Governmental 457(b) Custodial Account vs. Trust

[EBECatty]

I've never had reason to look closely, and the enactment of the 457(b) trust requirement predates my time in practice, but is there a particular reason why many governmental 457(b) plans seem to use custodial accounts (that meet the trust requirements under 457(g)(3) and 401(f)) instead of trusts?

[Peter Gulia]

Some banks, trust companies, and related service providers presume or assume that the responsibility of a trustee, even a directed trustee, sometimes could be more than the responsibility of a custodian that is not a trustee.

Some governmental 457(b) plans lack a lawyer or consultant who might advise a plan’s fiduciary about differences between a trusteeship, even if directed, and a custodianship.

[EBECatty]

Thanks. I wondered after posting this if it had anything to do with the types of providers servicing these plans perhaps being more accustomed to using 403(b) custodial accounts (as opposed to trusts), but maybe not. Appreciate your input!

[Peter Gulia]

Your surmise is sensible.

In the mid-1990s, many investment and service providers for governmental 457(b) plans were based in life insurance companies. (Most of the biggest players still are.) That’s why lobbying on what became § 457(g) sought to allow trust substitutes, do so with recognized forms, and include annuity contracts as trust substitutes.

When providers in 1996-1999 implemented the § 457(g) condition, many were done by adding one or two sentences of exclusive-benefit lingo to an annuity contract. When a governmental plan’s investments did not include collective trust units, some put non-annuity mutual fund shares under a custodial account.

A large governmental § 457(b) plan often negotiates for the recordkeeper to provide a trust company, which might be a subsidiary or affiliate, to serve as the plan’s directed trustee.

[EBECatty]

Peter, very helpful context. That makes sense. Greatly appreciate you sharing your expertise.

[rocknrolls2]

My recollection was that Section 457 was initially intended to permit a non-qualified retirement plan for governmental entities. The reason for this was because private employers can immediately deduct contributions to qualified plans but cannot deduct contributions to non-qualified plans until the participant has to include the contribution into his/her income. For governments, there is no deduction permitted because they are tax-exempt. The 1986 Tax Reform Act extended 457s to non-governmental tax-exempt entities. Because only rabbi trusts, the assets of which must be subject to the claims of the employer's general creditors, were then allowed. In the 1990s, the bankruptcy or insolvency of a governmental entity prompted Congress to enact legislation providing for the imposition of a trust requirement for governmental eligible employers (I think it might have been the City of Long Branch, CA). See Public Law 104-188, Section 1448(a)

[Liz Hallam]

rocknrolls2 was correct - the trust requirement was added after Orange County, CA (not just the City of Long Branch) filed for bankruptcy. All kinds of stories how judges' accounts were attached because in bank accounts (with high interest rates). Interesting because City of Bridgeport, CT declared bankruptcy before that and no Congressional action.  Custodial accounts and annuities satisfy requirements of 457(g).  It was not providers who required it was Congress.