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Compliance Consult | PLANADVISER March/April 2015

Co-mingled 403(b)s

Does this jeopardize their tax-exempt status?

By David C. Kaleda editors@assetinternational.com | March/April 2015
Art by June Kim

With the release of the Internal Revenue Service (IRS) Revenue Ruling 2014-24 and the issuance of a Securities and Exchange Commission (SEC) “no-action” letter last year, advisers and their clients are asking whether plans established under Section 403(b) of the Internal Revenue Code of 1986 (IRC) can invest in group trusts or other pooled investment vehicles without jeopardizing the tax-exempt status of the trusts or triggering federal securities law registration requirements. This article intends to clarify the extent to which group trusts or other “pooled” investment options are available for 403(b) plans and to consider some other opportunities.

In its ruling, the IRS clarifies that certain 403(b) plans may invest in a group trust without the trust losing its tax-exempt status. These include 403(b) plans organized under IRC Section 403(b)(7), which are custodial accounts that may invest only in mutual funds, and under IRC Section 403(b)(9), which are a type of church plan. However, the ruling does not apply to 403(b) plans that are annuity arrangements under Section 403(b)(1). Therefore, the trust may lose its tax-exempt status if it admits a 403(b)(1) investor.

Importantly, even if a 403(b) plan can invest in a group trust for tax purposes, the group trust may be subject to registration as an investment company under the Investment Company Act of 1940 (’40 Act), and its units may be subject to registration under the Securities Act of 1933 (’33 Act). To avoid registration, the trust sponsors most often intend to comply with exemptions under Section 3(c)(11) of the ’40 Act and Section 3(a)(2) of the ’33 Act in cases where 403(b) participants may direct the investment of assets.

Unfortunately, the above ’40 and ’33 Act exemptions apply only to a 403(b) plan that is a 403(b)(9) church plan. The exemptions are not available if a participant-directed 403(b)(7) custodial account invests in a group trust. Therefore, group trusts continue to be unavailable to 403(b)(7)s unless the trust sponsor is willing to register the group trust under the ’40 and ’33 Acts.

Fortunately, however, 403(b) plans may have other options, including the use of an investment management service or implementation of a “generic investment option.” First, it is possible to structure an investment management program or service to 403(b) plans that does not result in the creation of an actual or “deemed” pooled fund subject to the ’40 Act. The SEC issued SEC Rule 3a-4 several years ago, in which it provides for a nonexclusive safe harbor from the definition of an investment company and registration under the ’33 Act for programs that provide discretionary investment advisory services to individuals, including 403(b) plan participants. Among other things, the rule requires that the investment advice be individualized and that the participant have the option to opt out of investments available under the service.

The SEC has ruled on a number of occasions—including the no-action letter issued to Benson White & Co., which became publicly available June 14, 1995—that investment services, if structured in a specified manner, may avoid ’40 and ’33 Act registration. The SEC does not always require that the advice be “individualized” or that the participant be able to opt out of an investment.

More recently, on April 8, 2014, the SEC issued a no-action letter to Invesco Advisers Inc. In the letter, the SEC determined that a “generic stable value investment option” under a 403(b) plan with both an annuity and custodial component would not result in a deemed investment company or require registration. The generic option appears to have been set up as a managed account or a so-called “white label” fund, possibly in reliance upon the Benson White model. The assets of the 403(b) were then invested in insurance company pooled separate accounts. The participants were given the option to invest only in the generic option and were not made aware of the underlying account investments. The 403(b) plan sponsor, which is either a fiduciary under the Employee Retirement Income Security Act (ERISA) or contractually bound to comply with ERISA’s fiduciary standards, selected these underlying investments. The SEC determined that the separate account investments were exempt from registration under the ’40 and ’33 Acts.

In summary, while recent IRS rulings confirm that 403(b)(7) and 403(b)(9) plans may be pooled for investment purposes, 403(b)(1) plans may not. Further, the SEC has yet to catch up to the IRS with regard to 403(b)(7) plans. However, sponsors of and advisers to these plans still have options.

David C. Kaleda is a principal in the Fiduciary Responsibility practice group at the Groom Law Group in Washington, D.C. He has an extensive background in the financial services sector. His range of experience includes handling fiduciary matters affecting investment managers, advisers, broker/dealers, insurers, banks and service providers. He served on the DOL’s ERISA Advisory Council from 2012 through 2014.