United States: View From Mcdermott: Employee Benefit Plan Considerations For Health Systems In 2017

Health system employers, including hospitals and other not-for-profit employers within the healthcare industry, face unique challenges with respect to employee benefits and compensation compared to for-profit employers. Following is a summary of some of the key issues, risks and opportunities health system employers face with respect to employee benefits and compensation in 2017, including:

  1. Litigation alleging excessive fees in Code Section 403(b) plans;
  2. New requirements for 403(b) plan documentary and administrative compliance;
  3. New design opportunities for Code Section 457(f) deferred compensation arrangements; and
  4. Challenges posed by potential Affordable Care Act (ACA) replacement proposals.

403(b) Plan Excessive Fee Litigation

In 2016, at least ten large class action lawsuits were filed against prominent higher education institutions (e.g., John Hopkins, MIT, Cornell) claiming fiduciary breaches occurred under their Code Section 403(b) defined contribution retirement plans as a result of insufficient oversight of plan investments. The complaints allege that fiduciary breaches caused excessive fees to be paid by participants. The allegations reflect legal arguments that are similar to the allegations made against fiduciaries of Code Section 401(k) plans sponsored by for-profit companies over the past several years. Although the targets of the 403(b) lawsuits originally filed were higher education institutions with relatively large plan asset balances (in excess of $2 billion), the scope of these lawsuits recently expanded to sweep in the healthcare industry with a similar lawsuit filed against Essentia Health in December 2016.

Plaintiffs typically assert numerous different allegations in the lawsuits, but they generally fall into one of eight broad categories:

  1. The funds are too expensive. Plaintiffs allege that alternative funds were available at lower costs and with similar risk/return characteristics.
  2. Fiduciaries failed to offer lower-cost share class funds. Plaintiffs allege that fiduciaries failed to investigate the availability of lower-cost share classes of mutual funds (e.g., ''institutional'' funds) and continued to offer higher-cost share classes (e.g., ''retail'' funds).
  3. The failure to remove underperforming funds. Plaintiffs allege that fiduciaries failed to adequately monitor investment options and remove those that exhibited poor performance against benchmarks.
  4. The plan offers too many fund options. Plaintiffs allege that fiduciaries provided too many investment options, which create duplicative offerings with higher fees that confuse participants, preventing them from making educated choices.
  5. The failure to conduct periodic RFPs for evaluating service providers, or to take advantage of ''big plan'' market power or economies of scale. Plaintiffs allege that fiduciaries failed to conduct periodic Requests for Proposal (RFPs) to ascertain whether a better or less expense fund provider was available. This allegation typically includes the assertion that the fiduciaries failed to capitalize on economies of scale or the plan's market power by virtue of the size of the 403(b) plan, or by potentially combining plans to secure the best pricing for administrative and investment services.
  6. Too many recordkeepers were involved. Plaintiffs allege that by utilizing multiple recordkeepers or 403(b) contracts, the fiduciaries impeded the plan's ability to consolidate management of plan investments, which negatively impacted the plan's ability to secure more favorable fee terms, streamline administration and reduce costs.
  7. The failure to appropriately evaluate revenue sharing funds. Plaintiffs allege that fiduciaries did not compare overall plan fees, including revenue sharing, against a reasonable participant-based recordkeeping fee.
  8. Annuity products offered were too expensive and restrictive. Plaintiffs allege that the fiduciaries continued to offer annuity products whose fees were excessive, and which ''locked in'' participants to excessive fees.

Because the 403(b) fee litigation derives from 401(k) fee litigation, some of the allegations do not take into account the nuances of Code Section 403(b) plans. For example, the requirement that 403(b) plans must be set forth in a written plan document was first imposed by regulations effective beginning in 2009. Prior to that time, many not-for-profit organizations created a 403(b) ''plan'' out of a combination of various vendor contracts, each of which contained separate terms and conditions for holding particular 403(b) assets. Some of the litigation does not take into account specific characteristics of prior 403(b) arrangements that have existed since the 1970s and 1980s. Not-for-profit organizations may find themselves in a situation in which contractual obligations entered into decades ago, which were legally compliant at that time, are held against them in present date fee litigation allegations.

Fiduciaries of Code Section 403(b) plans should take steps to ensure compliance and the ability to demonstrate best practices in case their organization becomes subject to a lawsuit. Following are some of our recommendations:

  • Conduct periodic fiduciary training. Fiduciary training should occur for retirement plan investment committee members frequently. Many organizations do this annually, or every 2-3 years. Additionally, new committee members should be trained separately as soon as possible upon appointment to ensure fiduciary obligations and duties are understood by all committee members.
  • Maintain and use a written investment policy. Establishing investment policies and procedures and following those policies and procedures demonstrates a duty of care and thoughtfulness in approach. Fiduciaries should document how they intend for investment decisions to be made under the plan by adopting a written investment policy. Investment policies highlight the types of investment funds which the committee believes should be offered, and then identify which benchmarks to compare the performance of the investment options against. Because circumstances and the economy change over time, the investment committee should review the investment policy at least annually to ensure that it continues to reflect the current objectives and meets the diverse needs of the plan's participants.
  • Keep detailed committee minutes. Process is the key to demonstrating fiduciary prudence. It is important to maintain a written record of the process undertaken in reviewing investments and making investment decisions. This does not mean creating a transcript of the investment committee discussions, but committees should prepare a written record sufficient to demonstrate a thoughtful and deliberative process.
  • Periodically evaluate plan fees for reasonableness. Although the claims in the class action litigation allege that securing the lowest fees is the only factor in determining whether investment options are prudent, the standard for reasonableness allows fiduciaries to collectively evaluate both cost and value. That is why documentation of the steps taken for such evaluation is important, as it will create the foundation for proving a thoughtful and deliberative process.
  • Periodically conduct RFPs. Although RFPs can be time consuming and daunting, conducting an RFP signals to the current provider that the organization is willing to make a change and solicit more competitive pricing. Even if an organization remains with the same provider, the organization often can negotiate a reduction in fees based on the ''market data'' it collected from the other submitted proposals. The DOL has indicated that it believes that plan fiduciaries should undertake a formal RFP process every three years. While that view may be subject to debate, it nevertheless signals that the DOL will have a negative opinion of fiduciaries who have not engaged in an RFP for many years.
  • Consider retaining an investment advisor. Independent investment advisors are typically retained to conduct fee analyses as well as assist in monitoring, selecting and, in some instances, reducing investment options. The expertise and additional fiduciary protection provided by independent investment advisers can add significant protection for the organization and the committee, while also helping make the review process more effective and streamlined.

New Requirements for 403(b) Plan Documentary and Administrative Compliance

The Internal Revenue Service (IRS) has recently issued a number of new rulings and directives that should cause 403(b) plan sponsors to review and confirm that their plans remain in compliance.

403(b) Plan Remedial Amendment Period

On January 13, 2017, the IRS released Revenue Procedure 2017-18, which introduces a remedial amendment period concept for 403(b) plans. The remedial amendment period confirms that the primary responsibility for ensuring a plan's documentary and legal compliance belongs to the plan sponsor, and brings 403(b) plans into line with the plan document requirements applicable to other tax-qualified retirement plans.

Sponsors of 403(b) plans may self-correct plan provisions that violate the Code Section 403(b) rules by adopting plan amendments by March 31, 2020. This correction window is referred to as the ''remedial amendment period.'' Documentary failures corrected during the remedial amendment period will still be considered to be timely corrected. Plan sponsors that identify plan document failures may correct them by either:

  1. Adopting a 403(b) pre-approved plan by March 31, 2020, so long as the pre-approved plan has a 2017 opinion or advisory letter; or
  2. Amending an individually-designed 403(b) plan by March 31, 2020.

Corrections may include adding in a legally required provision, or correcting defectively drafted provisions. Regardless, any corrective change must be retroactive to the later of January 1, 2010, or the 403(b) plan's original effective date. Additionally, if a plan provision was administered incorrectly, the plan sponsor must fully correct the administrative failure, including retroactively if necessary.

An important caveat to using the new remedial amendment period is that the underlying written plan must have been adopted by December 31, 2009, in accordance with the 403(b) regulations. If this requirement is not met, the remedial amendment period is not available. In that case, a plan sponsor may apply for approval of a plan correction through the IRS's voluntary correction program. Either way, plan sponsors should work with ERISA counsel to ensure that their plan continues to be compliant, or is brought into compliance.

b. New Audit Guidelines on Hardship Withdrawals

The IRS recently released guidance, issued in the form of a memorandum to IRS audit examiners, regarding how agents are expected to evaluate the compliance surrounding a 401(k) or 403(b) plan's hardship withdrawal program. This guidance articulates the procedures that are sufficient for approving hardship withdrawals.

Generally, if a participant has an immediate and heavy financial need that satisfies one of the six specific requirements, the participant must provide evidence that substantiates the claim in order for the administrator to determine that the financial need is immediate and heavy. The administrative guidance indicates that the plan sponsor or third-party administrator can either:

  1. Obtain source documents (such as estimates, contracts, bills and statements from third parties); or
  2. Obtain a summary from the participant of the information contained in the source documents (in paper, electronic format or telephone records).

Although source documentation tends to be the most reliable, the IRS recognized that a participant's production of source documentation is not always feasible. Nevertheless, the administrative guidance specifically directs IRS agents to request to see source documents if the summary information provided is incomplete or inconsistent or if a given employee has received more than two (2) hardship distributions within a plan year and there is an absence of an adequate explanation for the multiple distributions.

Plan sponsors should expect increased scrutiny over hardship withdrawal administration and potential liability if administration is deficient or noncompliant. Because participants who take hardship withdrawals often have limited finances, if a hardship withdrawal is not properly substantiated, the only correction option available may be to have the plan sponsor contribute the money back to the participant's account. Given the increased scrutiny and potential liability, we recommend that 403(b) plan sponsors re-evaluate their current hardship withdrawal procedures in the light of the new guidance.

c. Required Minimum Distributions Under 403(b) Plans

The IRS and Department of Labor (DOL) have focused a significant amount of attention in recent years on retirement plan required minimum distribution rules, that is, the requirement that participants generally commence their benefits by the year in which they reach age 701⁄2, or actual retirement, if later. IRS auditors are concerned that participants do not commence benefits on time and, as a result, corresponding taxes are not timely paid. The concern is most acute with respect to terminated vested participants who leave the employer prior to retirement, but retain an account under the plan.

A slight variation on these issues applies to 403(b) plans. The 403(b) regulations provide that a required minimum distribution from one of an employee's 403(b) contracts is permitted to be distributed from another 403(b) contract in order to satisfy the required minimum distribution rules. In other words, an individual who participates in a plan or plans with multiple 403(b) contracts may add together the total distributions taken from any one or more of the 403(b) plans to meet his or her individual minimum distribution requirement. Unfortunately, some third-party administrators have applied this individual flexibility to mean that the required minimum distribution rules are optional as applied to 403(b) plans. We disagree with this position. The 403(b) regulations state definitively that 403(b) plan are subject to the required minimum distribution rules as a qualification requirement that applies to the plan. An individual's ability to meet the requirement through distribution from a separate 403(b) contract does not absolve a plan sponsor of the requirement for ensuring compliance by requesting proof of the distribution. Many 403(b) plan sponsors may not be meeting their required minimum distribution obligations due to confusion over the applicability of these rules.

Given the regulatory focus on compliance with the required minimum distribution rules, we recommend that 403(b) plan sponsors confirm with their third-party administrator that they are in fact complying with the required minimum distribution rules and not relying on individual flexibility to meet the requirement. In addition, we recommend that plan sponsors ensure that notices are sent to applicable participants to ensure that minimum distributions commence on time so that the plan complies with the minimum distribution rules.

Proposed Code Section 457(f) Regulations

The proposed 457(f) regulations offer some new design possibilities for nonqualified deferred compensation arrangements offered by tax-exempt entities. There are four key opportunities presented by the proposed 457(f) regulations which tax-exempt employers may wish to evaluate:

  1. A new ability for executives to make voluntary elective deferrals of their own compensation;
  2. The ability to delay Code Section 457(f) taxation until the actual payment date, if the payment arrangement qualifies under the Code Section 457(f) short-term deferral exception;
  3. The ability to incorporate a rolling risk of forfeiture as the plan's substantial risk of forfeiture; and
  4. The ability to utilize a noncompete as the plan's substantial risk of forfeiture. See [ https://www.mwe.com/en/thought-leadership/publications/2016/09/view-from-mcdermott-section-457f-proposed] for more information on the proposed regulations.

Whether any of these features is desirable from an organizational standpoint depends on the organization's objectives under the nonqualified deferred compensation plan and whether inclusion of the features further assists the organization in attaining those objectives from an executive pay perspective. Additionally, implementation of any of these features has specific requirements which must be met. Confirming that the organization can coordinate those requirements with its executive pay objectives is crucial before implementing any changes.

Additionally, the proposed 457(f) regulations outline some new restrictions on certain common arrangements that organizations should review more closely in 2017:

  • Vacation pay policies that allow significant accruals and carryovers may be reclassified as nonqualified deferred compensation. The proposed 457(f) regulations imply that if paid time off (PTO) accrual policies permit a significant accrual of PTO hours such that those hours are extremely unlikely to be used ''in the normal course'' by the employee, resulting in a large payment of cash to the employee to settle or reduce the accumulated PTO hours, then the arrangement should be characterized as a deferred compensation plan rather than an exempt ''bona fide sick or vacation leave'' plan.
  • The elimination of flexible allowance plans because of the potential nontaxation of certain deferrals. In these types of arrangements, the deferrals contributed to the plan are ''exchanged'' and used to purchase additional benefits under the nonqualified plan such as: life insurance, death benefits for surviving spouses, long-term disability coverage, long-term care coverage, conversion to an auto allowance, etc. In these situations, the executive achieves a tax deferral on the compensation or contribution, while converting it into a benefit that ultimately might not be taxable or includable in income. The proposed regulations now provide that the purchase of these welfare benefits essentially make the deferral amounts ''available'' to the executive, thereby triggering taxation at the time of purchase under the plan.

Potential ACA Replacement Proposals

Another significant issue that health system employers should continue to monitor is the Republican proposal to ''repeal and replace'' the Affordable Care Act (''ACA'') in the form of the American Health Care Act of 2017 (''AHCA''). The proposed legislation is subject to modification as it is debated and moves through Congress, but for now it provides a roadmap of issues that employers should be focused on as they plan for the future design of health care benefits for their employees.

Features of the proposed AHCA that may impact employers include the following:

  • The penalties under the individual and employer mandates under the ACA would be reduced to zero, retroactive to January 1, 2016. While this is a welcome development for employers, cumbersome employer reporting to both the IRS and covered individuals would likely continue to be required in some form.
  • Government subsidies in the form of premium subsidies and cost-sharing reduction for individuals who purchase coverage on the public Health Market Place Exchange (Marketplace Exchange) would apply to coverage sold outside of the Marketplace Exchanges and to catastrophic coverage, but will be eliminated by 2020. The premium subsidies would be replaced with new health tax credits that could be used by individuals to purchase coverage on the individual market, provided they are not covered under employer sponsored insurance or other forms of governmental health care plans. The credits would be based on age with credits beginning at $2,000 for individuals under age 30 and gradually doubling for individuals over age 60. The credits are additive for a family and capped at $14,000 and grow over time by CPI+1. The credits would be available in full to those making $75,000 per year or less ($150,000 for joint filers). The credit would phase out by $100 for every $1,000 in income higher than those thresholds. Conservative members of the House have criticized the refundable tax credits as a thinly disguised entitlement program threatening overall adoption of the AHCA.
  • Proposals designed to expand the adoption of Health Savings Accounts (HSAs), including the potential doubling of the maximum contribution to HSAs to the out-of-pocket maximums (OOP max) under high deductible health plans (for 2017, the single OOP max is $6,550 and the family OOP max is $13,100). Other changes to HSAs include rolling back the tax for HSA distributions not used for qualified medical expenses to 10 percent. Pre-ACA the tax was 10 percent, but was increased to 20 percent under the ACA. In addition, spouses who are HSA account holders would both be able to take advantage of catch-up contributions to one HSA. Also, effective in 2018, HSA withdrawals can be used to pay qualified medical expenses incurred before the HSA was established. If an HSA is established during the 60-day period beginning on the date that an individual's coverage under a high deductible health plan begins, then the HSA is treated as having been established on the date coverage under the high deductible health plan begins for purposes of determining if an expense incurred is a qualified medical expense.
  • The following taxes would be repealed: the medical device tax, the 3.8 percent tax on net investment income for certain individuals, the tax on over the counter medicines; the annual fee on certain health insurance issuers; and the Medicare tax increase on high wage earner.
  • Limits on Health Care Flexible Spending Accounts (FSAs) that were introduced under the ACA would be repealed essentially removing the $2,500 cap (indexed for inflation) on contributions to such accounts.
  • The deductibility of employer provided Medicare Part D subsidies would be reinstated.
  • In an effort to encourage healthier individuals to remain enrolled in the health insurance markets, individuals would be required to pay a 30 percent higher premium in the individual market for health insurance if they have a gap in coverage for more than 63 days and decide to later re-enroll.
  • Pre-ACA medical-expense deductions exceeding 7.5 percent of a taxpayer's adjusted gross income (AGI) would be reinstated, versus the 10 percent limit imposed under the ACA.
  • Medicaid expansion would be repealed by 2020 and replaced with state block grants. Finally, in addition to the above, the Trump administration recently announced that it was granting a one year extension to individual and small-group health plans that do not provide the minimal essential coverage required by the ACA. The Obama administration was criticized for requiring individuals to obtain coverage that included minimum essential coverage after telling the public as part of the ACA roll out that if they liked their health coverage, they could keep it. Thus, the Obama administration ''grandmothered'' these non- ACA compliant plans until December 31, 2017. The Trump administration extended this grandmothered plan deadline to December 31, 2018. These non-ACA compliant plans are estimated to be less expensive than ACA compliant plans because they provide less comprehensive coverage, which presumably attracts healthier consumers. Extending the deadline for these grandmothered plans frustrates insurance companies selling products on the Marketplace Exchange because they deter consumers from purchasing ACA compliant plans, which presumably would boost the ACA compliant risk profile.


Health system employers face a number of opportunities and challenges with respect to employee benefits and compensation in 2017. Although 403(b) plans and 457(f) plans traditionally have been less regulated, new guidance and regulations provide a timely opportunity for health systems to review internal controls and make sure their plans are in compliance and working effectively. Additionally, as ACA replacement proposals continue to unfold, health systems will need to evaluate proposals and the short-term and long-term impact they will have on their health plan operation.

View From Mcdermott: Employee Benefit Plan Considerations For Health Systems In 2017

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