W. Scott Simon
This month’s column continues my interview with Steve Schullo that began in last month’s column. Schullo, now a retired elementary schoolteacher who taught in the Los Angeles Unified School District (LAUSD) for nearly 25 years, has been active in attempting to reform K-12 403(b) plans and the investment options that are offered to plan participants such as teachers, psychologists, counselors, substitutes, custodians, nurses, et al.
In retirement, Schullo has just published another book titled “Fighting Powerful Interests: Educators Challenge Tax-Sheltered Annuities and WIN!” which can be downloaded (as a PDF) for free. He is also a blogger at Late Bloomer Wealth.
The following interview was conducted via email and has been edited.
Scott Simon: You’ve noted that, at least in states like California as well as five or six other such “open vendor” states, purportedly a school district must allow a vendor–an insurance company or mutual fund company–to sell its products to participants in a 403(b) plan, as long as the vendor agrees to comply with the 2007 IRS regulations.
Steve Schullo: Yes, that’s right. In the LAUSD, that has resulted in something like 125 insurance company vendors selling high-priced annuities and around 25 mutual fund company vendors primarily selling funds with commissions and excessive advisory fees sold by broker/dealers. That’s all courtesy of how California Insurance Code section 770.3has been interpreted by insurance companies in their own favor. For the record, only 27 vendors remain today as the rest quit the LAUSD 403(b) plan once the new IRS regulations were issued in 2007. But that’s still too many.
But isn’t it good to provide school employees with a lot of investment choices?
Well, it’s good if the costs of the vendors’ products are fully disclosed so that teachers can make an apples-to-apples comparison. But they never are, so teachers rarely get the full horrible story about high and hidden fees and costs.
There’s also the deer in the headlights syndrome. Studies have shown that if you give people too many investment choices, they tend to freeze because they are overwhelmed by so much choice. The default choice they make is often based on the advice of the nearest fast-talking investment salesperson who, by the way, is not a fiduciary. That’s why I favor a set-up–whether in a 403(b) plan, a 457(b) plan, a 401(k) plan, any retirement plan–where true discretionary fiduciaries are in control of the plan to look out for the interests of school employees. Discretionary fiduciaries are legally and financially motivated to be on the side of those they serve: plan participants.
It doesn’t sound as if you hold out much hope for participants in K-12 403(b) plans in open vendor states such as California.
Not as long as California’s ancient Insurance Code section 770.3 isn’t reinterpreted or outright repealed.
Imagine how much 403(b) plans–all retirement plans for that matter–have changed since 1969 when this code was enacted. In 2015, we still have a code section requiring that anytime a vendor signs a district’s agreements, the district must put them on the vendor list and make their products available to school employees. The ultimate result of this has been a huge array of high-cost investment products offered by vendors that are all too glad to sign an agreement complying with the 2007 IRS regulations. Those regulations, which required information-sharing, made it more difficult for vendors offering low- cost investment options and pushed almost all of the already tiny number of low-fee vendors off the LAUSD’s approved list of investment options. Vanguard, for example, never signed with LAUSD because LAUSD and the new IRS regulations required all vendors to share information, costing Vanguard money that it would not expend to pay those costs. So Vanguard and other low-cost providers refused to sign the agreements.
K-12 educators should be entitled to rational, low-cost investment options in 403(b) plans, just like those available in any other kinds of plans. After all, look at the national trends including recent litigation that has favored plan participants and the U.S. Labor Department’s fiduciary proposals. And yet, public school employees in California as well as other open vendor states are stuck with antiquated laws–passed when the Beatles were still together–that have wholly failed to look out for their interests.
So are public school employees in open vendor states condemned to invest only in 403(b) plans?
Based on my experience, no. Such plans, and the death grip that insurance company vendors have on them, can simply be sidestepped by turning to a 457(b) plan. For years, I explained the annuity trap and high-cost mutual funds to the unions and LAUSD benefits personnel, but to no avail.
In 2006, however, this bleak situation changed when a few courageous LAUSD personnel who were disturbed by the domination of the high-cost annuity providers in the 403(b) plan stepped forward and proposed offering a new 457(b) plan. Toward that end, they created the LAUSD Retirement Investment Advisory Committee, which is composed of representatives of the LAUSD’s eight unions–employees who would participate in the 457(b) plan. I was asked to be a member-at-large of that committee.
California insurance code section 770.3 concerns 403(b) plans but not 457(b) plans. The LAUSD was free to issue a request for proposal to competitively bid for a single vendor–like in 401(k) plans–that would keep records and administer mutual funds to be selected by the committee. I was so glad but that feeling ended when the LAUSD hired an insurance company–Variable Annuity Life Insurance Company (VALIC)– to be the third-party administrator for this new low-cost plan. I was really upset. How could the LAUSD offer a low-cost plan if they were going to contract with VALIC, a company that, in my assessment, had played a big part for decades in creating the high-cost problems with the LAUSD 403(b) plan?
Was the LAUSD 457(b) advisory committee sabotaged from the start?
Not so fast. While VALIC was a big problem, perhaps an even bigger problem our committee ran into was Mercer, the large international consulting firm, which insisted, over our committee’s vociferous objection, that its own mutual fund recommendations with their hidden revenue-sharing arrangements be adopted. See, VALIC told the LAUSD board of education that its fee was only 15 basis points, but what they didn’t say was that they relied on revenue-sharing with 27 basis points, too. Within minutes, Mercer told the board that there would also be 27 basis points of costs, but neither VALIC nor Mercer totaled them up together. I remember at the time thinking that 42 basis points was quite a bargain. And yet, why the bifurcated presentation with VALIC announcing 15 basis points and Mercer 27 basis points?
The problem was that in our ignorance, the committee didn’t realize that the 42 basis points was only for administration and didn’t include the costs of the investment options, which were not included at the time because they were unknown. When the costs–administrative and investment-related–were all added up, we found that school employees would be paying over 100 basis points for half of the 18 funds that the committee was being forced to accept. This appalled me because it showed very clearly that the committee were never part of the decision to select the investment options for the LAUSD 457(b) plan.
When our committee offered three lower-cost funds which met the requirements of a diversified portfolio as described in our Investment Policy Statement, the committee chair warned us not to go against Mercer’s original high-cost recommendations. Our three recommended changes–out of 18 funds–were not exactly a threat to Western civilization, but Mercer apparently seemed to think so.
Some commentators in the financial media note that costs aren’t all that important. I strongly disagree. From one who has been through the wars with powerful financial interests, I can tell you that costs really do matter and they matter a whole lot to those that are threatened by any reduction in them. In fact, in my experience, costs are the single most important factor that the financial industry cares deeply about, and it takes great pains to protect those costs by creating confusion and complexity for decision-makers and even attempting to intimidate those who would oppose them.
For example, once our advisory committee found out that it would have no role in selecting the investment options for the LAUSD 457(b) plan, we demanded at a contentious advisory committee meeting that VALIC disclose all costs, including the financial industry’s sacred cow–revenue-sharing–to all school employees during enrollment presentations. The VALIC reps were very angry about that, arguing that the employees would be confused. [I touched on this in my July 2007 column as part of a nine-part series on “Fleecing 403(b) Plan Participants.”] I kid you not. As they walked out the door, they warned our committee that they were going to speak to their legal team about this forced disclosure. This advisory committee meeting was a big event, which is why a prominent reporter from the Los Angeles Times was on hand to report it.
Simon: What is the LAUSD 457(b) plan like today?
Although our 457(b) plan advisory committee lost that first battle to replace three funds with lower-cost funds, we won the war on disclosing and eventually reducing costs. Over the years we slowly got rid of the stench of high-cost revenue-sharing mutual funds. Today, our advisory committee has a team in place that’s committed to fiduciary responsibility. None of our funds charge revenue-sharing fees. Now our committee chooses the funds.
Our committee pushed back hard against the old anti-investor practices of hiding and confusing costs, and ignoring committee recommendations to lower costs. This is why it is so important to have a committee of employees making the core recommendations to a K-12 school district’s chief financial officer, whether it’s the investments, TPA, or the financial consultant. After all, it’s the school district employees that are paying the freight.
Just last year, after years of gradual replacement of those high-cost funds for lower-cost, best-in-class investment options, the LAUSD 457(b) plan won an award from the National Association of Government Defined Contribution Administrators. Not bad for a bunch of rag-tag LAUSD employees who came together, knowing little about retirement plans but then earning a prestigious award.
My interview with Steve Schullo will conclude in next month’s column.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.