At $652 billion, the 403(b) retirement plan market may be dwarfed by its more familiar 401(k) cousin, which had $2.7 trillion in assets at the end of 2006. But the Internal Revenue Service overhauled the regulations for 403(b) plans last summer, and as these regulations take effect in 2008, the market will change rapidly. The changes will affect both educators and their school districts. With few experts able to advise participants and their school districts, advisors helping educators work through the new system will have a chance to build their client base as the market consolidates.

Background

A 403(b) plan is an employer- sponsored retirement plan for public education organizations and some non-profit companies. In the 403(b) market, participants usually choose their own investment contract. The first investment contracts in the 403(b) market were fixed annuities. Even as recently as 2003, half of all 403(b) assets were invested in fixed annuities.

Historically, a sales force of commissioned captive agents sold fixed annuities. They commonly met with educators in the teachers' lounge to educate them about tax-deferred savings. Over the past two decades, variable annuity companies have used a similar strategy to expand the 403(b) market. More recently, mutual funds have gained market share as participants have moved toward lower-cost investment choices. Now, most school districts maintain a list of approved providers that includes fixed annuity, variable annuity and mutual fund firms.

Over the years, the number of providers on this list has increased to the point where there are frequently more than 20 from which an employee can choose. Each provider has its own contract or custodial agreement, as well as its own rules, fees and surrender schedule. There is no continuity between providers, and there is limited or no communication between providers for employee hardship or loan requests.

To complicate matters, in 1990 the IRS issued a revenue ruling on trustee-to-trustee transfers of 403(b)s. Ruling 90-24 allowed 403(b) owners to transfer a current plan into another plan of their choice, even if the new plan was not approved by the employer. This ruling created an almost unlimited number of investment options, but it also created many accounts that neither the IRS nor the employer could track.

Streamlining the Process

The complicated 403(b) market needed updating in order to be more easily managed by both school districts and the IRS. Since 1964, the 403(b) rules had been updated but had not gone through a complete overhaul. In July 2007, the IRS finalized the first comprehensive 403(b) regulations in 43 years. These new rules require a written plan that will standardize each district's 403(b) providers. While providers and employers have until Jan. 1, 2009, to be fully compliant, the changes have already begun.

In September 2007, new 403(b) regulations effectively undid the 90-24 ruling of 1990. The idea behind the 1990 revenue ruling was to allow participants more investment choices. In the late 1980s, schools had a restrictive list of approved firms, many with high fees. The 1990 ruling allowed participants the flexibility to move their investments to any account of their choice. However, there were no centralized administrators to monitor these transfers.

As 90-24 transfers became more prevalent, more variable annuity and mutual fund companies moved into the 403(b) market. This larger number of firms magnified the transfer issue. When a transfer is completed, custodians have little communication with one another. Most 403(b) providers only require the signature of a participant to certify any loan or hardship withdrawal. Compliance falls on employees, most of whom know little about the regulations.

The new regulations require multiple providers to communicate with one another and to work with school systems to set up a system of verification and information sharing. During the rest of 2008, school systems and custodians will put together the pieces to become compliant. School systems will take on more liability as the administrators of plans. Through the school systems, companies will share information on transfers, rollovers, hardship withdrawals and loans.

In December 2007, the IRS issued guidance on the new regulations and released model plan language for the written plan that must be in place by Jan. 1, 2009. The guidance and model plan language can be found at www.irs.gov/pub/irs-drop/rp-07-71.pdf.