A 403(b) Collective Trust? A Note of Caution…..

Robert J. Toth, Jr.

Collective trusts have seemingly become all the rage in plan investment circles, and for some very good reasons.

But what of a 403(b) plan purchasing collective investment trusts (CITs)? Surely, the CIT advantages can be made available to these plans, especially since the IRS specifically approved the commingling of 401(a) assets and 403(b) assets in something called 81-100 trusts under Revenue Ruling (Rev. Rul.) 2011-01! (“81-100 Trusts” refers to the Rev. Rul. 81-100 which recognized the tax exempt status of a collective trust which holds the assets of unrelated 401(a)-and now (since 2011-1) 403(b) plans).

Well, as seems to be with all things 403(b), there’s trouble in the details. Two issues need to be addressed with a 403(b) plan’s purchase of the collective trust interests of the sort that are typically sold to 401(k) plans.

First, Code Section 403(b) only permits investments in mutual funds and annuity contracts.* The CIT interests purchased by 401(a) plans, however, are “unitized.” This means that the commingled value of all the assets in the trust are valued every night, like a mutual fund, and each unit given a net asset value. But the problem is that the typical CIT is NOT a mutual fund registered under the Investment Company Act of 1940, and the interest which is being purchased is therefore not a mutual fund share (note that there are exceptions: some CITs WILL actually be registered under the 40 Act, but these are not trusts in which 401(k)s typically invest). It is therefore unlikely that the Internal Revenue Code would permit its purchase under a non-403(b)(9) arrangement.

To get around this problem, you could try to design a CIT in such a way to “look through” the CIT to the underlying mutual fund in order to qualify under Section 403(b). This, however, would require share accounting of the investments of the CIT. Legal niceties aside, this would be virtually impossible to do from the practical standpoint given the manner in which CITs operate (for example, they typically hold a percentage of their assets in cash, which then screws up share accounting).

But even if you could do share accounting and overcome the legal and logistical challenges to making this work for the Section 403(b) rules, there is a serious securities law problem. Investments by 403(b) plans do not qualify for the exemptions from registration under the Investment Company Act of 1940 or the Securities Act of 1933, while 401(a) plans do enjoy that exemption. The collective trust with 403(b) funds would likely have to be registered under the ’40 Act as a mutual fund or, at least, the CIT shares registered as securities under the ’33 Act. Unless the plan sponsor otherwise has security law exemptions (think government and certain church plans), this then would be a non-starter. The 81-100 trust for 403(b) plans of organizations without a security law exemption will, it would seem, have limited usefulness.

What does this all mean? It means that if you have a 403(b) plan which is investing in collective trusts, you probably need to sit down and talk with your lawyers or compliance staff. It will be very interesting to see how many of the 403(b) prototypes which the IRS is currently reviewing will specifically authorize collective trusts without a thought to these issues…..

*Note that 403(b) does have an exception: 403(b)(9)  permits church retirement income accounts to invest in vehicles other than annuity contracts and mutual funds.

Robert J. Toth, Jr., is Principal at Toth Law. Used by permission.

Opinions expressed are those of the author, and do not necessarily reflect the views of NTSA or its members.