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| by W. Scott Simon
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10-04-07
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Over the last 40-plus years, the Internal Revenue Code section 403(b) regulations have not been enforced to any great degree. This, combined with the fact that school district 403(b) plans are not subject to ERISA, has made the officials at these schools think that they have no fiduciary responsibilities. Yet many of these same officials are terrified of the liability they may incur if they do anything in connection with the 403(b) plans at their schools.
This concern with liability and denial of responsibility reveals a basic disconnect in the thinking of many such officials. Now, it's been some time since I was bored to tears in my remedies class in law school but I do seem to remember that in cases such as this, you cannot have any liability if you have no responsibilities. To put it another way: only if you have responsibility can you incur liability.
Fiduciary Duties under ERISA and State Law
In fact, school districts have plenty of responsibilities (known as "duties" in trust law) to participants in 403(b) plans - and therefore the possibility of plenty of liability. The astute observer will reply, of course, that school officials have no ERISA fiduciary duties to their teachers invested in 403(b) plans because such plans are not subject to ERISA. While that's true, in many states there are laws on fiduciary duties that apply to the conduct of officials in school districts.
Many state fiduciary laws incorporate the "sole interest" and "exclusive purpose" duties of ERISA. These two duties together express the duty of loyalty - first appearing in eleventh century England - which underlies all trust fiduciary law. The paramount duty of fiduciaries of 403(b) plans where state-level fiduciary law applies to their conduct, then, is to operate such plans solely in the interest of members and beneficiaries for the exclusive purpose of providing them with benefits. In these states, this requires such fiduciaries to place the interests of members (teachers, in this case) and their beneficiaries ahead of any others. This requirement seems to be violated in cases where:
- The interests of insurance companies are placed before those of teachers because the 403(b) investment options provided by such companies are comprised of high cost annuities invested in risky and poorly performing mutual funds.
- The interests of mutual fund companies are placed before those of teachers because the 403(b) investment options provided by such companies are comprised of high cost, risky and poorly performing mutual funds.
- The interests of teachers' unions are placed before those of teachers because the unions are paid by insurance companies to endorse their (mostly) junky, costly products - thereby helping to contribute to a total cost hurdle of 200-500 basis points that must be cleared by such teachers before they can even begin to accumulate a nest egg in their 403(b) retirement plan - at the same time that such unions make available to their own staffs lower cost investment products.
- The interests of teachers' unions are placed before those of teachers because the unions are simply asleep at the wheel and don't protect their membership (even in cases where the unions don't receive payments from insurance companies).
- The interests of school districts are placed before those of teachers because the districts have decided that they owe no fiduciary duties to such teachers, yet the teachers reasonably believe that the (mostly) junky, high cost 403(b) investment options offered to them have been vetted fully by the districts and are being overseen by them.
The Unconscionable Three
There are a few states such as my own state of California, Washington and Texas, where officials at school districts with 403(b) plans have painfully few fiduciary obligations - even under state law (and none, as noted, under ERISA).
The law in these three states such as California Insurance Code section 770.3 removes the discretion of such officials to screen, limit, reject or terminate relationships with service providers such as insurance companies that provide annuity contract investment options to school district 403(b) plans. In other words, such laws require schools to give access to any retirement firm licensed to sell a product. No discretion, Jack, no duty.
In such states, then, not even state-level fiduciary duty exists. (School officials do, however, have limited fiduciary duties to ensure that no prohibited transactions or self-dealing arrangements occur between school officials and any service providers.)
Even in the three states cited, though, officials at school districts with 403(b) plans must comply with state-level fiduciary duties with respect to investment options comprised of 403(b)(7) mutual fund custodial accounts. (Such officials must also comply with state-level fiduciary duties in cases where their school districts have 457(b) plans.) Many of these duties are based on principles similar to those contained in ERISA such as modern portfolio theory and other generally accepted tenets of investing, the prudent man rule as well as the requirement to allow only 403(b) investment options that are reasonable in cost and broad in diversification.
The Future
The overall aim of the new regulations to take effect on January 1, 2009 governing 403(b) plans is to align the rules for such plans (that cover public school and other governmental employees as well as certain income tax-exempt IRC section 501(c)(3) organizations such as research foundations and private schools) with those for 401(k) plans (that cover corporate employees) and 457(b) plans (that cover employees of state and local government entities). This alignment will, among other things, make administration of 403(b) plans simpler and easier for school districts, thereby helping ensure compliance with the law - which is always a good thing.
Under the new 403(b) regulations, school districts will clearly become plan sponsors and be completely responsible for everything that touches their plan including investments, expenses and all administrative matters. School districts will also become the focal point of the Internal Revenue Service. They can delegate to a provider but if that provider gums up the works, the responsibility as well as the liability for same remains with the school districts. While school districts were always exempt from ERISA, they were never exempt from any rules. School districts must follow state laws on fiduciary duties as they were always required to do; they just didn't know they had to.
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W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understanding is the definitive work on modern prudent fiduciary investing. Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals. For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. |
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