CDSC Charges

[Guest Admin]

If Employer "A" chooses to terminate the contract with an Insurance carrier and they also wish to reimburse each participant for the CDSC(back end charge), does the reimbursement count as a contribution and need to be tested for Non-Discriminatory practice or can it avoid being considered a contribution.

Thanks

[E as in ERISA]

Do the plan and contracts prohibit them from either:

1. Paying it outside the plan.

2. Treating it as a payment of an expense within the plan.

[Guest Admin]

The plan is a 401(k) plan that is changing investments from an Insurance carrier to the American Funds. The Insurance carrier is charging each particpant "X" dollars in an CDSC when they leave. Employer wants to issue a check to reimburse each participant the "X" CDSC charge so they don't suffer the fee hit. I am looking for any insight on how that reimbursement must be catergorized. Is it an extra Employer contribution that needs to have testing done on it?

Thanks

[Mike Preston]

In normal circumstances, it would be considered a contribution. However, if it is somehow found that there was a fiduciary breach by entering into the contract in the first place, restitution to the plan participants would not be considered a ontribution.

It is somewhat difficult to convince everybody involved to volunteer that there was a fiduciary breach. When everything is explained, for some reason, people just don't want to belly up to that particular bar.

Besides, it is a very unusual plan that can't handle the restitution as a contribution and still pass muster under the non-discrimination tests of the code. Of course, if the plan is a prototype that doesn't support disparate benefit amounts, or the plan sponsor is unwilling to amend the plan in order to allow it to support disparate benefit amounts, then I guess the plan sponsor can't do what it wants to do.

[E as in ERISA]

I agree with Mike Preston. The general thought is that this is a restorative payment.... However, there have been other threads suggesting that it doesn't hurt to have someone review the contract (and the plan?) and see if there is any way to have all or a part of the back end charges paid as an expense outside the plan. (If that works, it seems that maybe there is a way to have them characterized as an expense and paid by the employer inside the plan??)

[jpod]

1. I just want to be clear. The employer wants to put the money in the employees' plan accounts, right? If the employer was just going to give the employees the money directly, that would be W-2 compensation subject to full withholding, FICA and Medicare, etc., but you woudln't have all of the deduction issues.

2. I agree, based on precedent, that the CDSC is in the nature of a "capital cost" of the Plan's underlying investment, rather than an administrative expense. Therefore, a reimbursement by the employer would be treated as a contribution, absent the "fiduciary breach" approach which Mike Preston has described.

3. Query whether the decision to terminate the arrangement with the insurance company, thereby triggering a CDSC, is ITSELF the fiduciary breach, as opposed to the initial investment with the insurance company in the first place.

4. At the risk of mentioning the obvious and making myself look foolish, if you haven't signed on the dotted line yet with the American Funds, and if the plan is large, maybe American Funds (or its advisor or distributor) will cover the CDSC. If American simply pays it to the insurance company, there is no transaction to account for at the plan level. If American reimburses each participant's account, it seems to me this should be treated as plan earnings.

[Archimage]

You could also try to get the insurance company to bill the company directly in the amount of the CDSC instead of having the company directly reimburse the participants.

[Guest timeout]

Rev. Rul. 2002-45 is a good read re: above.

[jpod]

Timeout:

Are you getting something out of this ruling which I am not? According to the ruling, it's only a "restorative payment" if a non-frivolous lawsuit has been filed or the employer has reason to fear a non-frivolous lawsuit. This is what Mike Preston said from the get go.

The fact is, evidently, that this employer does not want to admit to a fiduciary breach or to do anything that could be construed as an admission of a fiduciary breach, and I don't blame it.

[KJohnson]

ARCHIMAGE--I think JPOD's point is that even if the insurance company billed the employer directly, it will still be considered a contribution.

Employers cannot pay things like brokerage commissions and call them administrative expenses under Rev. Rul. 86-142. I agree that the surrender fees are probably more akin to brokerage fees (can't be paid by the employer unless treated as a contribution) than they are to quarterly fees for an investment manager (can be paid by the employer directly and will not be treated as a contribution).

Thus a restoration payment would be the only method to make this work. And I think this is a tough call without further allegations of fiducairy breach.

[Archimage]

I wish the IRS/DOL would just make an official ruling one way or the other.

[Guest yukon]

KJohnson:

Just want to make sure I understand. Are you saying CDSCs can't be billed to the ER outside the plan? In other words, the insurance company never deducts the expense from participant accounts, and instead, simply bills the ER??

[KJohnson]

I think that's correct (unless the employer treats the payment of the surrender charge as a contribution). The distinction is whether a charge is an "overhead expense incurred in connection wth the maintenance of the trust" or whether it is "intrinsic to the value of the asset."

If it is an overhead expense of the plan, the employer can pay it directly, not treat it as a contribution, an also deduct it as an ordinary business expense.

If, on the other hand, the charge is part of the "intrinsic value of the asset" then if the employer pays it directly it must be treated as a contribution and cannot be deducted as a business expense.

I believe that the IRS would view the employer paying the surrnender charge as an "intrinsic" part of the investment. The analogy might be placing money with an investment manager who has a loss for the year. The employer says--I don't want my employees to lose money in their accounts" and then pays the investment manager the amount of the loss so he will not show negative results. The IRS woudl say that is actually an employer contribution (absent meeting the qualifications for a restoration payment).

[Archimage]

However, you could view it differently. It is a sales charge and not a direct loss on the account. I really think it could be viewed either way. I think a better approach would be to let the CDSCs be deducted up to a certain percentage. Some of these investment vehicles charge an excess amount that I believe would violate a breach of fiduciary duty. I think the plan administrator would definitely have an argument of paying 70% of a 15% CDSC which would not have to be treated as a restorative payment.

[Guest yukon]

Do you have any specific references I could read? In the 14 years (or so) that I've been in this industry, I've seen numerous situations where the employer has paid the bill, and left the participants whole, during a transfer between custodians.

Also, how does Rev Rul 2002-45 affect your opinion? What if there is a threat of litigation for a suspected fiduciary breach? Say, for instance, if the CDSC is a significant amount of plan assets, or a small group of participants take the brunt of the charges due to large account balances...and they decide to sue?

[Guest timeout]

Jpod,

No. Same reading - it was offered as a fairly recent revenue ruling about a 'real controversy' (e.g. I do not think a CDSC is a 'real controversy' unless of course there is something like an 'unreasonable compensation' situation - which I do not think is the case with the Admin post).

[Archimage]

I think in most cases reimbursement of CDSCs would be treated as a contribution to the Plan. However, I do believe there are certain rare cases which could fall under the Rev Rul 2002-45. That is the point I am trying to make.

[E as in ERISA]

Is the IRS' conclusion in PLR 200137064 correct in the first place? And if so, does it really apply to all DSCs?

First, not all amounts deposited into a plan are subject to 401(a)(4), 404, 415, and 4972, are they? If an employer reimburses a plan for expenses, that reimbursement doesn't always get allocated to all participants and subjected to those rules, does it?

Second, it seems that the DSCs might work differently in different plans, depending on the arrangement...

I have been in an investment election in a plan (e.g., a fund with bonds or a GIC) where I had to stay with that election until maturity and only then did I have a choice to roll into the superceding bond or GIC fund or change to a different investment. (And I had notice of that). But I have been in lots of other investments where there was never any limits on how long I had to stay in.

In PLR 200137064, it appears that participants were subject to time commitments and DSCs were being charged to the participants' accounts even before they changed to another investment provider. It says, "[t]he contracts... provide for withdrawal charges equal to eight percent of the account value during the first five Participant Account Years, four percent for the Participant Account Years six through ten, and zero percent thereafter. A Participant Account Year begins when an individual account is established and an initial contribution is credited to the account. A Participant Account Year ends on the day immediately preceding the next anniversary of such date. The withdrawal charges are assessed directly against individual accounts." So even if participants terminated and took a distribution, then they were getting hit with a DSC? Regardless of whether the whole plan changes investments?

But aren't there a lot of participant-directed plans where these charges are not incurred while participants are transferring money among the different funds or taking distributions -- the charges are only incurred when the plan as a whole changes to another investment provider? So a person who voluntarily transfers out of the funds on one day may have no charge, but the person who happens to be in them on the day the plan investments are changed gets hit with a charge....

I think that under the facts of the PLR you have an argument that the individual participants shouldn't bear an expense caused by the fiduciary's decision to change investments. And I think that you have a much stronger argument in the second situation when the charge is clearly related only to the fiduciary's decision to change investments and not to the participants' decision.

[KJohnson]

Should participants have to pay brokerage fees when a fiduciary makes a decision to sell stock? My understanding is that a surrender charge is simply a method of an insurance company making sure it "gets back" the commission it paid to a broker if the plan decides not to stick with the insurer. In some ways it is a sales charge just like brokerage.

For those interested, here is the link to the PLR cited by Katherine.

http://www.benefitslink.com/IRS/plr200137064.shtml

[E as in ERISA]

If all participants are getting charged the fee every time a transaction occurs that would be one thing. I don't like that answer, but at least it seems fairer than the situations where these DSCs aren't charged to individual participants when they transfer in and out of an investment -- only when the whole plan transfers out of the investment. So the IRS might have a different answer if presented with the second situation.

At some point, you almost get to the settlor vs. plan expense argument.... (I said "almost" -- you clearly can't claim this is a "settlor" functioned as defined by the DOL).

[Guest asire2002]

What would you think about the employer "advising" participants to move their money into an option that doesn't have this charge attached prior to the conversion date?

[Mike Preston]

If the investment contract has such a loophole in it, then the participants are perfectly within their rights to exercise the options available to them, and certainly telling them about their options in not contrary to anything I can think of.

[alanm]

kjohnson got it right. The IRS has spoken on this issue. Take a look at PLR 200137064. Also they expressed an opinion at the 1999 National Conference of ASPA, see Q&A-79. Restoration of a backend load is a contribution to be tested for discrimination.

[E as in ERISA]

It is my understanding that not all CDSC are the same -- some may apply each time a participant withdraws from a fund; others may apply only when the entire plan is withdrawn from the fund, etc. The terms of the contracts and the economics of the situations may vary significantly. There are at least two questions that need to be answered -- Who gets allocated the charges? and How does the employer's repayment of the charge get treated? The results could (should?) be different under different circumstances.

In PLR 200137064, the IRS does not consider the question of who should be allocated the charges. Participants have been had a guaranteed rate of return, and most have been receiving even more. It is assumed that based on the plan terms and the contract, that the individual participants who are invested in the funds will have their accounts charged, depending on how long they have been invested in the fund. The charge will reduce the rate of return (but it will not reduce it below the guaranteed amount). The employer was going to make a payment to the plan that would be allocated directly to these individual's accounts. The IRS concluded that the payment was an additional contribution that had to be discrimination tested, etc. The basis for this conclusion was that such payments are not "restorative payments" if they make up for general market fluctuations or if similarly situated participants are treated differently. The IRS said this was a fact specific conclusion. Has the IRS opined in writing in a situation where the CDSC was charged only when the entire plan was withdrawing?

In a case where the CDSC is only being charged when the entire plan is withdrawing from the fund, I think that you have to start with the question of who should be charged the fee. I wouldn't necessarily assume that the charge will be allocated only to those currently in the fund based on how long they have been in the fund. You may have to allocate the charge across the board. So you have different issues about the allocation of the charge and different issues about the allocation of the payment. I think that makes a better case for arguing that the payment is a restorative payment, because it is not necessarily an offset to previous earnings of a participant within the fund and similarly situated participants may have the same treatment....

I don't know what the IRS would think of this argument. (I guess that most on this board would believe that the IRS would not agree?) But at some point it would have to give recognition to the fact that not all of these arrangements are the same.

[MR]

What about compensating the affected employees by way of a taxable bonus? Let 'em do a CODA of up to 100% of bonuses.

[alanm]

That works

[jpod]

While it may "work" in a sense, it does not satisfy the employer's liability to the plan for breach of fiduciary liability, to the extent there is a breach (although it certainly minimizes the risk that anyone would be inclined to complain, perhaps not even the DOL).

[Guest Gordy]

Reisch Luftman et al have an article on their site www.reisch.com/practice_areas on "The Dos and Don'ts

of Restoration Payments. It may help shed some light on

the issue.

[four01kman]

Why not have the broker (broker-dealer) pay the CDSC out of the new commissions?

[Earl]

you mean like the commission he is getting on the money he already got a commission on?

[four01kman]

That's right. Sometimes (maybe not this time) the reason for the new investment is the failure of the old. If a broker received a commission on the old, and is about to receive a commission on the new, doesn't it make some sense for the CDSC to be paid out of the "new" commission"?

[alanm]

Rebating commissions is a violation of NASD regulations. Only insurance companies are exempt from the regulation. this doesn't have anything to do with ERISA which what this discussion is concentrated on.

[four01kman]

Not talking about commission rebate. It is possible for a broker-dealer to "reimburse" a plan for plan expenses, not settlor expenses. This is not done by the broker but by the broker-dealer.

[alanm]

I don't think so. The rules cover the Broker-dealer and brokers who are supervised by the broker dealer. My firm is a TPA and broker dealer and we have been over this issue numerous times in audits by the NASD. Essentially, brokers can't buy the business by paying the CDSCs, however insurance companies can because they are not subject to the NASD rules on this issue. The only way a broker dealer can do it is to call it restoration made to avoid litigation. That is very difficult to argue unless the client has filed a complaint with the SEC or NASD or filed suit. So you get over that hurdle and now you are back to the IRS opinion that such payments should be tested for discrimination because they mainly benefit those with large balances, which usually mean high comps and owners. In fact, the insurance companies aren't free of the IRS position just because they don't have a problem with the NASD. The end result of an insurance company buy down of CDSCs is that they increase the internal expense ratios of the annuity products to get their money back over time. When they get their money back, they still don't reduce the expense ratios. Participants end up paying for the CDSC and more.

[four01kman]

Having done this in the past more than once, I know it is an okay transaction, blessed by attorneys. What you might want to do is specifically ask your attorney(s) the specific question regarding the broker-dealer paying the "old" fund the amount of the CDSC as a "plan expense".

[Guest philc]

Plan is changing carriers and there will be a market value adjustment assessed against the "fixed" fund. The employer wants to pay the adjustment (small amount) to make participants in that fund whole. Seems fairly clear that this would be a contribution vs. a restorative payment.

What would seem fair, equitable and acceptable would be to make the payment only for participants in the fixed fund in the amount their account was reduced.

But if the amount being restored is considered a contribution, doesn't the allocation of that amount have to follow the terms of the plan re- allocating employer contributions (e.g. comp/comp)? If so, some participants who weren't in that fund could be getting an allocation.

I have looked at RR 2002-45 and the PLRs but they seem to deal with what is/isn't a restorative payment but haven't seen anything that deals with the payment as a contribution and how it would be allocated.

How have others done this?

[alanm]

You hit the nail on the head. Even if you test it as a contribution, you must allocate a contribution according the plan's formula and you can't fit a formula to the actual charges to the account balances of participants. A problem that can't be solved by following all the various rules. The only sure way is to pay the participants the back end charge outside the plan as an increase in their paycheck and tax it. then allow them to make an extra deferral if they wish.

Many insist it is ok to restore the back end charges to the plan because they have always done it that way. They will probably continuing doing that until they are audited, as I have been. Since these type of transactions infrequently come up in plan audits because they are not very visible, they get away with it.

[PensionNewbee]

I'm fairly new to the conversion process, but I have seen the new investment company pay a % of the deferred sales charge and allocate that to each participant's account to help make up for the loss created by transferring the assets.

[Guest jhall]

Am interested in opinions on the following situation. 401(k) Plan frozen and assumed by Buyer as part of a stock deal is to be merged into Buyer's 401(k) Plan Oct. 1st. 3 of the frozen plan's fuinds impose redemption fees on fund balances liquidated prior to a 90 day holding period. Plan Administrator was not aware of the redemption fee issue until now and so did not notify participants of the potential issue in sufficient time to put them on notice of the charges.

Roughly 1/3 of participants will be affected (assuming no new investments in these 3 funds). The amounts are small. Roughly 90% of the affected participants are NHCEs. Given the amounts involved, I think it is highly unlikely that any participants will take legal action over this matter although some will certainly grumble and the Plan Sponsor would prefer to pay the redemption fees on behalf of affected participants

Given IRS rulings, payment of the fees would not appear to qualify as a restorative payment. Thus, any payment by the employer would appear to constitute a contribution subject to nondiscrimination and general testing. Plan Sponsor does not want to make reimbursements outside the plan because they are afraid it will raise red flags, will cost them more because of gross up and administrative processing issues, and also because a number of the affected participants are former employees who still have accounts in the Plan and are not as easily reachable as are active employees.

Now, for my real question. I have seen some discussions indicating that a plan sponsor that is not worried about nondiscrimination issues or annual contribution limits, etc. might consider making the contribution and going through the required testing. Given the numbers, I'm not worried about HCE vs. NHCE issues in this case. What concerns me is the fact that although all affected participants will be treated equally, some NHCEs will receive additional contributions while other NHCEs will not.

Furthermore, there is the question of how you would allocate these contributions to affected participants. I have seen some commentators suggest that the Plan could be amended to include a special allocation formula to distribute the redemption fee amounts separate and apart from the normal contribution allocation formula. Is there any way to realistically structure such an allocation? Is it possible to get comfortable that such an amendment would not pose risks to the Plan's qualified status, particularly where it would be an amendment taking the Plan off of a prototype.

Any assistance you could provide would be greatly appreciated.

thanks,

Jamie

[Bird]

Now, for my real question. I have seen some discussions indicating that a plan sponsor that is not worried about nondiscrimination issues or annual contribution limits, etc. might consider making the contribution and going through the required testing. Given the numbers, I'm not worried about HCE vs. NHCE issues in this case. What concerns me is the fact that although all affected participants will be treated equally, some NHCEs will receive additional contributions while other NHCEs will not.

Yes, whether the result is good, bad or indifferent depends on your perspective. I don't think you'll have perception/morale problems if it is explained properly.

Furthermore, there is the question of how you would allocate these contributions to affected participants. I have seen some commentators suggest that the Plan could be amended to include a special allocation formula to distribute the redemption fee amounts separate and apart from the normal contribution allocation formula. Is there any way to realistically structure such an allocation? Is it possible to get comfortable that such an amendment would not pose risks to the Plan's qualified status, particularly where it would be an amendment taking the Plan off of a prototype.

You've done a good job of identifying the problem (!). The first part is easy, the amendment just says "notwithstanding anything herein to the contrary, we are making a special contribution in these amounts (list participants and amounts)."

All I can say on the issue of taking the plan out of prototype status is that the accumulated weight of this and other situations has convinced me to not use prototypes.