ERISA and tax-deferred retirement plans - Employee Retirement Income Security Act of 1974

Healthcare Financial Management, Oct, 1992 by Michael S. Melbinger

The employees of hundreds of tax-exempt organizations and state entities nationwide depend on insurance products as investment vehicles for their tax-deferred savings accounts or retirement plans. In recent months, many insurance companies have failed or been seized by insurance regulators, victims of losses resulting from investments in real estate and junk bonds. Moreover, the financial stability of remaining companies has been questioned. In 1991, the four prominent insurer rating services downgraded their ratings on the claims-paying ability of virtually every life insurance company in the United States.

The impact of an insurance company failure upon a plan sponsor and plan participants depends on the type of product the plan sponsor holds and the type of plan for which the product was purchased. Tax-exempt organizations and governmental entities place most of their Section 403(b) tax-deferred annuity plan funds with insurance companies. In fact, Internal Revenue Code Section 403(b) permits contributions to be invested only with an insurance company or a mutual fund with a registered investment adviser.(a)

Employers that terminate a defined benefit pension plan are required by law to purchase a terminal funding annuity contract from an insurance company to provide monthly retirement benefits to former plan participants.(b) Many ongoing defined benefit pension plans and even some defined-contribution plans are funded solely through a group annuity contract with a single insurer.

The employer's response

Because of the uncertainties inherent in today's rapidly changing economic environment, many employers are reluctant to invest additional retirement plan funds with insurance companies. Employers maintaining retirement plans that currently hold insurance products of a troubled insurer may need to respond quickly to several different aspects of the insurance company insolvency crisis. The employer and plan fiduciaries also may need to evaluate any fiduciary exposure from the purchase of a new insurance product, and make certain that the plan and its participants are protected should further insurance company insolvencies occur.

The application of ERISA

Virtually all retirement plans are subject to the provisions of the Employee Retirement Income Security Act of 1974 (ERISA). ERISA imposes certain standards of conduct on plan fiduciaries. An ERISA fiduciary is required to discharge its duties with respect to a plan solely in the interest of plan participants and beneficiaries and for the exclusive purpose of providing benefits to participants and their beneficiaries and defraying the reasonable expenses of administering the plan.(c) A plan fiduciary must discharge its duties: (1) with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in a similar enterprise; (2) by diversifying the investments of the plan so as to minimize the risk of large losses; and (3) in accordance with the plan document and other governing instruments unless such documents are inconsistent with ERISA.(d)

However, there are several exceptions to ERISA's coverage. The fiduciary duties of ERISA (as well as its other provisions) do not apply to employee benefit plans maintained by a church, or by the U.S. government or the government of any state or political subdivision thereof.(e) Additionally, a tax-deferred annuity plan (403(b) plan) may not be subject to ERISA, depending on the degree of employer involvement in the plan.

A tax-exempt employer with a tax-deferred annuity program for employees first may have to determine whether the program is a retirement plan subject to ERISA. If an employer simply makes tax-deferred annuities available to its employees, its program may not be subject to ERISA. However, a tax-deferred annuity program will be subject to ERISA if any one of the following conditions exist:

* Participation in the program is not completely voluntary for employees.

* The employer is able to enforce certain rights under the annuity contracts, other than as an authorized representative of the employees. (The employer may hold annuity contracts in its name on behalf of employees.)

* The employer makes a matching or other contribution to the plan or is otherwise involved in the plan in any way, except in permitting annuity providers to publicize their products to employees (and summarizing such information) and withholding salary reduction contributions elected by employees for payment to the annuity provider.(f)

Additionally, to avoid application of ERISA, the employer must ensure that the number and variety of annuity providers that may approach employees is sufficient to "afford employees a reasonable choice."(g) If the tax-deferred annuity program of a tax-exempt employer has any of the characteristics listed above, or fails to offer a sufficient variety of annuity options, the program will be deemed to be an employee benefit plan subject to ERISA.