457 Trust Requirement

[Guest JD Colville]

IRC 457(g) requires that governmental plans will not be treated as eligible deferred compensation plans unless all ""assets and income" of the plan ... are held in trust for the exclusive benefit of participants and their beneficiaries." Ms. Calhoun has written an excellent article on this topic that I recommend reading.

There seems to be a conflict as to the meaning of the term "assets and income". One of my colleagues has indicated that several commentators have indicated that the term assets only applies to amounts actually deferred from employees salary (similar to 402(g) deferrals) and to employer contributions that have previously been placed in a trust, a custodial account, or in an annuity policy. The contention is that employer sponsored 457 plans with no employee salary deferrals and only a promise to pay on the part of the employer are not subject to the trust requirement.Further, the contention is that the legislation adding 457(g) to the Code was never intended to require the funding of plans that previously had no "assets" and that the funding requirement for these plans was not changed by 457(g).

Unfortunately, I cannot find support for this position in either the statute, the Committee Reports or in Notice 98-8. However, Paragraph 19 of Notice 98-8 does refer to "amounts deferred" when discussing the trust requirement.

To what plans does the trust requirment apply? Does the trust requirement apply only to employee salary deferrals as "amounts deferred" or does it apply to all "book accounts" under 457 plans? If it only applies to salary deferrals , is there a pass through trust requirement when an individual is to receive a distribution because assets have been identified to pay the distribution?

I would appreciate any clarification which anyone could provide. References and citations would be fantastic.

Thank you for your assistance.

JDC

[Note: This message was edited by CVCalhoun]

[Guest CVCalhoun]

Thanks for your kind comments!

I would disagree with your colleague. The IRS model section 457(g) amendments refer to the amounts which must be held in trust as "all amounts of compensation deferred pursuant to the Plan, all property and rights purchased with such amounts, and all income attributable to such amounts, property, or rights". It does not limit the amounts to those deferred on a salary reduction basis.

Of course, one could argue that compensation is not "deferred" if the employee had no ability to receive such amounts in cash. But the IRS position is clear that compensation is considered deferred even if the employee could not have elected to receive the compensation in cash. And Congress implicitly ratified that interpretation when it added section 457(e)(12), which provided that nonelective deferred compensation of nonemployees (e.g., independent contractors) would not be subjected to the section 457 rules--thereby strongly implying that the concept of "deferred compensation" included amounts put aside on a nonelective basis.

[Note: This message was edited by CVCalhoun]

[Guest Ralph Amadio]

I am glad that someone else has heard this line of "reasoning" put forth in regard to 457 plans. I can assure you that the intent of Congress, which was much influenced by the factors involved in the Orange County California bankruptcy, was specifically to require a "funded" position for 457 plans which made fiduciaries of the newly formed trusts totally responsible for:

1) The character of assets transferred into trust,

2)The character of assets held in trust and 3) their actions as fiduciaries

This law was a "clean-up your act" requirement passed by the Congress, with the considerable urging by the Legislature ( I was in the hearings) and Governor of the State of California, and was specifically for the purpose of protecting the retirement monies of public employees nation wide.

Some providers and consultants, it appears are hard pressed to accept this change, since it places certain forms of investments under the spotlight. Excess commissions, improper investment practices, improper audit procedures, etc. are now coming to light.

In California, where I practice, any number of "sins of the past" have already cropped up which sometimes are embarrassing to plan committees and public agency administrators.

In addition, certain assets that have never been marked to market are found to be worthless, still on the financials at book value. Some providers have blithely moved these assets into trust, with no understanding or thought of the consequences to the plan fiduciaries, usually the public agency itself.

In California we have both statutory and constitutional provisions for retirement fiduciaries for public plans, and our Courts have been known to have very sharp teeth. I would hope that more practitioners would start questioning providers as to their agendas, realizing that some have conflicts of interest, and dealing with these plans with an eye towards a good defense position.

All in all, I strongly disagree with your colleague, and agree with Carol's position on this issue. We are now operating plans (at least in California) under rules as stringent, if not more so, than ERISA, and we need to provide our client employers and their employees with the protections that we have used for private sector clients for the past 28 years.

[Guest Ben]

This is an excellent message board. I had a clarifying question related to the trust requirement for governmental eligible 457 plans. Regarding the JD Colville question and CV Calhoun reply on the extent of the trust requirement, I am not clear on the extent of the trust obligation discussed. What about situations where there are obligations under the eligible 457 plan that are not funded, i.e., no assets have been set aside at all or only a limited amount of assets have been put aside informally? Does the government have to put in assets (1) to the full extent of the obligation, or (2) only to the extent assets have been informally earmarked already (if none have, no assests have to be transferred)? A few examples might illustrate what I am trying to clarify.

EXAMPLE 1 - DB TYPE BENEFIT: Consider a 457 plan with a defined-benefit-type benefit where the government has not put aside any assets to fund the obligation or only a very limited amount of funds. Does the government have to put money or assets into the trust by January 1, 1999 to meet this obligation or does it only have to put assets in the trust to the extent there are assets set aside for this purpose? In this regard, I understand a governmental eligible 457 plan would not be subject to the Code section 412 requirements. If the government has to put in money or assets to fund the obligation, how is the amount required calculated? Best estimate of an actuary?

EXAMPLE 2 - NONELECTIVE TYPE CONTRIBUTION: Consider a 457 plan with a nonelective type contribution, e.g., the plan provides for a flat dollar amount for each employee or a profit sharing type contribution which does not involve any salary reduction by the employee. If the government has not actually earmarked any assets to pay these amounts and has been paying benefits on a pay as you go basis up to now, does it have to put in money into the trust equal to the amount of contributions and earnings that should be there by January 1, 1999? I understand the reply of CV Calhoun above to be that the trust requirement applies to a 457 plan with nonelective contributions, but does money have to put into the trust to meet this obligation if there has not been any put aside for this purpose before.

EXAMPLE 3 - SALARY DEFERRALS: Consider a 457 plan with salary deferrals by employees. What if the government has been paying benefits on a pay as you go basis without putting the salary reduction amounts aside? Do I understand the messages above to be saying that money does have to be put into the trust to meet these obligations?

[Guest CVCalhoun]

Yes, the statute is definitely intended to require that the obligations be funded, regardless of whether or not any assets have ever been put aside informally in the past. Congress was very concerned about governmental employers being unable to meet their obligations under 457 plans. So in examples 2 and 3, the employer would have to set up a trust.

It is hard to imagine how a 457 plan could be structured as a defined benefit plan, since section 457 requires that deferrals not be in excess of a maximum dollar limit per year--and as you point out, the amount deferred would be hard to calculate if expressed as a defined benefit. However, if such a plan existed, it, too, would have to be funded. Presumably, in the absence of regulations on the subject, the best estimate of an actuary would be the safest method of determining funding.

[BeckyMiller]

We have been in contact with the IRS National office on an informal basis relative to the trust requirement and the related funding requirement for non-elective 457 plans.

As you know, 457(g) applies to all assets and income of the plan as described in 457(B)(6).

457(B)(6)(A) includes all amounts deferred under the plan, in addition to any property set aside to pay for such benefits.

The 1987 through 1989 activity on this provision clearly concluded that non-elective deferrals are included in 457(B)(6)(A), unless excepted by 457(e)(11) or (e)(12).

Thus, the accrued benefits under a non-elective plan are plan assets subject to the trust requirement.

In our conversations with the National office, we argued that the only asset of the trust would be the receivable from the employer for future amounts to fund such benefits when due. Since such asset (the receivable) was not subject to misappropriation or mismanagement, the interests of the plan participants would not be enhanced by requiring such asset to be held in trust.

Our discussion focused on two types of plans. One type of plan that we frequently encounter are non-elective defined contribution plans, usually "top-hat" type arrangements for key officials, such as a superintendent of schools. The other type is a defined benefit supplement arrangement, but not an "excess benefit" plan as defined in 457(e)(14). We agree with the comments made above that such defined benefit arrangements would generally be ineligible deferred compensation plans, but it is theoretically possible to limit the accruals to the 457(B) provisions. Unlike the salary deferral arrangements, which, in our experience, are virtually always funded, neither of these arrangements is usually funded.

The IRS National office specifically asked us if funding these arrangements would create a hardship for our clients. In some cases, it could be a significant hardship as the dollar value of the accrued benefits is significant. A few days following that question, a representative of the National office called back. He stated that they were sympathetic to the situation, but they did not see any basis in the law or its history to give them the flexibility to interpret 457(g) any differently than that it applied to all eligible deferred compensation plans and that all such plans needed to be funded.

He did say that the Service will work with entities for whom this requirement creates a hardship. For example, that allowing some time for the transition of assets would be considered.

In any event, he concluded that the trust needed to be in place by January 1, 1999.

We found the IRS very open to discussion on this issue and very responsive.

Though the people who precede me on this discussion topic were generally in agreement that such plans were subject to this standard and that funding was required, that is not well understood in the general population of benefit consultants. Many people that I deal with believed, as I had hoped, that the statute establishes a trust requirement, but not a funding requirement.

I hope this summary of our experience will increase the awareness and amount of discussion on this very important issue.

[Guest RARogers]

BeckyMiller - You raise an interesting issue - on what basis would you have to determine the "funding" of a defined benefit 457 plan? It would seem that the trust requirement for a db 457 plan would be meaningless without a requirement that the benefit meet some funding standard. But unlike ERISA plans, a governmental plan has no minimum funding requirement. This has been an issue with determining the $7500 limit, but it appears also to be an issue with the "funding" requirement.

With that said, I don't believe that the IRS would require that the full value of the accrued benefit be funded - this is not a funding requirement for ERISA plans. (For example, in a cash balance plan, a participant may have an "account" of $50,000, but that doesn't mean that the plan has $50,000 in it attributable to that account - in fact that is an advantage of a cash balance plan, you don't have to fully fund account balances currently.) If you wanted to be very conservative, you could follow ERISA funding standards. On the other hand since there are no statutory funding standards, and since the IRS has given no guidance on the issue, you could argue that you didn't have to fund at all, except perhaps on a "pay as you go" basis (which arguably is itself a funding method - certainly it was a funding method pre-ERISA)- you would run the funds through the trust before you made a payment.

[BeckyMiller]

Re: Funding

Just to clarify - it is not my interpretation that these plans need to be funded. I had believed, and continue to hope for future clarification, that the trust requirement merely required that a trust be created to the extent that the plan had assets.

We all know from 20+ years of ERISA interpretation that there is a lot of ambiguity regarding when a plan is considered to have assets.

It was our conversations with the IRS which yielded the position that the IRS National Office apparently believes that such plans must be funded. The National office appears to be taking the language of 457(g) which refers back to 457(B)(6) literally. Where (B)(6)(A) includes a reference to the amount deferred, the IRS is saying that amount must be in trust, whether resulting from a participant election or as the current accrual under a non-elective plan. In other words, if the present value of $100 to be received 10 years from now is $13, the trust is to receive a contribution of and to hold $13. Obviously that is a gross simplification, all of those concepts of mortality, discount factors, rate of return, turnover, etc. would go into setting the number, but it would be something greater than zero.

Personally, I am having a very difficult time with this approach. It is a major change for historically unfunded, non-elective plans. If applied literally, it seems to go way beyond the minimum funding rules for a tax qualified plan. I have a hard time believing that this is what Congress intended when they added this provision to the law.

Absent more precise, formal guidance, it is difficult to advise my clients to transfer assets into such a trust for non-elective plans. This is likely to merely trigger more ineligible plans.

My purpose in adding my prior comment was merely to give my fellow professionals a heads up on where the IRS National office was going with this matter.

[Guest RARogers]

One more comment about nonelective contributions to 457 plans. As governmental qualified plans are not subject to nondiscrimination testing, it should be possible to establish a qualified plan that would do the same thing as an eligible 457 plan, but better. In other words, why even go the 457 route anymore for a nonelective plan when a qualified plan is available? A qualified plan of a governmental employer is not subject to funding requirements (unless the state has some minimum funding standard, which might also be applicable to a 457 plan), the trust is tax exempt, and when the participant is paid, he or she has the favorable tax rules afforded to payments from a qualified plan (rollover).

[Guest JCG]

Using a qualified plan instead of a 457 plan is a valid consideration which should be a part of the analysis an entity makes when deciding what kind of plan to choose. However, the fact that a participant can access his/her money upon separation from service regardless of age without a penalty, is a very attractive feature, especially for entities with employees who can retire after 20 years (police officers and firefighters). Additionally, the plan documents are less complex and administration is generally easier for 457 plans, also plan into a 457 plan's favor. Also, the funding providers and administrators in this field are used to dealing with the bid process which must be adhered to when competing for a case.

So, sometimes a 457 plan makes sense, sometimes the 401 plan makes sense. It depends on the particular entity's situation.

[joel]

What degree of protection do the participants of non-governmental 457s have against the claims of the employer's creditors?

Peace,

Joel L. Frank

[mbozek]

? Isnt the answer none- The assets of a np 457 plan must be subject to the claims of the employer's creditors because assets held in an irrevocable trust exempt from the employer's creditors are included in the employee's income to the extent vested.