457 Annuity Withdrawal Penalties

[Guest Freeda LaGrone]

Now retired, my school district contracted with an insurance company for a 457 group annuity in 1996, complete with withdrawal penalties of 20% at year 1 to 5% year 15(no matter the age or retirement eligibility).When the District asked us to sign up for this annuity, there was no mention, spoken or written, of the withdrawal or surrender penalties, or for that matter an annual asset management fee of .25% deducted from the Fund. How does this comply with the provision that, "The plan must be amended to provide that it will be impossible----for any part of the value of the annuity contract to be used for, or diverted to, purposes other than for the exclusive benefit of plan participants and their beneficiaries"?

[Carol V. Calhoun]

Without commenting on your specific case (particularly in light of the fact that I represent employers and plans, not employees), I will say that there has been an overall issue about how the new 457(g) rules apply to existing contracts. In 1996, 457(B) plans were required to be unfunded, so the exclusive benefit rules did not apply to them. Nevertheless, in many cases, benefits were measured by the performance of an annuity contract owned by the employer (or treated under tax rules as owned by the employer). On January 1, 1999 (the date on which the 457(g) rules began to apply to existing governmental 457(B) plans), employers were often faced with the choice of (a) removing money from existing contracts, which might well have involved incurring surrender charges at that point, or (B) leaving the money in the existing contracts, and removing the provisions that caused them to be treated as owned by the employer. Regardless of whether those contracts would have met the 457(g) standards had they been originally purchased after January 1, 1999, in many instances employers decided that it was better for employees to leave the money where it was (and let the surrender charges wear away with time) than to move money that was already in annuity contracts.

[QDROphile]

Another perspective on surrender charges is that it may be a questionable economic/investment choice to select an annuity with a surrender charge, but the surrender charge is a cost of the investment (somewhat like commissions are a cost of investing in stock -- they effectively reduce the investment return on the money). For example, the stated rate of return on the annuity may have been much lower if the term of the investment were not "protected" by the surrender charge. The surrender charge, by itself, does not violate the exclusive benefit rule. No one, such as the school district, is benefitting from the surrender charge.

Using plan assets to run the plan (pay the management fee) does not violate the exclusive benefit rule. Maintaining the plan is a benefit to the participants. The fee must be reasonable for the services it covers.

You could say that the insurance company is benefitting from the surrender charge. I think the charge is a cost of the investment, not an improper use of the money. If the surrender charge was unreasonable at the time of the investment (my bias is that it probably was because I generally dislike insurance company investment products), someone may have been at fault for the choice of the investment. Unless there was something under the table in the deal, the bad investment choice is not a violation of the exclusive benefit rule, but it may have been a breach of fiduciary duty. Also, as Carol Calhoun suggests, what appears unreasonable now in your personal circumstances may have been reasonable under the circumstances at the time the investment was chosen and in light of subsequent developments.

You can't get a good answer to your questions without considering all of the facts and circumstances.

Since Carol was so good about disclosure, I will follow suit and confess that I am an employer lackey, too.