Summary

The House passed revenue reconciliation measure (H.R.2014) would repeal the tax-exempt status of the pension business of both the Teachers Insurance Annuity Association and Mutual of America. These entities would be treated for federal tax purposes as stock life insurance companies. While this change would raise about $1.2 billion in revenue over 10 years it would have a major impact on the operations of their pension business.

Introduction

The Teachers Insurance Annuity Association-College Retirement Equities Fund (TIAA- CREF) provides retirement benefits exclusively for employees of U.S. colleges, universities, independent schools and other non-profit educational and research organizations. TIAA-CREF serves nearly 2 million current and retired employees at over 6,000 institutions nationwide and has assets of $195 billion under its management. Mutual of America provides retirement benefits to employees of social welfare agencies and is modeled after the TIAA-CREF. Participating institutions contribute amounts on behalf of their employees where they are invested in self-directed, tax-exempt accounts. Upon retirement, the amounts accumulated are used to purchase annuities to provide lifetime income. Like other pensions or annuities, distributions are taxed as ordinary income when received.

Background

There are two types of pension plans -- defined benefits (DB) and defined contributions (DC) -- and TIAA-CREF operates much like a combination of the two. In a defined benefit plan, the employer promises to pay a specific benefit at retirement in accordance with a formula specified in the plan (for example, 1% of final average pay for each year of service). The pension is made available as a lifetime benefit. The employer funds the benefit obligations through deductible contributions to a tax-exempt trust fund and bears the risks and rewards of investment performance.

A defined contribution plan is a tax-deferred savings arrangement. Individual accounts are established for each participant, and accounts are credited with investment earnings. Examples include profit-sharing and 401(k) plans. The participants bear the risk and rewards of investment performance. Participants usually receive their benefits in a lump sum but may also purchase individual annuity policies on the commercial market.

An annuity provides lifetime retirement income much like a defined benefit plan, but annuities can be provided only by commercial insurance companies. The amount of the annuity is determined by life expectancy and how much has been accumulated in the participant's account. Contingency reserves are required by state regulations to back up annuities. TIAA-CREF operates as a defined contribution plan during the investment accumulation stage but as an annuity provider during the payout stage.

TIAA-CREF

TIAA developed out of the Carnegie Foundation and was established in 1918 to provide a pension system for teachers at educational institutions in the United States and Canada. Since it was decided by the Carnegie Foundation Board to provide contractual annuities and insurance through a third-party funding agency, it was necessary to form an insurance company. TIAA chose to incorporate under New York laws applicable to stock life insurance companies because the state had strong insurance regulation. During its first 7 decades, TIAA-CREF's tax exemption was based on Treasury and Internal Revenue Service (IRS) rulings.¹ But its tax-exempt status was challenged in the mid-1980s when the tax-writing committees attempted to remove it. Other commercial insurers had argued that they were at an unfair disadvantage in competing with TIAA-CREF because it was tax-exempt. TIAA-CREF successfully argued that it should be treated not as an insurance company but as a pension plan with the same tax-exempt status as other qualified pension arrangements. The Tax Reform Act of 1986 specially provides for the tax exemption of TIAA's pension arrangements.² However, its group medical, disability, and life insurance plans became taxable in 1987.

A small portion of TIAA's income is allocated each year to contingency reserves rather than to individual participants' annuity contracts, in accordance with state insurance regulations designed to ensure that contractual obligations can be fulfilled in the event of unanticipated adverse circumstances. These continency reserves generate income.³ In accordance with TIAA-CREF's charter, any unused contingency reserves are systematically paid to TIAA annuitants in the form of dividends during the payout period. This distribution is accomplished by setting the payout annuity dividend interest rate at a level that exceeds the actual investment earnings rate.

Proposed Change

Present law provides that an organization described in 501(c)(3) and (4) of the Internal Revenue Code is exempt from tax only if no substantial part of its activities consists of providing commercial-type insurance. The issuance of annuity contracts is considered providing insurance. Nearly all of the operations of TIAA-CREF involve the provision of annuities.⁴ The House-passed revenue reconciliation measure {1054(a) of H.R.2014} would repeal the present-law grandfather rule enacted in 1986 that preserved the tax-exempt status of the pension annuity operations of both TIAA-CREF and Mutual of America. Both would be treated for federal tax purposes as stock life insurance companies. This change would result in increased revenues of about $1.2 billion over 10 years. The Senate-passed revenue reconciliation measure {853(a) of S.949} would repeal the tax-exempt status of the pension business of Mutual of America but not of TIAA-CREF.

Discussion

During the period when contributions are being made by, or on behalf of an individual teacher, assets segregated to the account of that teacher are pension funds and earnings would continue to accumulate free of current tax. However, earnings on the contingency reserves would be treated as investment income includable in the corporate income of TIAA. Taxing these earnings would reduce the amount of dividends provided to annuitants. The effect on individual annuity holders is uncertain, although TIAA-CREF estimates that it would reduce retirement income by 3% to 5%.

TIAA-CREF argues that the House bill would effectively impose a tax on TIAA-CREF participants and would single out educators by denying them tax benefits that are granted to most other American workers. The actual effects of the bill are more complex. The proposed change would not expose a tax directly on TIAA-CREF participants nor treat them differently than other DC plan participants who purchase annuites with their retirement account balances on the commercial market. However, TIAA-CREF participants may receive reduced retirement benefits because earnings on the contingency reserves that back up their annuity contracts would be subject to tax like those of commercial insurance companies.⁵ But this would not change the underlying tax-exempt treatment of the amounts accumulated in the individual accounts of plan participants. They would continue to be treated the same as other DC plan participants. Again, because the proposed change would tax earnings on contingency reserves, the amounts distributed to TIAA annuitants would be reduced.

While technically an insurance company, TIAA-CREF maintains that it should be viewed like a DB pension plan rather than a commercial insurer since all earnings on contingency reserves are used exclusively to provide retirement benefits and none of these assets can be diverted to any other purpose. This, they say, is consistent with 401(a) of the Internal Revenue Code which extends tax-exempt status to a qualified trust created for pension, profit-sharing, and stock bonus plans.⁶ Accordingly, they maintain that tax-exempt treatment should continue to be extended to the earnings derived from TIAA-CREF's contingency reserves since 1) the amounts diverted to the contingency reserves would have otherwise been credited to individual accounts during the accumulation phase and 2) they are held for the exclusive benefit of the employees or their beneficiaries and ultimately will be paid in the form of additional retirement income.

Since TIAA-CREF is a not-for-profit company and distributes all earnings on the contingency reserve to participants in the form of dividends, it argues that it should continue to maintain its current tax treatment. While others argue that TIAA-CREF operates at a competitive advantage over other commercial insurance companies (including the 403(b) tax-sheltered annuity market.⁷ TIAA-CREF's market share is limited by its charter to colleges, universities, independent schools and other non-profit educational and research organizations. TIAA-CREF has been widely lauded as a model of pension portability. Not only does it provide the advantages of a fully-funded, fully-portable retirement plan, TIAA-CREF provides benefits in the form of a lifetime annuity supplemented with dividends earned on its contingency reserves. Some would argue that public policy should encourage this pension model. Others would question why educators should receive special tax treatment over others who purchase annuities from taxable commercial insurers.

This situation illustrates the possiblity of conflicting objectives in public policy, in this case between tax policy goals on the one hand, and retirement income goals on the other.

While tax equity amoung commerical insurers and taxpayers would suggest repeal of TIAA-CREF's grandfather rule, retirement income policy would suggest maintaining it since all earning on its contingency reserves are distributed to annuitants in the form of dividends that enhance retirement income. Such conflicts can be resolved only by Congress in deciding which objective is most important.

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¹ TIAA-CREF has long been recognized by the IRS as a charitable organization. In 1971, the IRS reviewed the organization's tax-exempt status and continued it, although a majority of the reviewing group agreed that members of the teaching profession could perhaps no longer be recognized as a chartiable class. In addition, IRS considered the organization to be similar to a mutual insurance company because most of the operating expenses were covered by premium payments rather than grants from another tax-exempt organization.

² CREF was founded in 1952 as a companion organization to TIAA to provide variable annuities based on common stock investments. While TIAA provides a guaranteed rate of return, retirement income under CREF rises and falls with underlying common stock investments. Contingency reserves are applicable only to TIAA. CREF would not be affected by the purposed change.

³ Earnings on the contingency reserves are not allocated to individual participant accounts as they are in a DC plan.

⁴ A small part of its operations includes the provision of group life insurance, group total disability benefits, and group major medical expense insurance.

⁵ Earnings from retirement products offered by commercial insurance companies are subject to taxation since they represent profits to the company's shareholders. If TIAA-CREF were taxed as a commercial insurance company, it would generally be allowed to exclude from its taxable income amounts earned on pension plan assets, as life insurance companies may now do if the pension assets are held in segregrated accounts. Thus, the income earned on amounts held in individual accounts would continue to be free from tax.

⁶ Section 401(a) requires that contributions to a qualified trust must be made "for the purpose of distributing to such employees or their beneficiaries the corpus and income of the fund accumulated by the trust in accordance with such plan" and that it be impossible "for any part of the corpus or income . . . to be used for, or diverted to, purposes other than for the exclusive benefit of . . . employees or their beneficiaries . . ."

⁷ Section 403(b) of the Internal Revenue Code allows religious, charitable, educational, research, and cultural agencies in the nonprofit and goverment sectors to set up salary deferral plans for their employees. Such plans allow employees to defer income tax on contributions up to $9,500. At the end of 1995, 403(b) plans held $230 billion in assets. About two-thirds were invested with TIAA-CREF.

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