Keep governmental 457(b) plans on track
Government agencies are increasingly switching from defined benefit plans to 457(b) plans. When set up properly, these plans can be straightforward and flexible. This article examines best practices and potential pitfalls with 457 plans.
As government agencies continue to freeze their defined benefit plans or withdraw from state plans, many are turning to 457(b) deferred compensation plans to help their employees prepare for a more financially secure retirement.
Set up properly, governmental 457(b) plans can be straightforward and flexible. Not set up properly, they can be expensive administrative quagmires that can lead to fiduciary concerns for plan sponsors and unsatisfactory outcomes for participants. For these reasons, the Internal Revenue Service (IRS) has been paying close attention to these plans for the past several years.
Using multiple providers can lead to suboptimal results
Many 457(b) plans are set up using multiple providers, but a multi-provider plan design can sometimes result in higher costs, fragmented communication, and concerns about fulfilling fiduciary duties.
Higher costs: In a multi-provider environment, plan sponsors lose the economies of scale they might gain if they consolidated all plan assets with one provider. This can mean high retail pricing for their investments. Lincoln Financial, as a single provider, can offer an open-architecture platform that includes cost-effective, flexible revenue-share-class investments.
Fragmented communication: In addition, participant communication may be fragmented and sporadic, resulting in low participation.
Fiduciary concerns: Multi-provider 457(b) plans also may be faced with administrative complications that don’t stand up to IRS scrutiny. According to a study of IRS audits, the most common administrative errors related to use of multiple providers are:1
- Excess contributions caused by weak communication among providers
- Failure to enforce the “first day of the month” requirement for contribution elections and changes
- Distributions that don’t meet the “unforeseeable emergency” criteria
- Failure to operate the plan in compliance with the plan document(s)
- Lack of coordination of maximum loan amounts among the providers
- Failure to default loans as required under IRC Section 72
It’s true that governmental 457(b) plans aren’t subject to ERISA requirements. But, as an article in the Journal of Pension Benefits points out, these plans are subject to state law and, in many cases, state fiduciary laws are based on principles very similar to those underlying ERISA including modern portfolio theory, the prudent man rule, and the use of generally accepted investment principles.2
In other words, in most states a 457(b) plan sponsor’s fiduciary duty is to select, monitor, and prudently review the performance of plan providers including the plan’s investments, costs, and fees. Using multiple providers can make this a complex, time-consuming task, prone to errors.
Using a single provider can mean a smoother-running plan
Consolidating under a single provider can make a lot of sense for many governmental 457(b) plans.
- Streamlined, consolidated investment choices may help reduce costs and fees and make it easier for participants to make investment decisions.
- Consistent, focused participant communications and education may help improve plan participation and increase participant satisfaction.
- Simplified administration generally leads to fewer errors and helps increase the confidence of plan sponsors.
As always, pay attention to details
Even aside from the issues specifically related to using multiple providers, plan sponsors need to be well-educated in the details of their plans so they stay in safe fiduciary waters. It can be helpful, for example, to keep these two caveats in mind:
- Employer contributions are treated as deferred income and therefore count toward the overall deferral limit, so plans should be set up to take this into account.
- If participants age 50 or older have contributed less than the maximum deferral for up to three years, the “special catch-up” provision allows an additional contribution to make up the difference. But calculating the “underutilized” amount can be tricky. Only the years in which the plan was in place and the participant was eligible for catch-up contributions can be considered.
1 Gregory E. Seller and Marilyn R. Collister,”IRS Audits of Government 457 Plans,” Focus on 457, January 21, 2005.
2 Fred Reish and Bruce Ashton, “Fiduciary Rules Applicable to “(b)” Plans,” Journal of Pension Benefits, January 2005.