YOU HAVE FOUND OUR OLD WEB SITE. BE SURE TO CHECK OUT OUR NEW AND IMPROVED SITE!     Note: A Hold Harmless agreement is a legal contract that some school districts require financial providers sign in order sell 403(b) products. Insurance companies have been more willing than mutual fund companies to sign these agreements. Mutual fund companies have said they object to language in many of these agreements that hold the financial institutions responsible for oversight they have no way of controlling. Many believe that insurance companies are more willing to sign these agreements because their higher operating expenses (often 1% to 2% higher than mutual funds) make the risk more worthwhile. Whatever the reason, most 403(b) plans offer an overwhelming majority of insurance-based investments at the expense of mutual funds.     In Defense of Hold Harmless Agreements   by Mark H. Fischer, CFA     Many employers are requiring hold harmless agreements from any investment vendor providing mutual funds or annuity contracts within their 403(b) retirement plan. Is this a fair requirement or an artifice created by insurance companies to protect a traditional insurance market?   In order to arrive at the answer, we need to understand how 403(b) plans are regulated. In general two laws apply to these plans, the Internal Revenue Code (IRC) and the Employee Retirement Income Security Act (ERISA). A large number of 403(b) plans are not subject to ERISA, while all plans are subject to the IRC. Hold harmless agreements protect employers and employees from liability pursuant the IRC. ERISA imposes certain duties on the plan sponsor and trustee. Investment vendors do not assume these duties. Therefore, most hold harmless agreements to not address liability arising from ERISA.   Employer responsibility pursuant to the IRC is fairly straightforward. The history of IRS oversight, however, has created a complicated situation. The 403(b) section of the IRC was established about 50 years ago. For the first 40 years, the IRS did not have a 403(b) enforcement program. This was kind of like having a speed limit without any police officers to enforce it. Thus, the speed limit was ignored.   For 40 years, employers, vendors and employees ignored the 403(b) tax laws. About ten years ago, a police department, so to speak, was formed. Audits soon followed and for the first time, employers began to be aware of their liability. This liability arises from the fact that the IRC, sees the 403(b) plan as an employer plan. This was and continues to be a shock to many employers. They believed that TSAs (tax sheltered annuities, which the 403(b) is often called) are just employee arrangements, and their only obligation is to transmit funds to the employees' vendor of choice. In fact, once funds are sent, the employer involvement in the plan is nil. Everything that happens in the employees' accounts is between the employees and their respective vendors. As a result, employers are not party to transactions that may violate the tax laws, and cannot prevent violations from occurring. This puts the employer in a very precarious position.   Employer responsibility pursuant to the IRC covers seven main compliance issues. First, the employer is responsible for proper calculation of the maximum allowable contributions to an employee account. Second, the employer must make the plan universally available to all eligible employees. Next, the employer is responsible for proper administration of hardship distributions and the proper administration of loans. In addition, the employer is liable if mutual funds are not purchased within a compliant custodial agreement. Finally, the employer is responsible for 70 1/2 notification, and proper tax reporting.   Due to the nature of the 403(b), the employer can only actively perform three (out of seven) of the compliance issues: calculations, universal availability and the verification of the custodial agreement. Many employers delegate the calculations to the vendors, because they do not have the necessary knowledge and resources to make the calculations. However, delegating the task does not shift the liability; the employer is still responsible for the accuracy of the calculations. With respect to the other four issues, since the employer is not privy to the transactions, it is at the mercy of the vendor to maintain compliance. However, the IRC does not impose liability on the vendor. This is where hold harmless agreements come into play.   A strong hold harmless agreement will protect the employer and employee from non-compliance arising from the vendors' actions. The agreement will require the vendor to take responsibility for their errors of commission and omissions. Most insurance companies choose to take responsibility; most mutual funds, however do not. The mutual fund industry's position is that they do not administer 401(k) plans for free, and are not willing to administer 403(b) plans for free. Thus, most mutual funds are not approved products in plans where employers require strict hold harmless agreements.   The following is a real life example of the need for a hold harmless agreement. An eastern school district employee needed a few thousand dollars to pay her property taxes. Her 403(b) account is at a large prominent mutual fund company. She phoned the mutual fund and asked if she could withdraw money from her account. The representative told her yes. She asked if she had to stop contributing to her plan. The representative said no. The representative mailed her the paperwork necessary to take a hardship distribution. She completed the paperwork, mailed it back and received a check.   What is wrong with this picture? First, taxes are not a hardship. Second, the representative did not inquire about alternate sources of funds that she might have available. Third, the employer was not notified of the hardship distribution. Fourth, in order for the employer to avail itself of the safe harbor provision with respect to hardship distribution, contributions must be suspended for one year.   This scenario repeats itself everyday, and every time it does, the employer is put at risk. If the employee or employer is audited, the employee will have to prove that a real hardship, as defined by the IRS, existed at the time of the distribution. If as in this case a bona fide hardship did not exist, the employer and employee both face monetary sanctions. If a strong hold harmless agreement were in place, then the employer would be protected.   You may ask what are the chances that the IRS would find out about the distribution? Tax law requires that the mutual fund custodian issue a 1099 reporting the hardship distribution.   Prior to closing, I am compelled to address a couple of bogus arguments against hold harmless agreement. First, the risk of audit is low and therefore in the practical order hold harmless agreements are not necessary. Would you advise someone not to wear a seat belt, because the chance of an accident is low? Would you advise a father not to maintain life insurance (term or universal depending on your druthers), because he probably will not die? Obviously, the answers are no.   The second argument is that the IRS is not imposing serious sanctions; therefore the risk is not real. A Minnesota school district's sanctions exceeded $225,000. A Midwestern university's sanctions exceeded 10 million dollars. Many large schools that have been audited have legal expenses that reached six figures. Therefore, the argument fails on facts. It also fails on logic. A prudent employer would examine their potential liability under the law, not the average negotiated settlement. Potential liability includes plan disqualification that would result in all the contributions being taxable. The fact is whatever leniency the IRS is extending today does not translate into the IRS' position in the future. Add to this, the fact that the IRS is not known for its kindness and understanding, and logic refutes the argument.   To close, the question should not be why an employer should have strong hold harmless agreements in place? The real question is: why do companies that hold themselves out as 403(b) provider refuse to accept responsibility for complying with the applicable laws?   As with 401(k) plans, there are companies that specialize in 403(b) plan administration. Some of these third part adminstrartors (TPAs) provide master custodial plans. The TPA often take the responsibility for the compliance of the mutual funds purchased via the custodial plan. This plan allows the availability of mutual funds on a tax compliant basis.   Mark H. Fischer, CFA, is the Vice President of Horizon Benefit Administration. HBA is a third party administrator (TPA) specializing in 403(b) plan administration. They offer a comprehensive compliance service that includes a fully compliant master custodial account.     Home | Disclaimer | © 2001 403(b)wise. All rights reserved.				Read a rebuttal to this story.