403(b) Plan Sponsors Face Tougher IRS Rules
Those regulations, which were published in July 2007 and generally go into effect on January 1, 2009, will end the informal way that many 403(b) plans have been administered. Most of the affected plans are funded solely through employees’ salary deferrals, with no matching contributions from employers.
Under the IRS rules, though, such plans must have official documents detailing administrative responsibilities and benefit features. That requirement will end the longtime hands-off way some nonprofits have offered salary-deferral-only 403(b) plans, with employers passing that authority to mutual funds and insurance companies offering investment options, as well as to plan participants.
That lack of centralized employer control resulted in situations such as participants asking investment fund providers for hardship withdrawals of funds, with employers unaware that such requests were made and without knowing whether participants were legally eligible to get the distribution, experts say.
At the same time, employees with 403(b) plan accounts at various financial institutions sometimes requested hardship distributions from all investment providers. While such distributions may have broken IRS rules that limit such distributions, the money may have been distributed anyway because of a lack of coordination among the funds.
"No one was looking. In fact, employers’ view, in many cases, was that their role was that of distributing to mutual funds and insurers the monies that 403(b) plan participants contributed through salary deferral to mutual funds and insurers," says Glenn Poehler, a principal in the Richmond, Virginia, office of Mercer.
Adding to this casual approach, consultants say, is that employees at times were allowed to self-certify that a hardship withdrawal or loan complied with federal law.
With the IRS rules coming into effect, those days are coming to an end. Effective January 1, 2009, employers with 403(b) plans will ultimately be held responsible for ensuring that federal rules are met, says Dan Schwallie, a consultant in the Cleveland office of Hewitt Associates Inc.
"The IRS has made it clear that employers are responsible," says Lisa Arko, a consultant with Watson Wyatt Worldwide in Philadelphia. Penalties for noncompliance can be severe, such as including employees’ salary deferrals as taxable income.
Many 403(b) plan sponsors are reducing the number of investment fund vendors they make available to employees. Arko says that in some cases, dozens of vendors offered funds to plan participants. Limiting them is a very practical step, experts say.
"It is a lot easier for an employer to deal with one entity and have one point of contact," says Peter Gold, a principal with Buck Consultants in Stamford, Connecticut.
Still, reducing the number of plan vendors can be a sticky issue in some parts of the nonprofit world. "In the university environment, most things have to be done by consensus," and that can slow things down, Gold says.
How far along employers are in finalizing plan documents and laying out administrative responsibilities varies considerably by industry. In general, though, nonprofits that have large internal human resources departments, such as health care systems and universities, are the furthest along or may already be in compliance, while smaller school systems and other organizations lacking HR departments will bump up against the deadline.
Some community colleges, for example, are "panicked" as the deadline nears, Mercer’s Poehler says.
On the other hand, some nonprofit employers have little if any additional work to do now because they centralized plan administration years ago.
"We wanted to be sure that all benefit programs were administered with the highest level of scrutiny," says Joseph Molloy, director of benefits at North Shore-Long Island Jewish Health System in Lake Success, New York.
Other IRS rules—such as one requiring that all employees, with limited exceptions, be offered the right to make pretax contributions to 403(b) plans—already are being met by some plan sponsors.
For example, the Archdiocese of Chicago allows all employees to make pretax contributions.
"Our philosophy is that if employees want to contribute, we did not want to stand in the way," says Chris Cannova, the Roman Catholic archdiocese’s director of compensation and benefits.
Like their private-sector counterparts, nonprofit employers also are adding automatic enrollment features to their 403(b) plans to boost participation. Unless employees take direct action, they are automatically enrolled in a 403(b) plan with a preset percentage of their salaries deferred to the plan.
"This tackles employee inertia," Cannova says.
Plan sponsors adding automatic enrollment have seen big increases in employee participation.
For example, employee participation at the Archdiocese of Chicago jumped to about 80 percent from about 35 to 40 percent since automatic enrollment was added on January 1, 2008, Cannova says.
At North Shore-Long Island Jewish Health System, plan participation leaped to the high 80s from just under 70 percent when automatic enrollment was added at the beginning of 2008, says Joseph Cabral, chief human resources officer.
"We want to help employees save for their retirement," he says.
While 403(b) plans are becoming more similar to 401(k) plans, thanks to the IRS rules and plan sponsors adopting automatic enrollment, a key difference remains: Employees’ salary deferrals into 403(b) plans are not subject to an IRS nondiscrimination test. The test does apply to salary deferrals made by 401(k) plan participants.
The nondiscrimination test is used to ensure that average deferrals made by highly compensated employees do not exceed those of rank-and-file employees by a legally set amount. In many cases, that test means that highly paid employees in the private sector can’t contribute the maximum deferral allowed—currently $15,500—because lower-paid employees, on average, aren’t contributing very much.