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Demystifying 457 Plans

Stable Value managers and providers have typically sourced the majority of their business from the 401(k) retirement plan market. With that bucket being full, managers and providers are looking to alternative sources of business. One sector that has remained largely under the radar is 457 plans, the government-sponsored cousin to corporate 401(k) plans. The purpose of this article is to delineate the differences between 457 and 401(k) plans.

457 Overview

Section 457 deferred compensation plans are "non-qualified" tax deferred plans available to state and local public employees. These plans are voluntary, supplemental, long-term retirement programs that give employees the opportunity to defer receipt of income until retirement or termination of employment. Employees pay taxes when they receive the money, not when they earn it. As such, 457 contributions reduce current taxable income. As in the 401(k) world, 457 plans have an array of options, but, unlike 401(k) plans, there is typically no employer match. Government employees enjoy lucrative defined benefit plans as their primary source for retirement income. This substantial benefit, combined with the lack of employer match in 457 plans, makes 457 plans a secondary priority for many public employees.

Recent Updates

The Economic Growth and Tax Relief Reconciliation Act (EGTRRA), signed into law by President Bush in 2001, was designed, among other things, to make 457 plans more closely resemble 401(k) plans. In some ways, EGTRRA makes 457 plans more attractive to participants. For example, 457 funds are now portable if an employee leaves government employment and enters the private workforce. In addition, the Act provides for an increase in contribution limits to mirror the limits in 401(k) plans.

Another feature of the Act authorizes the pre-tax purchase of service credits. This unique feature enables participants to pull money out of their 457 plan to purchase additional years of service from their defined benefit plan. This purchase will result in a higher defined benefit payout and/or an earlier retirement date for the participant. While this Act could potentially increase cash flow volatility, it has been AEGON's experience that the effect has been minimal.

Fewer, But Stickier, Assets

As of December 31, 2002, 457 plan assets totaled approximately $75 billion (compared to nearly $1.5 trillion for 401(k) plans), according to the 2003 SPARK Marketplace Update. It can be difficult, however, to ascertain how much of this money is invested in Stable Value type products. One obstacle is the variety of products offered in the 457 market, which can include fixed annuities, general account insurance products, and Stable Value funds. In addition, it is difficult to determine how assets in the 457 market are allocated.

One good source of information is the National Association of Government Defined Contribution Administrators, Inc. (NAGDCA), whose members include most state and large city/county 457 plans. NAGDCA compiles a survey every two years of all 457 plans. For the most recent survey in 2001, thirty-seven state governments and forty-four local government members responded. According to the survey findings, thirty-six percent of 457 plan assets are invested in Stable Value funds and fourteen percent are invested in fixed annuity contracts, for a total of roughly 50 percent in fixed or stable type instruments. From this data, it can be estimated that Stable Value assets in 457 plans total roughly $27 billion while fixed annuity assets total roughly $10.5 billion.

The NAGDCA data also appears to show a migration of assets from fixed annuity contracts to Stable Value funds. Comparing the last two surveys, allocations to fixed annuity contracts fell from 21 percent in 1999 to 14 percent in 2001, while allocations to Stable Value funds increased from 23 percent in 1999 to 36 percent in 2001.

From an underwriting perspective, 457 plans historically have been viewed as having less risk than 401(k) plans since the money tends to be very sticky. This is primarily because, though public employees generally make less money than private workers, they also are likely to stay with their employer longer. According to the most recent data available from the Bureau of Labor Statistics, for example, the median tenure of private employees was 3.7 years in 2002, while the median tenure of public employees was twice as long. This is partly due to the fact that the public sector workforce also tends to be older than the private workforce. So while plan demographics have traditionally made 457 plans less risky than 401(k) plans, the recent legislative changes could eventually result in similar risk profiles.

Comparison of 457 and 401(k) plans

¹Source: 2003 SPARK Marketplace Update

²Source: Stable Value Investment Association

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