsored retirement plans and the entities that served as plan sponsors. Investigation by regulatory agencies continually showed a meaningful gap in the investment performance and expense structures when comparing the two defined contribution plan types, with results tilting favorably in the direction of 401(k) plans.
Because most 403(b) arrangements were structured as individual contracts between the participant and the investment company, economy of scale was not achieved; thus, investment expenses were typically higher than those of 401(k) plans of similar-size organizations. Furthermore, most annuity contracts had stiff surrender penalties limiting transferability to another provider.
Welcoming ERISA to the 403(b) World
Beginning in the late 1990s and continuing well into the past decade, regulatory agencies analyzed and evaluated 403(b) plans within the existing framework of statutory law and regulations, building momentum toward major reform. In July 2007, the final 403(b) regulations were released, with an effective date for most of the legislation to be Jan. 1, 2009.
Since 403(b) plans had not been required to operate in accordance with laws under ERISA, there was some confusion as to the role of plan sponsor, there were very few 403(b) plan documents, and there was little in the way of oversight by anyone at the plan level.
The new regulations clarified the employer roles related to 403(b) plans and brought forth a host of new requirements for institutions. Under the new regulations, plan sponsors—including higher education institutions—were now required to do the following:
- Have written plan documents.
- File an annual Form 5500 (including a plan audit).
- Monitor contribution limits.
- Ensure compliance with rules for participant loans.
Transitioning to meet the new requirements was not always an easy undertaking, and many institutions, like Embry-Riddle Aeronautical University, Daytona Beach, Florida, faced a tight learning curve. Irene McReynolds, vice president of human resources, reflects, “The audit was a new experience not just for us, but for our vendors and our accounting firm as well. But working together, we navigated through uncharted waters and survived just fine.” To prepare for the audit, McReynolds and her team developed numerous internal and external reports and reviewed the data.
The new rules place a higher fiduciary standard on the plan sponsors responsible for making investment decisions on behalf of employees.
With regard to 403(b) plan investments, the new rules place a higher fiduciary standard on the plan sponsors responsible for making investment decisions on behalf of employees. “This was all new to us at Embry-Riddle,” remarks McReynolds. “We decided to hire an independent fiduciary adviser to help us develop and execute a formal governance process.” That included, explains McReynolds, creating an investment policy statement, establishing a formal retirement planning committee, and reviewing all investment offerings based upon established criteria.
Mixed Responses and Reviews
Many other organizations have not made as much headway as Embry-Riddle; and nearly three years after the effective date of the 403(b) regulations, the fiduciary learning curve continues to be challenging. While colleges and universities have responded to the plan documentation and audit requirements, many have not made progress on the investment oversight front—having not yet developed an investment policy, established a plan committee, or documented a fiduciary process.
Achieving best practices with regard to 403(b) plan administration has been slow. Assessing the collective status of reaching fiduciary governance best practices leads to two observations.
- Most college and university plan sponsors have responded in a positive way to changes mandating greater compliance, more operational controls, and specific 403(b) plan documents. Adopting a written plan, getting the first Form 5500 filed, and conducting a plan audit were major hurdles to clear. Going forward, most plan sponsors should find it much easier to accomplish these administrative functions.
- The ERISA requirements for 403(b) investment oversight remain under the radar for many plan sponsors. While most colleges and universities have long used formal committee structures in their foundation and endowment investment-oversight processes, higher education plan sponsors (like many other nonprofit and health-care organizations) paid virtually no attention to oversight of 403(b) savings arrangements prior to the release of 403(b) regulations in 2007. For many institutions, most of the focus and effort has still been on compliance with the operational, reporting, and document standards since the effective date in 2009.
Further Trends in Higher Education 403(b) Oversight
Against the backdrop of 403(b) oversight work already taking place, the following developments will have an ongoing impact on college and university plan sponsors.
Increased recognition of the institution's role as plan fiduciary. Prior to the 2007 regulations for 403(b), many institutions were unfamiliar with the concept of an ERISA plan fiduciary. The role of a 403(b) plan sponsor was not well established, as many investment providers serving this market viewed the plan participant as the client. The institution simply facilitated salary deferrals as a payroll function and had little involvement otherwise. For most colleges and universities, responsibility for the 403(b) was lodged in a midlevel human resources position, certainly not in the C-level offices.
At the University of Tampa, the 403(b) investment committee's role as a fiduciary was established several years back. Donna Popovich, executive director of human resources, points out: “We see our fiduciary role as very important to the investment outcomes for our employees. Our committee strives to reach a best-practice level of investment oversight.”
An awareness of the fiduciary obligation, and the resulting liability, is increasing throughout higher education retirement plan administration. The movement toward formal committee structures and written investment policy documents is also starting to grow. Committees are beginning to conduct due diligence on investment managers and scale down the 403(b) portfolio offerings to a much more manageable number. For example, two key accomplishments at Embry-Riddle in 2011 were (1) establishing a written investment policy outlining specific objectives and allowed asset classes and (2) implementing a quarterly review process by which plan investments are compared against benchmark indexes spelled out in the investment policy. (For detailed information on scaling down portfolio offerings, see “Single Provider, Multiple Choices,” in the March 2010 issue of Business Officer.)
Importance of benchmarking of fees and services. ERISA clearly spells out the requirements for prudence in the selection of service providers, along with the mandate to ensure that fees are “reasonable.” While most of the recent well-publicized fee lawsuits have targeted 401(k) plans, 403(b) counterparts are also fair game.
For 2009 plan year filings, Schedule C included an additional requirement for information relative to fee disclosure. Last summer, the DOL released new fee disclosure regulations under Section 408(b)(2). The deadline for compliance by service and investment providers is July 1, 2012.
Some plan fiduciaries may be confused as to what the disclosure means and what they are required to do differently. The new fee disclosure regulations are completely unrelated to the Schedule C attachment on Form 5500. The 408(b)(2) regs are a projection of fees, whereas the Schedule C is a documentation of actual dollars paid from plan assets. The 408(b)(2) disclosure requirement is one of absolute data with no benchmark element. Unless plan sponsors have something to compare it to, the information itself seems to be of questionable value.
However, failure to adequately review the data, and act accordingly, could result in a fiduciary breach and subject the plan sponsor to fines and penalties. To meet the requirements of ERISA, retirement plan committees should identify appropriate service and fee benchmarks for comparison to their plan. If a committee lacks this expertise, it might consider working with an independent adviser who will act in a fiduciary role, to assist in this benchmarking.
Plan sponsors are coming to the conclusion that there is simply no reason to offer plan participants only proprietary funds.
Also coming in 2012 is the requirement for fee disclosure to plan participants. For plan sponsors with multiple providers, this will be a more difficult task. Some institutions, like Nova Southeastern University, Fort Lauderdale, Florida, are well prepared for this challenge. Diane Emery, the human resources department's director of total rewards at Nova, says, “We have worked with our two vendors to provide the fee disclosures side-by-side in a coordinated delivery to participants. We believe this will be more in keeping with the nature of the regulation and provide true transparency.”
Consolidation of providers. In terms of service delivery structures, 403(b) plans now look more like 401(k) plans than ever. Historically, many higher education and nonprofit institutions have used multiple providers as a way to broaden the 403(b) investment selection for employees. The logic was that offering more products fostered competition, which should, in theory, drive expenses down. That logic proved false. Having multiple providers typically involved using individual contracts that had higher investment expense structures than those associated with a single provider using an institutional platform. Consequently, the list of providers that now offer the full scope of 403(b) services is not very long when compared to those offering 403(b) products five years ago.
Advances in technology have allowed service providers to offer open architecture investment platforms that can accommodate virtually any investment traded through the NSCC (National Securities Clearing Corporation). From the standpoint of flexibility, this has eliminated the need to have more than one provider. Transitioning to a single provider also allows the 403(b) plan sponsor to take advantage of scale, which typically serves to decrease overall expenses. Clearly, the trend is toward using fewer providers—and in many cases, only one.
Movement away from proprietary products toward open investment platforms. In the past, most investment providers offered a menu of proprietary or restricted investment options in the form of mutual funds or subadvised separate accounts. This included some of the biggest players such as TIAA-CREF, Fidelity, Vanguard, and VALIC. In addition to these big players, most of the top 403(b) investment providers now offer open architecture platforms with access to all mutual funds, not just proprietary ones. Plan sponsors are coming to the conclusion that there is simply no reason to offer plan participants only proprietary funds.
Changes in the delivery of participant services. The trend toward using a single provider has affected participants in several positive ways.
- Less sales pressure, more service. In a multiple-provider setting, participants were “sold” investment products. Now, in a single-provider setting, the focus is on “serving” the participants, not competing for their business. With multiple providers, representatives are usually compensated by sales commissions. With a single provider, the service team is typically salaried and receives additional incentives based on service-quality metrics. Plan sponsors working with a single provider tend to approach participant services much more strategically, placing a priority on efficient and effective communication methods.
- Better communication. Another difference is in the nature of communication. McReynolds at Embry-Riddle sees an opportunity to provide employees more-detailed information so they can make better decisions about their retirement plan choices. She observes, “We are providing a significant benefit, for which, in the past, our vendors took responsibility.” This has been a significant shift for employers who must become more active about supplying information to staff.
Investment education is no longer the sole objective. Participant services are moving toward helping participants understand how to prepare for retirement, showing them how to measure their progress, and suggesting they focus less on the investments themselves. The overall goal is to engage participants and give them the tools and technology to foster positive steps in the process.
For Embry-Riddle, says McReynolds, communication has included not only sharing clear explanations of investment options, but also evaluating the offerings, disclosing the relevant fees, and comparing the various funds. “We plan,” she says, “to convey much of the information via our employee newsletter, blast e-mail messages, and group and individual counseling.”
Yes, the 403(b) landscape has truly changed and, in many ways, for the better. But progress takes time. NACUBO is helping bring attention to the importance of fiduciary governance, as member institutions move their way along the learning curve. There is still a long way to go in collectively reaching a best-practice level.
Fiduciary training will become more prevalent, as committees seek to increase their knowledge and capabilities as stewards of plan assets. As institutions continue to respond to the trends mentioned earlier, we can expect that, over time, plan participants will reap the benefits of their plan sponsors' responses to ERISA's fiduciary guidelines.
JAMES E. "JEB" GRAHAM is a retirement plan consultant and partner, CapTrust Advisors LLC, Tampa, a registered investment adviser with the Securities and Exchange Commission.
This material is distributed solely for informational purposes and is not intended as legal or tax advice. The views contained herein are the opinions of the author.