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Tax Monitor

Tax Deferred Annuities – Heightened Fiduciary Scrutiny

November 14, 2016

By: Michael D. Foster

Over the last several years, much has been written in connection with the surge of “excessive fee” litigation against Section 401(k) plans.  The surge continues and has now been extended to Section 403(b) plans which are often referred to as Tax Deferred Annuities.  One commentator estimates that over twenty class action excessive fee litigation cases were filed during the first quarter of 2016 against 401(k) plans and the Wall Street Journal reports over a dozen such lawsuits have been filed this year against large university Section 403(b) plans. 

Typically, the lawsuits assert that the plans and their fiduciaries (1) offered investment options with excessive management fees, (2) caused the plan to pay excessive administrative fees through asset based revenue sharing agreements, (3) failed to timely remove underperforming funds, (4) did not have a prudent process for consideration, selection, evaluation or active monitoring of investments offered under the plan, (5) offered retail class shares of mutual funds rather than regularly available lower cost institutional shares, or (6) offered too many investment options. 

While many of the headlines focus on lawsuits against the 401(k) plans of Fortune 500 companies, earlier this year a similar class action lawsuit was filed against LaMettry’s Collision, Inc. and its 401(k) plan.  That plan had only 130 participants and under $10 million in assets.

That the lawsuits are now targeting large universities is not surprising and is particularly interesting given the history of 403(b) plans and tax deferred annuities (hereinafter, collectively “TDAs”). 

As reported by the Wall Street Journal, Cornell, Northwestern, Columbia, University of Southern California, Yale, Duke, Johns Hopkins and Emory were among those universities targeted.  The cases assert that the plans’ large number of investment options inflate costs by spreading assets over many investments.  The suits also allege that plan sponsors with a large investment menu have a hard time fulfilling their fiduciary responsibilities to monitor investments.  Some of the suits challenge the plan’s use of retail share classes of mutual funds rather than lower cost institutional versions.  Last year, in Tibble v. Edison International, the United States Supreme Court stressed a fiduciary’s continuing duty to monitor trust investments and remove imprudent ones. 

TDAs are not available to for-profit entities and may only be offered to employees of public schools and universities, Section 501(c)(3) tax exempt organizations and churches.  However, it is important to note that of these three, public schools and universities (governmental entities) and churches are not subject to ERISA.  In addition, it is possible that even TDAs sponsored by 501(c)(3) organizations might not be subject to ERISA if employer contact with the plan is minimized.  While the current wave of university lawsuits are all couched in terms of ERISA class actions and thus target plans sponsored by 501(c)(3) organizations which have elected to subject their plans to ERISA, as discussed below, given the historical background of TDAs, plans sponsored by public universities may prove to be even more vulnerable to these types of lawsuits. 

In 1958, Section 403(b) of the Internal Revenue Code allowed employees of nonprofit organizations, churches and governmental entities to purchase these tax favored annuities.  The programs were first offered as a way for employees to defer a portion of their income on a pre-tax basis through the purchase of annuities.  With the passage of ERISA in 1974, the investment options were extended to mutual funds held in a custodial account. 

In the early years, public schools and universities typically would allow a number of vendors to offer annuities to their employees with the employer having very little involvement other than withholding the salary reduction amount and submitting it to the vendor.  Recognizing this practice, ERISA provided a carve out for TDAs sponsored by 501(c)(3) organizations as long as there was limited employer involvement.  Generally speaking, to be exempt from ERISA, the 501(c)(3) organization could not have any employer contributions in the plan, participation in the plan had to be completely voluntary, the participant could only enforce his rights under the plan through the investment vendor, the employer could receive no compensation for offering the plan, and the employer’s actual involvement with the plan was limited to a few actions (e.g., allowing investment vendors to publicize their products, holding group annuity contracts in the employer’s name, etc.). 

Since the passage of ERISA and the increasing scrutiny of TDAs by the Internal Revenue Service, it has grown more difficult to maintain a non-ERISA TDA. 

Sponsors of TDAs that are not subject to ERISA should exercise caution.  While the lawsuits to date have been based upon ERISA’s breach of fiduciary duties provisions, the fact is that ERISA’s fiduciary duties simply mirror common law and state law duties.  Thus, almost all of the allegations made in the ERISA lawsuits could be made under state law breach of fiduciary duties.  In many ways, this could prove more dangerous since in most cases the duties would not be well developed and there would not be significant case law supporting a fiduciary’s actions.  In addition, several of the safeguards found in ERISA would not be available under state law.  For example, typically in ERISA actions, there is no jury trial.  In addition, under ERISA, fiduciaries are protected from the investment decisions made by individual participants if the plan qualifies under Section 404(c) of ERISA.  Again, that protection is not available under state law.  While some form of sovereign immunity may still exist in most states, it is no longer absolute.

Given the traditional non-involvement of employers with TDAs, plaintiffs’ lawyers may find this a lucrative area.  The Wall Street Journal reports that TDAs typically charge higher fees than 401(k) plans, and it would not be surprising if in fact fiduciaries of TDAs have not been as diligent in monitoring investment fees, recordkeeping fees and the like.  We would urge sponsors of all TDAs (and, for that matter, 401(k) plans) to review their plans, the investment options offered and the cost associated therewith.  We obviously are available to assist you in this endeavor if you would like.


This article was written by Michael D. Foster, an attorney practicing in the Jackson Kelly PLLC Tax Practice Group.


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