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For Want of the Nail, the Shoe Was Lost…..403(b) Plans Find the Nail

For want of a nail, the shoe was lost,
For want of the shoe, the horse was lost,
For want of the horse, the rider was lost,
For want of the rider, the battle was lost,
For want of the battle, the kingdom was lost,
And all for the want of a horseshoe nail!

The childhood ditty emphasizes how the lack of a seemingly small detail can lose a battle or even a kingdom. A “nail” preventing the use of stable value portfolios in 403(b) programs has recently been found.

The stable value industry was born from such a situation. On average, over the long term, professionals agree that a diversified bond portfolio will produce higher average returns than a money market fund. However, a large majority of defined contribution participants are simply not willing to invest in a bond portfolio at all if its price were not stable. Participants would give up the substantial return pickup from bonds, imperiling their retirement planning, and direct their money to low yielding money market funds, fixed annuities or bank deposits. For want of the “nail” of book value accounting, the benefits of higher long term bond market returns would have been lost for defined contribution participants.

While some investment purists would argue that participants with a long term horizon should simply purchase an unwrapped bond fund (i.e., even the low cost of the obtaining book value protection should be avoided), this fails to recognize that most participants currently utilizing stable value funds would flock to much lower yielding money market funds in the absence of the book value protection. So the “extra” cost built into stable value portfolios to maintain book value was not really “extra”. Furthermore, as the attached chart shows, the investors who would venture into the bond market have historically exhibited poor timing.

In 403(b) programs, the nail preventing access to the stable value products commonplace in the 401(k) market has been a legal constraint. For purely historical political reasons – certainly not investment or retirement savings policy – the Internal Revenue Code restricts 403(b) investments to annuity contracts or custodial accounts investing in mutual funds. Bonds, CDs, individual stocks and even commingled funds are simply not allowed under the Code. For lack of the legal nail, traditional stable value funds had been considered simply off limits to this segment of the retirement savings market.

A 403(b) Nail Has Been Found!

The State of Georgia currently offers three defined contribution plans – a 457 plan, a 401(k) plan, and a 403(b)7 custodial account. The 457 and 401(k) plans had been operating under a master trust arrangement for a number of years, allowing commonality of investment choices and the economies of scale of the combined entities. When the addition of a 403(b) element was being considered in 2000 for employees of State technical schools and county school boards, it was obvious that it would be advantageous to combine the 403(b) assets in the master trust as well. The problem was the Internal Revenue Code constraints on 403(b) investments. The stable value fund (called the Fixed Income Option or FIO) didn't fit.

At the same time, it was equally obvious that each of the components of the FIO were eligible investments. Traditional GICs are technically fixed annuity contracts. The cash “buffer” was invested in a money market fund. The bond portfolio was wrapped with an insurance contract which was also technically a fixed annuity. Georgia decided to seek a ruling from the Internal Revenue Service allowing the use of FIO in the 403(b) program.

The original submission in 2000 was supplemented several times with additional documents, discussions and explanations. The IRS issued a favorable ruling on July 8, 2002. “(We) conclude that the Fixed Income Option, which invests exclusively in annuities issued by insurance companies or the stock of one or more regulated investment companies, all pursuant to the requirements of section 403(b)(1) and section 403(b)(7) of the Code, blending of the returns of these underlying investments into the Fixed Income Option will not cause the Fixed Income Option to fail to meet the requirement of section 403(b)(1).”

The IRS ruling was the “nail” but Georgia still had to find some horseshoes, horses and riders to actually win the battle of implementation. The GIC/wrapper issuers had to agree to the new underwriting conditions created by the addition of 403(b) participants and a 403(b)(7) custodian had to be located who would agree to serve in an unprecedented role at a reasonable cost. Accounting procedures had to be put into place to keep the 403(b) assets commingled for some purposes but separately accounted for in other respects.

Peach State Reserves (as the combined Georgia programs are known) offered their stable value fund (the Fixed Income Option) to participants in the 403(b) component of their programs, effective July 1, 2004. The entire process took almost four years.

To be sure, there are still some “nails” missing which limit or prevent widespread availability of stable value options to 403(b) programs. The IRS ruling for the State of Georgia was a Private Letter Ruling. Private Letter Rulings are only binding on the IRS with respect to the party who actually received it. Many plan sponsors may not feel comfortable with proceeding without their own ruling. Private Letter Rulings take time – as much as a couple of years – and each plan may have its own set of horseshoes, horses and riders to deal with in order to implement a stable value option for 403(b) assets. However, the first nail is no longer missing.

Joseph T. Chadwick, Jr. is a Principal of The Chadwick Group, Inc. and served as a consultant to the State of Georgia Peach State Reserves program throughout the process.

Editor's note:  This informed article represents its author's knowledge of and experience with the State of Georgia plans and their ability to combine the 403(b) program's investment options with their 457 and 401(k) investment options.  While other 403(b) plans have long used "stable value" investment options in their plan lineups, they have usually been limited to single product insurance company group annuity contracts, portfolios of GICs with another insurance company "wrapping" the whole portfolio, or insurance company separate accounts wrapped by a group annuity contract.  The State of Georgia 's uniquely structured Fixed Income Option blends the return of a money market fund cash buffer and GICs. The State of Georgia 's use of insurance company-issued synthetic GIC contracts wrapping bond portfolios is fairly unique as well.  In this context, the insurance company wrap contracts are "group annuity" contracts, thus meeting the unique 403(b) annuity contract requirement. 

We also know that the 403(b) market is, at best, "murky" in that it is very hard to completely understand how it works.  There are a number of different types of 403(b) plans for different constituent groups, and opinions differ on the investment arrangements available for all.  In any case, we welcomed the opportunity to air the description of success for the State of Georgia .

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