School District Employer Sponsored Plan

[Guest JWEBB]

I am working with a school district that wants to eliminate an unfunded defined benefit plan and replace it with a non-Erisa defined contribution plan. They want a 15 year vesting schedule (this goes back to the requirements of the original plan) and discriminate amongst the employees, ie. only certified teachers will be eligible. They also want the ability to post retirement fund for some members of the plan. First, can this be done legally and if so, what type of plan would work best ie. 403(B), 457 or 401(a)?

[pjkoehler]

JWEBB: 403(B), 457(B) and 401(a) plans wont work given the district's preference to avoid funding the plan. The district should consider a 457(f) SERP. The 15-year vesting schedule is helpful in view of the more stringent definition of a "substantial risk of forfeiture." What the district may not be able to accept is that the employees' accounts are includible in gross income in the taxable year in which they first vest, i.e. not on distribution. One issue that I have seen that can be troublesome are restrictions set forth in the state's Government Code or Education Code that limit the district's power to establish such plans or impose harsh public disclosure requirements.

[Guest JWEBB]

Thanks for the reply pjkoehler! I don't think I did a very good job of explaining the situation. I think it might be helpful if I give you the specifics of the plan. What they are currently doing is paying a retireing person $35000.00 over 7 years or until age 65, whichever is earlier (this is what I was calling the "unfunded defined beneift plan"). They are now wanting to begin funding this throughout the employee's time with the district by funding them $1000.00 per year (hence the defined contribution) with a type of plan. So as to not hurt an employee getting close to retiring, they are going to add additional funding if necessary into the participant's account after retirement to satisfy the $35,000.00 current benefit again, over a period of time. Because the 403(B) allows for post-retirement funding, they are going to have to use this for that part of the funding.

The second part of your response is taken care of in the State in which the plan is possibly going to be established. The Governer just signed legislation allowing public schools to fund this type of program.

Given this scenerio, do you feel that at 457(B) or (f) would work or do you think that a 403(B) or 401(a) is the best route to go and why?

[pjkoehler]

JWEBB: How does the employee accrue the $35K benefit (e.g. years of service from participation date/total years from participation date to normal retirement age), how does he vest in it and when is normal retirement age? I gather the district would like to systematically underfund the plan in the pure actuarial sense, i.e. advance fund that portion of the benefit that can be supported by a contribution rate of $1000 and apply a pay-as-you-go method to the balance. It may be possible to use a 414(d) governmental plan and take advantage of its exemption from minimum funding. But there may be an issue as to whether a benefit obligation that terminates at age 65 is a bona fide pension plan; rather than a severance arrangement.

[Guest JWEBB]

The employee receives the benefit once they have reached 15 years of service and have met the requirments of the State retirement plan. Once this is achieved, the employee who takes early retirement recieves the 35k in equal payments of $5,000 for 7 years or until they reach age 65 whichever is less. The employee is not fully "vested" until the entire benefit is paid out because if the employee dies the payment stops. Because of the way our state retirement system works for early retirees this plan really promoted people to retire very early even when they may have been better off staying with the employer. You are correct that they are wanting to underfund it with hopefully a little help with the investment that the participant directs. I am considering an employer sponsored 403(B) plan for the pay as you go post retirement funding. I believe this is the only plan that offers this possibility with the new pension laws. This pay as you go method is funded from the districts general budget as necessary to make up for balance of the original $35,000 benefit. The real question is what to use for the 1000 per year employer contributions. We have talked with a couple of TPA's and they are recommending an employer sponsored plan either a 401(a) or 403(B) plan. Since this plan is unique I am looking for another opinion as to which type of plan is best suited to meet these needs.

Also, it is my understanding that since they are not subject to ERISA that the district does not have to file a formal plan document, but that it is recommended that they have one anyway that is not filed with the IRS. What are your thoughts on this.

The governor of our state just signed a law permitting the school districts to make employer contributions to TSA's and defined contribution plans, so I do not think we have any problems there.

[IRC401]

With any type of DC plan, you run the risk that with good investment results, the employee could end up with more than $35,000 (although I have yet to find a school district that didn't know how to invest poorly).

It sounds to me like they want a target benefit 401(a) plan. However, they will need a 403(B) plan in order to make contributions for terminated employees.

Is it a DB plan a possibility?

[Guest JWEBB]

The district is selling the idea of letting the individuals direct the $1000 per year so that the employee, if they make good in vestments, may accumulate more than the $35,000, but the district will be funding less than the $35,000 that they have obligated themselves to now. Withhout that potential, the negotiating committee will have a difficult time giving up the "for sure" $35,000. They are wanting to get away from the defined benefit plan. The way it is currently set up, it is called an early retirement incentive, but it is really "severence pay" for those who meet the requirements set up by the district. With prefunding the distirct will not only take advantage of less outlay for payments but also will reduce their FICA obligations on those dollars.

I have been told that most TPA's will recommend a 401 type plan because they are administered similar to a 401(k) and they can do so easier than any other type of plan...? any thoughts?

[pjkoehler]

JWEBB: Those tax-qualification requirements that still apply to a governmental plan include the necessity of a written plan document and the general requirement that the employer operate it in accordance with its terms. There are certain formalities attend to this, which the district should be apprised of. But, the district could establish a fixed dollar money purchase pension plan ($1,000 per employee per year) and modify its early retirement incentive program by using a floor offset db formula, i.e. the present value of the flat dollar period certain annuity is reduced by the cumulative balance in the MPP.

[Guest JWEBB]

Thank you for your input on this project. I have used this website on many occasion to find answers and am pleased with the guidance available and the level of expertise provided. We have also been working with an attorney that specializes in employee benefits on a national scale. She has led us down the path to an employer sponsored 403(B)(7) plan. Her thinking is that there is no distinct advantage to the 401(a) or the 403(B) other than if we use the 403(B) employer sponsored plan it will already be in place for the post retirement funding. This simplifies things for the district and has no effect on the limits that can be contributed by the district or voluntary. The district can also do a voluntary 457 plan that does not aggregate with the other two to offer the maximum deferal limit for their employees.

We have the plan document for the 403(B) employer sponsored plan and are working to adapt the custodial agreement to reflect the intended vesting schedule.

We are looking at doing the defined contribution then, as you stated, taking the present value of the $35,000 income stream discounted at a rate specified by the employer and using that number as a DB to offset if necessary any shortfalls.

The 403(B)(7) company we are working with has the capabilities to administer this type of program.

If you see any holes in this proposal, please point them out. We are open to any suggestions or critisism you may have to offer.

The attorney we are working with also pointed out to us that if the district uses a 401(a) plan, they HAVE to keep it in place for 5 years. If then a couple of years from now the teachers want to negotiate something different, the 401(a) would have to be maintained whereas the 403(B)(7) would not have to be.

[pjkoehler]

JWEBB: I think this approach works as well. Of course, the district is limited in its choice of investment media compared to a 401(a) qualified plan. Also, you should be sure that the state law that authorizes the district's purchase of TDA's for its certificated employees is broad enough to permit substitution of custodial accounts. Some of these laws have not been updated since the enactment of 403(B)(7) and refer only to annuity contracts.

[Guest JWEBB]

pjkoehler, Thanks again for all your help!!

In your last reply you stated: "Of course, the district is limited in its choice of investment media compared to a 401(a) qualified plan.". Could you please explain what you mean by this? I am planning on using a mutual fund company and a TPA that told me it didn't matter whether the district wants to set up a 403(B) plan or a 401(a) plan. The only difference would be the Plan Document. Are they missing something? As to your second thought, as to the allowance of 403(B)(7) instead of only annuities is a GREAT one. I check on it and Legislation was just passed to allow it! You are very perceptive.

If anyone can come up with anything I am missing or overlooking, please don't hesitate to let me know! Again, this is a Wonderful service and I appreciate it very much!

[pjkoehler]

JWEBB: 403(B)(7) by its nature limits the investment media to the universe of '40 Act Investment Company stock, effectively publicly traded mutual fund shares. Other than PT issues, generally a 401(a) qualified plan is not directly limited in terms of the issuers or the kinds of securities that may be plan assets. Since the universe of publicly traded mutual funds is so vast, this may not be perceived as a meaningful distinction, but it's a difference nonetheless.

[mbozek]

PJ: Prohibited transaction rules do not apply to govt plans so investments by qualified govt plans is much broader than plans subject to ERISA. Also assets in a 403(B)(7) account are not held in trust but are held by a custodian which could make them vulnerable to the claims of the emplyee's creditors depending upon state law. A participant in a 403(B) annuity plan can defer up to $15,000 in pre tax contribitions, in addition to contributions by the employer. Finally there is no irs approval needed for a 403(B) annuity plan.

[pjkoehler]

mbozek: Sec. 503(a)(1)(B) denies tax exempt status to a governmental plan that engages in a "prohibited transaction" described in Sec. 503(B), which specifies a series of transactions involving plan assets and the public agency/sponsor, a "substantial contributor," or other related parties. Transactions between the plan and a fiduciary, who is neither a creator nor a substantial contributor, are not technically prohibited under 503(B), however, the regs provide that they are subject to close scrutiny "in the light of the the fiduciary principle requiring undivided loyalty to ascertain whether the [plan] is in fact being operated for the stated exempt purpose." Treas. Reg. Sec. 1.503(a)-1(B).