Is Restricting 403(b) Vendors Legal in California?

Some compliance entities and school districts are testing the system, will anyone notice?

A strange thing is occurring in K-12 403(b) plans in California. Many employers are not allowing new vendors on their “approved vendor list” or have erected significant barriers to entry. The irony is that these barriers were not in place for the worst vendors this state has ever witnessed and those bad vendors continue to be allowed to hawk their wares with little restriction. New vendors that have something real and different to offer are being denied access. What is going on with vendor lists and what is actually legal according to California law?

I’m not an attorney and cannot provide legal advice, but I can provide some context and commentary. 

At least one significant compliance administrator and one very large school district have put in place mechanisms to limit what vendors are offered through their 403(b) plan. I will refer to the list of available vendors in a school district as the Approved Vendor List for lack of a better term.

In a new development, one administrator is now charging $12,500 to a vendor if they want to offer a Roth 403(b).

Shouldn’t school employers have the right to choose what vendors can be offered in their own 403(b) plan? 

Ordinarily, I would say yes, but this is California. In California, school employers must abide by an obscure insurance code (Section 770.3). This code is often referred to as the Knox law and is what makes California one of a handful of “any willing vendor” states in the country. This law essentially disallows a school employer from controlling their vendor list unless the employer creates their own program (more to come on this, but see this Jeffrey Chang blog post here).

School employers have been trying to find ways around insurance code section 770.3 for years, and there is actually a body of opinions issued by the Attorney General’s office that provides guidance on the issue (going all the way back to 1974).

A school employer’s 403(b) compliance administrator generally would add a vendor after reviewing whether its proposed products met the requirements of section 403(b), could provide the necessary information to comply with the IRS, and was registered with 403bcompare.com. In addition, there are usually rules that the distributors of the vendor products must follow. 

Recently, some compliance administrators and school districts have changed their policies and have put in place requirements to restrict new vendors. In some cases, the compliance administrator will place a requirement that a new vendor must first line up a certain number of participants before they will be added to that school district. In other cases, the school employer has simply closed the list to new entrants entirely. These new restrictions make it very difficult for low-cost, high-quality vendors to gain access to these school districts.

My opinion on these restrictions is that they are not likely legal if an employer is trying to offer a 403(b) program within the context of Insurance Code section 770.3, let me explain why.

In the 1974 Attorney General Opinion the following question was proposed:

“May a school district establish its own administrative requirements for agents, brokers, and companies which they must meet before the district will purchase therefrom tax-sheltered annuities for its employees?”

In the summary response the opinion stated:

“A school district may impose reasonable requirements upon insurers in aid of its administration of a program of tax-sheltered annuities for its employees, so long as those rules do not arbitrarily exclude insurers from such a program, interfering with the employees’ right, under Insurance Code section 770.3, to select a lawfully qualified agent, broker or company.”

There was a much longer and more detailed response which included the following:

“While a district thus may no longer, by contracting with insurers of its choice, in effect impose substantive conditions upon those with whom it would deal, section 770.3 does not reflect a legislative intent to wholly eliminate the district’s authority reasonably to control the general circumstances under which it chooses to participate in a tax-sheltered annuity program.”

“It may be generally stated that a school district remains free to establish non-arbitrary requirements upon insurers which, in the district’s discretion, are in aid of its administration of such a program.  So long as the imposition of such rules does not unreasonably discriminate against any insurer or interfere with the district employees’ freedom, pursuant to Insurance Code section 770.3, to designate qualified insurers, such rules would be permissible.”

It’s clear that a district has some ability to control their vendor list, but only to the extent that it “aids…(in the) administration of a program of tax-sheltered annuities for its employees”, but more importantly that it doesn’t “arbitrarily exclude insurers from such a program”. The district cannot establish “non-arbitrary requirements upon insurers which, in the district’s discretion, are in aid of its administration of the program”. The opinion goes on to say, “so long as the imposition of such rules does not unreasonably discriminate against any insurer or interfere with the district employees’ freedom…to designate qualified insurers.”

Taken in whole, I see no ability of the employer to place a burden on the employee to recruit four other employees (or whatever arbitrary number the compliance administrator or district has chosen) in order to gain access to a vendor they want to use. 

A district can impose a requirement on a vendor if it aids in administering their program (such as requiring them to share data to keep in compliance), but they can’t impose arbitrary requirements or requirements that discriminate in favor of one set of vendors. More importantly, those requirements must not “interfere with the…employees’ freedom…to designate qualified insurers.” A qualified insurer or vendor by definition already complies with IRS rules and regulations and requiring an employee to recruit four other employees 100% interferes with the employees’ freedom to choose a vendor.

I see absolutely no ability for a school employer in California to put a requirement on a 403(b) vendor to gather more than one employee in order to be added to the vendor list. There is simply no other way, in my opinion, to read the AG Opinion.

We need also to distinguish who can demand a vendor be on the approved vendor list. A vendor has no right in California to be added to any employer-approved vendor list. That vendor can do everything right, including signing up for 403bcompare, putting forth an IRS compatible product, and putting systems in place to work with the various employer and compliance administrators, but they still have no right to be added to an employer 403(b) program. Not until one employee determines that they want that vendor and the compliance administrator determines the vendor is otherwise eligible, do they have a right to be included.

This doesn’t mean that a compliance administrator cannot add vendors to an employer-approved provider list without any employees first being interested. Simply that if the employer or compliance administrator has not already added them, they have no right to be on the list unless one employee expresses interest.

I want to add that I might be wrong on this last point. 

It could be argued that a vendor DOES have a right to be on any employer-approved provider list even before an employee expresses an interest in using that vendor. The AG Opinion is clear that the employer cannot interfere with the employee’s freedom to choose. Taken to an extreme, this would mean that they would need to know from whom they could choose in order to make a choice. A vendor that is not on the list, but is otherwise qualified cannot be chosen unless they are known. It could be argued that the employee is entitled to a list of known vendors in order to have the freedom to choose. Thus, a vendor is entitled to a payroll slot even though no employee has indicated they want to place money with them.

For those who follow my blog, follow 403bwise.org and listen to the Teach and Retire Rich podcast, you might be wondering why I’m arguing so hard for requiring employers to add vendors. You might recall that I’m 100% on board with the idea of school districts going single vendor (if done correctly). You might also recall a recent podcast where Dan Otter and I talked about how it’s likely legal for school districts in California to reduce their 403(b) plans to a single vendor.  Such a process gets rid of all vendors and replaces them with a single recordkeeper. I promise you, I’m not arguing out of both sides of my mouth.

There are laws, rules, regulations, and legal opinions in California that govern the 403(b). I don’t always like or agree with these laws, but they still govern how these plans are to be administered. When a conflicted compliance administrator begins to place restrictions on what vendors are allowed and does so in a manner that clearly violates the regulatory documents that govern, then I’m going to push back. I might not agree that participants should have the freedom to choose whatever vendor they want, but I do agree that they have this right under current California law and thus it should be protected until the law changes or the employer takes control of their plan.

One consequence of restricting vendors may be that the school district becomes a fiduciary to their 403(b) program. School employers need to think very carefully about this. The liability associated with becoming a fiduciary to a program that offers several low-quality, high-cost 403(b) vendors could be astronomical.