Public Pensions: Section 457 Plans Pose Greater Risk Than Other Supplemental Plans
Published: 1996-04-30T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Pursuant to a congressional request, GAO reviewed the status of public pension funding, focusing on how plans established under Internal Revenue Code (IRC) section 457 differ from plans created under IRC sections 401(k) and 403(b).
section_title: What GAO Found
paragraphs: GAO found that: (1) most state and local government employees are covered under section 457 plans because the Tax Reform Act of 1986 prohibited state and local governments from establishing plans under sections 401(k) and 403(b); (2) section 457 plan participants risk losses if sponsoring governments go bankrupt or the deferred monies are mismanaged or lost; (3) section 457 does not require sponsoring governments to maintain deferred monies to pay future benefits; (4) section 457 plan participants risk losses because sponsoring governments may view deferred monies as available for public use; (5) while funds enrolled in section 401(k) and 403(b) plans can be transferred to investment retirement accounts (IRA) when the employee leaves state or local government employment, amounts payable from section 457 plans can only be rolled over into other section 457 plans; (6) section 457 plan participants must declare a fixed date for when they will begin receiving their benefits shortly after retiring or leaving employment; (7) according to IRS, the transfer of section 457 plan deferrals into IRA or allowing plan participants to change their distribution dates would create a taxable event or be incompatible with the plan's tax deferred condition of government ownership; (8) section 457 plans allow a lower maximum annual employee deferral and employer contribution than section 401(k) and 403(b) plans, and are not indexed; and (9) new legislation could increase the section 457 plan deferral and contribution limit and index section 457 plans to inflation.

section_title: Letter
paragraphs: This report is one of three we are issuing in response to your request that we review the status of public pension plan funding. This report specifically addresses your concerns about the financial security of amounts deferred by participants into state and local government supplemental pension plans.
In this report we discuss how plans established under Internal Revenue Code (IRC) section 457 differ from plans created under IRC sections 401(k) and 403(b) in terms of protection against financial loss and other issues.
As agreed with your office, unless you publicly announce its contents earlier, we plan no further distribution of this report until 15 days from its issue date. At that time, we will send copies to the Commissioner of the Internal Revenue Service, the Chairman of the Securities and Exchange Commission, and interested congressional committees. Copies will be made available to others upon request.
This report was prepared under the direction of Donald C. Snyder, Assistant Director. Mr. Snyder can be reached on 202-512-7204, if you or your staff have any questions.
subsections: section_title: Introduction
paragraphs: Millions of state and local government employees are supplementing their future retirement benefits by contributing to salary reduction plans called salary reduction or defined contribution arrangements. Such plans enable participants to defer part of their current salary for future use. The goal of these plans is to postpone federal income tax until the amounts deferred from an employee’s salary and any earnings or losses thereon are received by the participant at separation or retirement.
All salary reduction plans pose some risk of financial loss from poor investment performance. However, amounts in plans organized under Internal Revenue Code (IRC) section 457(b) (hereinafter referred to as 457 plans) bear additional risk because salary deferrals to 457 plans are assets of the sponsoring employer that may be used for nonplan purposes and which are subject in the event of bankruptcy to the claims of general creditors. For example, one municipality’s recent bankruptcy could cause financial losses to employees who participated in its 457 plans. In addition, amounts earmarked to pay another county’s 457 plan obligations could have been at risk when the county intended to use those amounts to meet payroll expenses. In that case, the county might not have had the funds available when the time came to pay out the amounts due the 457 plan participants. In both cases, county officials were entitled to use the money saved to pay 457 plan obligations for nonplan purposes. As a result, concerns have been raised about the security of deferrals that participants make from their salary under 457 plans.
subsections: section_title: Three Types of Salary Reduction Plans
paragraphs: A state or local government may elect to offer its employees, among other retirement plans, a deferred compensation arrangement under IRC sections 403(b), 401(k), and 457(b). In all three types of plans, employees may voluntarily defer compensation through payroll deductions. Federal income tax is postponed until employees begin to receive their account balances, usually at retirement or when they are no longer employed by the plan’s sponsor. These three salary reduction plans typically are intended to supplement an employer-sponsored qualified pension plan under IRC section 401(a).
In general, 401(k) plans, sometimes referred to as cash or deferred arrangements, are qualified plans that allow employees to choose between receiving current compensation or having part of their compensation contributed to a qualified profit-sharing or stock bonus plan. A 403(b) plan, a qualified-type plan sometimes referred to as a tax-sheltered annuity, is a deferred compensation arrangement that may be sponsored only on behalf of employees of public educational systems and other specific tax-exempt organizations.
Section 457(b) plans are nonqualified, unfunded deferred compensation plans that may cover all employees of a state or local government and certain highly compensated employees of a tax-exempt organization. Such plans permit these employees to defer limited amounts of compensation so that, under the principles of constructive receipt and economic benefit, tax will also be deferred on the amounts plus their earnings until some future event.
Eligibility and the security of deferred amounts vary among the three plan types. Employees of public schools, colleges and universities, and some private institutions exempt from tax under IRC section 501(c)(3), such as hospitals, typically participate in 403(b) plans. Contributions to these plans are generally maintained as an annuity contract or custodial account, both of which are reserved for the sole benefit of the participant and his or her beneficiaries.
Employee deferrals under section 401(k) plans are held in trust for the sole benefit of the participants and their beneficiaries. These participants are primarily employed in the private sector. However, some state and local governments established these plans in the late 1970s and early 1980s for their employees. With the enactment of the Tax Reform Act of 1986,state and local government employers who had not previously established 401(k) plans were prohibited from establishing new 401(k) plans, but existing plans could continue. Despite concerns raised by representatives of state and local governments, among others, the rationale for this exclusion was that allowing public employees to have access to both 401(k) plans and 457 plans would be “inappropriately duplicative.”
Only employees of and independent contractors providing service to state and local government and tax-exempt organizations may participate in 457 plans. Unlike 401(k) and 403(b) plans that are funded and must comply with the nondiscrimination and minimum participation rules, section 457 plans are unsecured promises of the employer to pay amounts in the future. A section 457 eligible, salary reduction plan requires that all deferred compensation and income shall remain solely the property of the employer and be subject to the claims of the employer’s general creditors.
section_title: Compliance With Employee Participation Rules
paragraphs: In 1999, 401(k) and certain 403(b) plans must begin testing for nondiscrimination and minimum participation rules. Generally, the nondiscrimination rule requires that benefits or contributions provided under the plan do not discriminate in favor of highly compensated employees. The minimum participation rule requires that the plan benefit at least the lesser of 50 employees or 40 percent of all employees. The minimum coverage rule requires that the percentage of nonhighly compensated employees who benefit under the plan must be at least 70 percent of the highly compensated employees who benefit under the plan, or the nonhighly compensated employees in the workforce must receive benefits that on average are at least 70 percent of the benefits received by highly compensated employees. State and local government sponsors of these plans have expressed concern that required compliance with these rules will be burdensome and costly.
section_title: Principles of Constructive Receipt and Economic Benefit
paragraphs: Two tax principles, constructive receipt and economic benefit, are often intertwined in matters regarding nonqualified, unfunded deferred compensation. Under the principle of constructive receipt, income is taxable even when an employee has not actually received current compensation, if the compensation is credited to the employee’s account, set apart for the employee, or otherwise made available to the employee. The principle of economic benefit, on the other hand, taxes assets that have been unconditionally and irrevocably transferred into a fund for the employee’s sole benefit because he or she has received a benefit (that is, some deferred salary) that, although not readily convertible to cash, has an immediate value (that is, a fund for his or her benefit) that is secured from the employer’s creditors.
Section 401(k) and 403(b) plans are funded, qualified or qualified-type arrangements where the deferred amounts are placed in trust; that is, set aside for the exclusive benefit of the employees who participate in the plans, secured from an employer’s creditors. So that such arrangements would not cause the participants to be taxed under the basic principles of constructive receipt and economic benefit, the Congress overrode these two principles by providing for income to be taxed only when it is distributed.
Section 457 plans, on the other hand, are nonqualified, unfunded deferred compensation plans that follow the basic principles of constructive receipt and economic benefit. Participants are not in constructive receipt of their deferrals because the amounts are not set apart for or otherwise available to them at any time. Participants do not derive the economic benefit of their deferred compensation because the deferred amounts are the property of their employers and subject to the employers’ general creditors. Instead, participants have bookkeeping accounts with balances that represent the amount that the employers promise to pay at some future time. These account balances are comprised of amounts deferred under the plan and any earnings or losses that would have accrued to those amounts if the account balances had been invested as stated under the plan. Although most employers sponsoring 457 plans invest amounts as necessary so that they will be able to provide the promised benefit when due, there is no requirement for them to do so.
section_title: Origins of 457 Plans
paragraphs: In 1972, IRS issued the first of a number of private letter rulings holding that tax may be deferred on employee contributions from salary to a nonqualified, unfunded deferred compensation plan where a state or local government was the employer. Nonqualified, unfunded deferred compensation plans of state and local governments and tax-exempt organizations were not subject at that time to certain restrictions placed on qualified plans: (1) they did not need to comply with nondiscrimination rules applicable to qualified plans; (2) there was no limit on the amount participants could contribute; and (3) participants in nonqualified, unfunded plans, unlike participants in qualified plans, could make tax-deductible contributions to individual retirement accounts (IRA). In 1977, however, IRS stopped issuing private letter rulings on the income tax treatment of amounts deferred under nonqualified, unfunded deferred compensation plans, pending formal review of its position. In 1978, IRS changed its position and published proposed regulations that would have subjected participants in nonqualified, unfunded deferred compensation arrangements to immediate taxation on deferred amounts. “cannot have any secured interest in the assets purchased with their deferred compensation and the assets may not be segregated for their benefit in any manner which would put them beyond the reach of the general creditors of the sponsoring entity.”
section_title: Requirements for Tax-Deferred Plans
paragraphs: Section 401(k) plans must meet three federal requirements for employee participation to be considered qualified. First, the value of the benefits that highly compensated employees as a group may receive is limited by the value of the benefits the less well paid employees collectively receive; this is the nondiscrimination rule. Second, at least the lesser of 50 employees or 40 percent of all eligible employees must participate in the plan; this is the minimum participation rule. Third, the plan must benefit a percentage of nonhighly compensated employees that is at least 70 percent of the percentage of highly compensated employees benefiting under the plan or the nonhighly compensated employees in the workforce must receive benefits that, on average, are at least 70 percent of the benefits received by highly compensated employees; this is the minimum coverage requirement. Additionally, among many other requirements, sponsoring employers must meet certain nondiscrimination tests and report their annual levels of participation, current assets, and current liabilities.
Tax-sheltered annuities under section 403(b) must meet nondiscrimination rules. Salary reduction deferrals to 403(b) plans must also meet special nondiscrimination rules that are deemed satisfied if all employees defer in excess of $200. Starting in 1997, section 403(b) plans that provide employer matching contributions will have to meet special nondiscrimination rules provided by section 401(m). Starting in 1999, section 403(b) plans that provide nonelective contributions (employer contributions that do not reduce a participant’s salary) will be required to meet the nondiscrimination, minimum coverage, and minimum participation rules.
For a 457(b) plan to be eligible for tax deferral treatment, the Congress limited the amount of compensation that may be deferred, but permitted participants to wait until after separation from employment to elect the time and method of payout. However, minimum participation, minimum coverage, and nondiscrimination rules that are a cornerstone for the tax-favored status of qualified, funded plans were not imposed.
section_title: Prevalence of State and Local Supplemental Plans
paragraphs: Little information is available on the number of 401(k) and 403(b) plans sponsored by state and local governments or the number of people participating in them. However, a 1993 study of over 400 state and local government general pension plans showed that about 8.4 percent of responding governments sponsored a 401(k) plan and 7.1 percent sponsored a 403(b) plan. In that study, 457 plans were the most frequently used salary reduction plans. About 90 percent of local governments and all 50 states provided their employees access to 457 plans. In 1994, an estimated 1,750,000 people participated in about 10,000 plans sponsored by government entities nationwide.
section_title: Recent Legislative Proposals
paragraphs: Several bills have been introduced in the 104th Congress to redesign section 457 plans. For example, H.R. 2491, the omnibus budget reconciliation bill, contained provisions that would require all assets and income of a 457 plan to be held in trust for the exclusive benefit of participants and their beneficiaries. However, IRS officials told us that imposition of such a trust requirement would result in immediate taxation for deferrals to a 457 plan because of the requirements of IRC section 457(b)(6). With respect to section 401(k) plans, another provision of the reconciliation bill would have provided a simplified and less costly alternative method of testing for nondiscrimination requirements under IRC. In separate legislation, under section 14212 of H.R. 2517, which was incorporated into the reconciliation bill and then dropped, state and local governments and tax-exempt organizations would have been extended the eligibility to provide 401(k) plans to their employees.
section_title: Objectives, Scope, and Methodology
paragraphs: In response to concerns about financial losses to state and local government supplemental pension plans, the House Ways and Means Committee asked us to examine the nature and security of such plans. After discussions with Committee staff, we agreed to determine (1) whether amounts held in state and local government salary reduction plans or otherwise promised to participants inherently are at risk of financial loss to the participants and (2) how statutory provisions comparatively treat participants in these plans.
To determine how the plan provisions affect financial risk, we interviewed representatives from IRS and Securities and Exchange Commission (SEC) staff. In addition, we discussed the risk of financial loss relative to plan provisions and whether the provisions treat participants comparably with representatives of the Government Finance Officers Association; the International City/County Managers Association-Retirement Corporation; the National Association of Counties; the National Council on Teacher Retirement; the National Association of Government Deferred Compensation Administrators; and the Nationwide Insurance Company and its subsidiary, the Public Employees Benefit Service Corporation.
To determine how state and local government plans are generally administered, we contacted plan administrators in Alabama, California, Connecticut, Florida, Georgia, Michigan, Minnesota, Mississippi, Nebraska, New Jersey, Ohio, Oklahoma, Tennessee, Texas, and Wisconsin. We selected these states on the basis of information they reported on their 457 plans in the 1993 PENDAT database. We focused our review on 15 states and on eight counties in California. We selected these counties because of the Committee’s concerns about the impact of the Orange County, California, bankruptcy on 457 plans sponsored by other California counties.
We conducted our work from January 1995 through January 1996 in accordance with generally accepted government auditing standards.
section_title: Sponsoring Government Actions May Pose Risks for 457 Plans
paragraphs: The statutory requirements that provide for tax deferral for 457 plans also place the assets held to pay participants’ benefits at risk of loss from creditors of the government sponsor in the event of a bankruptcy and, unless the sponsor provides for a rabbi trust, from the government’s using them for other than plan purposes. Two 457 plans in California illustrate these risks. In one case, a county filed for bankruptcy protection, which put amounts set aside to pay the county’s obligations under its 457 plan at risk of being used to satisfy the county’s creditors. Because participants in 457 plans have no greater rights of their employer than general, unsecured creditors, such actions could reduce the amount participants otherwise would receive from the plan. In the other case, a county government intended to use amounts it set aside for its 457 plan obligations to meet payroll expenses. However, if the amounts held for 457 plan purposes had been placed in a rabbi trust—as permitted for all nonqualified, unfunded deferred compensation plans—they may have been protected from use for nonplan purposes by the sponsor but not from a sponsor’s creditors.
subsections: section_title: Bankruptcy Threat to Orange County 457 Plan
paragraphs: Orange County kept its tax revenues in an investment pool managed by its treasurer and that permitted investments from cities, municipalities, and political instrumentalities outside Orange County. The county regularly contributed deferrals to the pool to assist it in meeting its obligations under this plan. The 457 plan provides that the experience of the investment pool will be used to determine the final amount due participants when they separate from service or retire. Thus, participants’ bookkeeping accounts are credited at specified intervals with the interest, gains, and losses realized by the investment pool.
From July to December 1994, the investment pool sustained heavy losses. This resulted in both the pool and Orange County filing for Chapter 9 bankruptcy on December 6, 1994. On May 2, 1995, the state Bankruptcy Court approved a comprehensive settlement of the pool’s bankruptcy case. Under this court order, Orange County received amounts from the pool at a rate that was lower than 100 percent of its claims.
No participant funds were used to pay pool creditors and the participants had no standing as claimants in the pool bankruptcy. The participants are general, unsecured creditors of Orange County only—not of the investment pool. However, Orange County’s claim against the pool included a claim for amounts it invested there so that funds would be available as needed to pay its yet unmatured obligations under the 457 plan.
Technically, because performance of the pool serves as a measure used to calculate returns for the 457 plan, the investment loss that occurred in the pool would normally affect the account balances of plan participants. As of March 1996, the bankruptcy in Orange County is still ongoing. It is possible that all creditors may eventually be paid 100 percent of their claims and that participants in the 457 plan that invested in the pool may have their account balances fully restored. Administrators of the 457 plan told us that the bookkeeping accounts for each participant would be credited with interest, but all accounts have been reduced 10 percent for losses on investments in the pool.
section_title: Los Angeles County Intended to Use Deferred Amounts for Payroll Expenses
paragraphs: In 1992, Los Angeles County intended to borrow $250 million of amounts deferred under its 457 plan to make payroll payments. SEC staff learned of Los Angeles County’s intentions and questioned the proposed action as potentially impairing the status of the plan under the federal securities laws. The SEC staff asserted that borrowing amounts set aside to pay the county’s obligations under its 457 plan for any reason other than satisfying obligations to the locality’s general creditors would conflict with representations made earlier to the SEC staff. These representations had been made in connection with a request by the insurance company that operated the separate accounts for participants when it sought the SEC staff’s no-action assurance that the separate accounts and the interests therein did not need to be registered under federal securities laws. The SEC raised concerns that the disposition of the assets needed to pay the county’s obligations under the plan as proposed by Los Angeles County conflicted with the representations made in seeking the no-action letter.
As a result of both SEC’s questioning and media reports accusing local officials of wrongdoing, the county created a new investment option under its plan in the form of a loan fund, offering at least a 6-percent return over 15 years. A few participants agreed to have their deferrals treated as though invested in the fund and the county was able to raise $19 million of the $250 million it originally intended to borrow. We note, however, that SEC does not regulate 457 plans and its ability to influence the operation of 457 plans is limited to instances in which an unregistered collective trust or separate account seeks to rely on certain exemptions from federal securities laws in order to hold funds earmarked to pay a 457 plan obligation.
Although the county chose not to do so, it could have simply used the assets without paying interest on their use because statutory provisions governing section 457 mandate that amounts deferred remain the property of the employer. There is no requirement that sponsoring governments actually invest amounts participants have deferred or credit their deferrals with interest earned. Instead, the governments are only responsible for making payments to participants under the terms of the plan, usually when they retire or change jobs. The terms of the plans usually provide that the amounts deferred will be treated as though they were invested in some identified asset or fund and that the benefit paid will include earnings that would have accrued on those amounts had they been so invested as well as any gains or losses that might have been experienced had the amounts been so invested. Although it is not required under section 457, sponsors and administrators normally make the actual investments referenced under the arrangement to insure that they will have the amounts necessary to meet their 457 plan obligations. Notwithstanding this normal administration of 457 plans, 457 plan deferrals can never be invested solely for the benefit of the participant. They must always be available to the general creditors of the employer. Also, unless amounts set aside by the employer to meet its obligations are placed in a rabbi trust, these assets may be used for nonplan purposes.
section_title: A Rabbi Trust May Provide Some Protection
paragraphs: Under IRC, 457 plans have a means to restrict a government’s nonplan use of amounts deferred to 457 plans—the rabbi trust. Under such a trust, the plan sponsor typically has no access to the funds but in an insolvency or bankruptcy, such funds can be reached by the general creditors. If the deferrals held by Los Angeles County for its 457 plan had been placed in a rabbi trust, the county may not have been in a position to use them to meet its payroll. However, a rabbi trust arrangement would not have protected Orange County employees, because that government declared bankruptcy.
section_title: Provisions of 457 Plans Disadvantage Participants
paragraphs: Section 457 plans are substantially different from 401(k) and 403(b) plans. In addition to the differences discussed in chapter 1, these plans have limited portability and in some cases participants in 457(b) plans must irrevocably select a date to begin receiving their benefits. In addition, participants cannot defer as much as participants in 401(k) or 403(b) plans.
subsections: section_title: Participants’ 457 Plan Benefits Have Limited Portability
paragraphs: Participants in 457 plans who leave their government employer before retirement are restricted in their ability to move the amounts in their 457 plan accounts to a funded tax-sheltered account. The plan accounts can only be transferred to another eligible 457 plan if the new government employer will accept the transfer. Amounts deferred under section 457 cannot be rolled over to an IRA and have tax deferred on the distribution as can 401(k) and 403(b) plan funds. Participants in 457 plans who leave government service and do not have another 457 plan that they can transfer their bookkeeping accounts to have only two options: (1) commence immediate payment of benefits and pay income tax on the distribution or (2) defer the commencement of benefits to any date in the future that is before they turn 70-1/2 years old. IRS officials told us that under current law, allowing nonqualified, unfunded deferred compensation amounts to be transferred to an IRA makes the amounts immediately taxable to the participant because any distribution, even to an IRA, results in the participant having an economic benefit in the funds and being in constructive receipt of the money. The mere promise of the employer to pay will have been fulfilled. Additionally, under the qualified plan rules, a transfer of nonqualified, unfunded plan amounts into a qualified, funded plan could disqualify the qualified plan and make funds in it immediately taxable to the participants.
section_title: Date That Benefits Begin Is Irrevocable
paragraphs: If a participant cannot transfer the deferred amounts to another 457 plan or chooses not to do so, he or she must, after leaving employment, select a date to begin receiving benefits. Selecting the date may be difficult because the employee’s retirement date may be years in the future. Moreover, once selected, this date cannot be changed, except for emergencies. In contrast, separating participants in 401(k) and 403(b) plans are not required to declare a date for benefits to begin. These participants may begin collecting their benefits at any time after turning 59-1/2 years old. IRS officials said that the tax principle of constructive receipt would be compromised if participants in 457 plans were permitted to change the date previously selected for receiving benefits.
section_title: Maximum Annual Deferrals Allowed Are Lower
paragraphs: The maximum annual amount that employees may defer and employers may contribute is lower for 457 plans than for the other two plan types. For example, the maximum allowable employee deferral to a 457 plan is $7,500, a limit that is about $2,000 lower than the limits of the other two tax-deferred plans. In 1995, the maximum employee deferral to a 401(k) plan was $9,240, and deferrals to a 403(b) plan could not exceed $9,500.
Although employees can defer no more than $7,500 under a 457 plan, this does not include employer contributions to another plan, usually the employers’ regular or basic pension plan. Employers sponsoring 401(k) or 403(b) plans can make annual contributions of no more than $30,000.
Moreover, the tax-free deferral limit of a participant in 401(k) and 403(b) plans is reduced if the participant also defers any amounts under a 457 plan. The maximum total deferral a participant can make to a 401(k) or 403(b) plan is governed by the maximum deferral allowed under section 457 when a participant actually makes deferrals under a 457 plan. That is, total deferrals by participants contributing to both a 457 plan and one of the other two plan types cannot exceed $7,500. Thus, any deferrals, even if it is only $1, made to a 457 plan, limits the maximum annual deferral the participant can make to a 401(k) or 403(b) plan to $7,500. Additionally, any employer contribution to a 457 plan will limit the deferral the employee can make under a 401(k) or 403(b) plan to $7,500.
subsections: section_title: Maximum Annual Deferral Cap Is Not Indexed
paragraphs: When the Congress enacted IRC section 457 in 1978, it set the annual deferral limit at $7,500, an amount that exceeded the $7,000 deferral limit set for 401(k) plans in 1986. However, the 401(k) plan limit was indexed for inflation, and the 457 plan limit was not. In time, the 401(k) limit surpassed the 457 limit. Section 403(b) limits will be indexed for inflation when the 401(k) limit reaches $9,500, the current deferral limit for 403(b) plans.
Over time, inflation will continue to reduce the section 457 deferral limit relative to earnings, and the maximum percentage of income participants will be able to defer will decrease. For example, using an average annual inflation rate of 4 percent, 10 years from now the deferral limits for employee contributions in the other two plans will be $13,677, $6,177 more than the current section 457 limit.
IRS officials said that the limit on deferrals and the lack of a cost-of-living adjustment, as in sections 401(k) and 403(b), could be changed by the Congress without compromising either the nature of 457 plans as nonqualified, unfunded plans or the tax principles of constructive receipt and economic benefit. Any such changes to section 457(b) would, however, cause a tax revenue loss in the future if participants took advantage of higher deferral limits.
section_title: Summary and Conclusions and Agency Comments
paragraphs: With enactment of IRC section 457 in 1978, the Congress specifically authorized a tax-deferred, nonqualified, and unfunded compensation plan to enable employees of state and local governments to provide themselves with additional retirement income. The Congress’ action had been prompted by proposed IRS regulations that would have subjected all nonqualified, unfunded deferred compensation amounts to immediate taxation. Eight years later, in the belief that 457 and 401(k) plans offered duplicative benefits, the Congress excluded state and local employers from establishing new 401(k) plans for their employees.
As a nonqualified, unfunded deferred plan, however, section 457 provides significantly less protection for plan participants compared with qualified, funded deferred plans such as 401(k) and 403(b) plans. Until recently, there was little or no evidence that greater protections were needed; however, events in Orange and Los Angeles Counties have posed possible financial risks to participants’ deferred amounts in 457 plans that suggest greater protections may be needed.
Section 457 plan participants voluntarily forego current income in order to provide for themselves in their retirement years. Yet the money that these participants forego is at risk. This is because 457 plans are nonqualified, unfunded deferred plans that require that the amounts deferred may not be set aside for the exclusive benefit of the employee but must remain the property of the employer, subject to the claims of the employer’s general creditors. To date, the use of the Orange County Investment Pool to calculate how amounts deferred under its 457 plan are to be treated as invested has resulted in financial paper losses that ultimately may affect county employees’ retirement benefits. Los Angeles County intended to use funds of its plan to meet its payroll. Under current law, potential bankruptcies and financial difficulties of other state and local governments pose similar risks to the salary deferrals that employees have made under 457 plans.
Apart from the greater risk to plan participants, as compared with other salary reduction plans, employees who participate in 457 plans are treated differently from those in 401(k) and 403(b) plans. For example, as a result of IRC provisions, the maximum annual amount that may be deferred under an eligible 457 plan is notably less than the maximum annual amount that may be contributed to 401(k) and 403(b) plans. Further, those deferred amount limits are not indexed for inflation. This is particularly noteworthy because a 457 plan is often the only deferred compensation plan available to most state and local employees to supplement their regular government pension.
Other disadvantages occur because of differences between nonqualified, unfunded and qualified, funded plans. For example, participants who leave employment before retirement have limited portability for their funds. Participants transferring to another state or local government may transfer account balances in a 457 plan to another 457 plan only if their new employer will accept that transfer and their old employer permits transfers. In lieu of such a transfer, participants leaving state or local government who choose to withdraw their 457 plan amounts are subject to immediate taxation. No legal barrier exists under the principles of constructive receipt and economic benefit for raising the limits that participants could defer or for indexing the limits for inflation. However, changes to portability would not comport with these two principles.
Given the risk of financial loss associated with deferrals under 457 plans, imposing a rabbi trust requirement, where a plan sponsor could not use such amounts for its own interest, would not be successful in fully assuring the security of these funds for plan participants. Such a trust requirement would not preclude a bankruptcy court from securing such funds for the general creditors of the state or local government employer. Moreover, a trust may not be successful in barring an employer’s creditors access to these funds, for example, if an employer experiences a temporary liquidity shortfall or financial insolvency. Thus, the existence of a rabbi trust would not have eliminated the risks posed by events in Orange County and may not have eliminated risks of nonplan use in Los Angeles County. However, under the tax theories that drive section 457 and other nonqualified, unfunded deferred compensation plans, any trust that would not subject its assets to the claims of the employer’s creditors and would provide the participant an unconditional and irrevocable right to receive the deferred amounts in it would create an immediate—not a deferred—tax liability for the employee. The complexity of IRC makes amending section 457 very difficult, as proposed in H.R. 2491, for example, because of the many ways section 457 dovetails with other provisions.
subsections: section_title: Agency Comments and Our Evaluation
paragraphs: SEC provided written comments on a draft of this report (see app. I). SEC found the report informative and said that it would serve as a reference for SEC staff as they consider section 457 issues. SEC said it agreed with our recommendation that the Congress amend IRC section 401(k) to permit state and local governments to establish 401(k) plans. We did not recommend that the Congress make such an amendment; rather we concluded that addressing all the problems with section 457 plans that we identified merely by amending IRC section 457 would be difficult. SEC added that if the Congress proceeds with legislation relating to public plans, it should consider statutory changes to clarify the status of 457 plans under federal securities laws. SEC said all qualified plans are now exempt from SEC regulation. Those governmental plans, as defined in IRC section 414(d), that are established for the employees’ exclusive benefit and which cannot be used by the employer for other purposes (exclusivity and impossibility requirements) are exempt. SEC staff told us that they have received numerous inquiries with respect to whether 457 plans also may be considered exempt under federal securities laws, although IRC prevents 457 plans from meeting the exclusivity and impossibility requirements. SEC also noted some technical changes that we incorporated into our report where appropriate.
IRS also provided written comments on a draft of this report (see app. II). IRS made several general comments primarily concerning technical terms. IRS pointed out the distinction between the tax-favored status of 401(k) plans and the tax-deferred status of 457 plans. We clarified these differences throughout the report. IRS emphasized the fact that 457 plan deferrals may be treated as invested in a certain way, but in fact there is no requirement to invest such amounts. As a result, if the sponsor becomes insolvent, the rights of participants in a 457 plan are no greater than other general, unsecured creditors. IRS also pointed out that most state and local governments have basic pension plans for employees and 457 plans are additional plans. We refer to them as supplemental plans to reflect this relationship. IRS suggested that we should clarify that only state and local governments can offer nonqualified plans to their rank-and-file employees, which we did. IRS clarified some features of rabbi trusts that we did not include in the report, though the major feature of a rabbi trust—the inability of the sponsor to have access to the assets therein—is the focus of chapter 3. IRS also made technical comments that we incorporated into our report where appropriate.