This article originally ran on April 6, 2014.
By Michael A. Webb
Unlike qualified plans, where the plan termination regimen is well established via an IRS determination letter process, and thousands upon thousands of terminations have occurred without incident over the years. However it is only within the last few years, via the final 403(b) regulations and Revenue Ruling 2011-7, that it was clearly established that a 403(b) plan could be terminated at all. And, though it was welcome news that a 403(b) plan could indeed be terminated, the guidance created more questions than answers as to the actual termination process. In this article, we will attempt to get to the bottom of the issues that can make plan terminations, as a practical matter, difficult or even impossible to complete.
403(b) Plan Termination Basics
When you go to the IRS’ 403(b) Plan Termination Page, and start to read about the termination process, it does not appear to be all that daunting, at first. All a plan sponsor needs to do to complete the process is a) establish a plan termination date, b) cease contributions, c) fully vest any nonvested employer contributions (elective deferrals are always 100% vested, and d) authorizing the distribution of benefits as soon as administratively practicable. Sounds simple, huh? Well, the first three steps are straightforward, but it is with this last step that the process begins to break down.
Before we address that issue, however, the page goes on to state that a plan sponsor or any related entity must cease contributions to any other 403(b) plan for 12 months. Thus, the scope of the guidance is greatly narrowed, as a 403(b) plan cannot be terminated and replaced by another 403(b) plan (unless the employees wish to take a contribution Holiday for 12 months!).
There is a limited exception if less than 2 percent of the employees who were eligible to participate in the terminating plan are eligible to participate in any new 403(b) plan, a rare scenario.
So in what situations would it make sense for a 403(b) plan to be terminated? Well, the primary scenario is if the plan sponsor wishes to replace the 403(b) plan with a 401(k) plan, the primary type of qualified plan available to most sponsors that would permit pre-tax elective deferrals. However, a 401(k) plan may not be practical for many tax-exempt entities to implement. For examples, school districts may only implement a 401(k) if they are located in a state that maintains a grandfathered state-sponsored 401(k) option. And nongovernmental 401(k) plans require nondiscrimination testing of elective deferrals, otherwise known as Average Deferral Percentage (ADP) testing. Many tax-exempts do not have sufficient voluntary participation percentages to pass such testing, and the failure of such testing generally results in refunds of contributions to senior executives (not a pleasant scenario).
Thus, for most plan sponsors, terminating a 403(b) plan and replacing it with a 401(k) plan is not a feasible option. Of course, there are exceptions where the establishment of a 401(k) may make sense, such as at a small nonprofit where there are no highly compensated employees and where discrimination testing is not necessary, or plans where voluntary participation is extremely high or who utilize auto enrollment. But such plans are not commonplace.
Are there other scenarios where terminating a 403(b) makes sense? Certainly, but again these are not common scenarios. One is where the plan sponsor has ceased operations and no longer exists, but of course finding the proper entity to serve as the “plan sponsor” for termination purposes can be difficult in these cases. Another scenario is where a tax-exempt is taken over by a for-profit which cannot sponsor a 403(b) plan. And finally, an entity could simply decide to exit the business of providing any sort of retirement benefit for its employees. But again these are the relatively rare exceptions to the general rule that 403(b) plan terminations will have no applicability to the vast majority of plan sponsors.
Practice Pointer: Advisors should be able to compare and contrast 403(b) and 401(k) plans so that plan sponsors are aware of the pitfalls of terminating a 403(b) plan in favor of a 401(k).
The Distribution Dilemma
Now that we established that a relatively small number of 403(b) plan sponsors are good candidates to terminate their 403(b) plans, we can examine the issue of the practicality of terminating such plans even for this limited group of employers.
The other significant requirement to terminate a plan, listed on the IRS 403(b) Plan Termination Page linked above, is distribution of plan assets within 12 months of the plan’s termination date. If this were a qualified plan, distribution of all plan assets would be straightforward, since all plan assets generally reside in a trust controlled by the employer. However, it is a rare event that a 403(b) plan utilizes a trust. Instead, a 403(b) plan utilizes annuity contracts and/or custodial accounts, which can be controlled by the employer (group contracts), the participant (individual contracts) or both (group contracts with individual certificates/rights). Thus, plan termination distributions in a 403(b) plan can be much more problematic, since the employer may not be in ultimate control of the amounts distributed.
The IRS did provide some relief in this regard in the aforementioned Revenue Ruling 2011-7, greatly simplifying termination distributions for annuity contracts. The Revenue Ruling considered delivery of a full-paid individual annuity contract is considered to be a full distribution for plan termination purposes, eliminating the requirement for such contracts to be distributed in cash. Thus, plan termination distributions could be made for many participants for whom such distributions would not normally have been practical if the contracts did not permit cash distributions upon contract termination. However, issues regarding contracts already received by a participant, such as individual annuity contracts or certificates in a group annuity contact, a common occurrence in 403(b) plans, were unresolved.
And, unfortunately, the guidance did NOT extend to custodial accounts (i.e. mutual funds), where the requirement to distribute all assets in cash remained. This means that termination distributions for plans where individual custodial accounts exist are, as a practical matter, impossible to execute.
Finally, for plans subject to ERISA, there is the question of whether a plan that is considered terminated for IRS purposes would also be terminated from a Department of Labor perspective. The reason for this possible divergence lies in the fact that the DOL might require that all plan assets be distributed in cash, rather that the IRS’ interpretation that delivery of a full-paid individual annuity contract constitutes a distribution. The consequence of conflicting determinations would be an administrative nightmare, as the plan sponsor would need to continue to satisfy the requirements of ERISA (including 5500 annual report filings, providing Summary Plan Descriptions, etc.) for a “terminated” plan!
Practice Pointer: If a plan sponsor is a good candidate for 403(b) plan termination, advisors will want to recommend that the client work closely with benefits counsel well versed in such matters to determine if termination distributions are possible under current law.
There’s a good reason why there has not been an abundance of 403(b) plan terminations in the three years since Revenue Ruling 2011-7 was issued. Aside from the fact that there are simply not a large number of good candidates for plan termination, the guidance certainly does not pave the way for smooth terminations in the relatively few cases where it makes sense. It remains to be seen whether any future guidance will improve the termination landscape.
Michael Webb is the NTSA Education Committee Chair and a Vice President at Cammack Retirement.
Cammack Retirement is an independent retirement plan consulting firm specializing in non-profit industries. Offering tailored, actionable solutions, to help clients achieve the greatest return on their employee investment, Cammack LaRhette delivers end-to-end solutions for complex retirement plan challenges.
Please note that this article is for general informational purposes only, is not intended to be taken as legal advice or a recommended course of action in any given situation. Readers should consult their own legal advisor before taking any actions suggested in this article.