Non-profits will have to kick a 40-year-old habit of handing off responsibility for defined-contribution plans to vendors. That’s because an Internal Revenue Service rule issued in late July revamps the existing tax code, forcing employers to take greater responsibility for developing and overseeing 403(b) retirement plans. When the new rule goes into effect on January 1, 2009, it should bring the administration of 403(b) plans into line with rules governing 401(k)s, which are offered by some non-profits as well as by many profit-making companies.

The non-profit 403(b) plans were set up by the government in 1958 to encourage employees of schools, universities, hospitals, and other tax-exempt organizations to bolster their pensions with retirement savings, notes 403bwise.com, an educational website focused on the plans. As is the case in a 401(k), employees participating in a 403(b) direct parts of their salaries into tax-deferred accounts. That is, dividends, interest, and capital gains that accumulate in a 403(b) grow tax-deferred until they’re withdrawn.

For decades, many non-profits, hoping to avoid the arduous administrative duties of a 403(b), set up the plan’s automatic payroll deduction process and then bowed out. Indeed, non-profit employers allowed insurance companies, mutual funds, and other third-party vendors that sold plan investment products to develop plan documents and deal directly with employees. Many 403(b) plans use annuities sold by insurance companies as their primary investment vehicles.

Starting in 2009, however, the rules will change. Similar to for-profit companies that sponsor 401(k) plans, non-profit 403(b) sponsors will have to prepare written plan documents and become the plan’s chief administrators. That also means that the non-profit employer will become the primary fiduciary of the plan and be responsible and liable for its proper administration. In the past, it was unclear which organization – the employer or vendor – was accountable.

The need for change was probably brought on by “a vacuum of responsibility,” contends attorney Ralph DeJong, a law partner in the Chicago office of McDermott Will & Emery. “Historically, tax-exempt organizations that sponsored or made available 403(b) tax-sheltered annuities,” he says, “took a hands-off approach.”

One reason: There is still “widespread belief” that all non-profits are exempt from the strict fiduciary requirements of the Employee Retirement Income Security Act, says Jeff Robertson, an attorney with Barran Liebman LLP. That belief probably had its roots in the fact that most 403(b) plans sponsored by government entities or that don’t include employer contributions are exempt from ERISA.

Currently, all but the most sophisticated non-profits run 403(b) plans in a “loose” way, requiring only a contract between employees and the vendor that “may or may not comply” with the tax code, says DeJong. In addition, many “employers using multiple 403(b) plan vendors have done little or no monitoring of investment options and their performance,” argues a new report released by Ginny Boggs, a senior compliance consultant at Milliman, a benefits advisory firm.

Boggs insists that the “existence of unmonitored excessive choice” among the annuities offered in 403(b) plans has hurt employees, “overwhelming them with choices and diluting the overall quality investments.” That was also found to be true in the private sector, where plan sponsors, attempting to comply with ERISA’s rule to provide “a reasonable choice” of investment options, flooded participants with an excessive amount of alternatives.

The most notable change to the tax rules is that employers will have to develop a plan document that identifies how the vendor and employer will work together to administer the 403(b) plan. The IRS is expected to release model language for the plan document sometime in 2008. But it’s unclear how much guidance employers will need to complete the task that DeJong describes as, “very challenging”—especially for smaller businesses.

For example, plan documents will probably still designate the vendor as the record-keeper and provider of investment options, but shift other major responsibilities to the employer. The employer is likely to become responsible for monitoring the movement of assets among vendors, tracking annual employee investments (for 2007 the investment limit for an individual is $15,500, with a $5,000 catch-up allowance for employees 50 and older ), and overseeing compliance with nondiscrimination policy known as the “universal availability rule” and other key regulations. Under the availability rule, if sponsors offer their plans to a singe full-time employee, they must offered the benefit to all employees.

Compliance failures are the main reasons the IRS pushed through the new rule, says DeJong. In June, the tax agency announced that a pilot project involving public schools in three states showed “fairly widespread noncompliance” with the universal availability rule. IRS officials blamed the failure on a “lack of understanding about what the law requires, not a deliberate failure to comply,” noted the agency in a June press statement. Typically, schools with failing 403(b) compliance grades neglected to offer the plans to substitute teachers, janitors, and cafeteria staff members who worked more than 20 hours a week. Presumably, plan administrators weren’t aware that they had to offer plans to those workers.

The IRS identifies several other common 403(b) administrative mistakes made by employers, mostly related to elective contribution limits. For instance, the IRS claims that employers not only fail to monitor how much workers contribute to 403(b) plans, but fail to return excess contributions and associated earnings to employees and properly withhold and report attendant withholdings to the government.

The agency also reports that non-profits often fail to satisfy tax rules related to the hardship distribution requirements of 403(b) plans, frequently releasing funds without adequate documentation and when other financing options are available. They also often err by distributing an amount that exceeds the funds needed to relieve the hardship.

Non-compliance could mean fines for the employers and employees. In the extreme, it could mean that a plan is stripped of its tax-deferred status, which would cause employees to forfeit their tax benefit, says DeJong.