Fleecing 403(b) Plan Participants

W. Scott Simon


There it was–right in the elevator with me. More precisely, it was taped to the back
wall of the elevator in a hospital. “It” was a notice from the provider of the hospital’s
403(b) plan–a large insurance company known for its high-cost products–to
employees of the hospital notifying them of a series of informational meetings about
their 403(b) plan. I was visiting a friend in the hospital–ordinarily a place of (relative)
calm–but on that day my blood pressure spiked as soon as I saw that notice. Even
now as I’m writing this column in my Starbucks office, my face is beginning to flush–
and Melba isn’t even around to fetch my blood pressure medication for me! Okay,
okay, calm down big guy; just focus on writing an informative column. Focus, focus.

A Brief Background

A 403(b) plan (so-named after the section of the Internal Revenue Code where the
provision for such plans first appeared in 1958) is a tax-deferred retirement savings
plan. Contributions to a 403(b) plan are tax-deductible, and any earnings accumulate
tax-free until withdrawals are made at which time such withdrawals are taxed at
ordinary income rates.

403(b) plans are available to employees of educational institutions such as public
school districts and certain (Internal Revenue Code section) 501(c)(3) non-profit
groups such as colleges, universities, hospitals, and charities. Participants in these
plans include teachers, nurses, school administrators, doctors, professors, school
personnel, researchers, librarians, and some members of the clergy. All told, there are
about 7 million participants in 403(b) plans investing about $700 billion. Perhaps an
equivalent number that are eligible to invest in them fail to do so.

There are three primary segments of the 403(b) market: public school grades K-12,
hospitals, and colleges and universities. (The 501(c)(3) charitable and church
segments lag far behind in assets and contributions.) The colleges and universities
segment has been dominated by longtime provider TIAA-CREF (TIAA being the
Teachers Insurance and Annuity Association, which invests in fixed-income
investments, and CREF being the College Retirement Equities Fund, which invests in
stocks). TIAA-CREF offers professors and other higher-education personnel investment
products lower in cost compared to many other financial services firms.

Many in the hospital segment of the 403(b) market have terminated their defined
benefit plans. Some of them, as a result, have changed their 403(b) plans to bear a
greater resemblance to a 401(k) plan. Nonetheless, many hospitals have retained their
403(b) plans, as I was reminded the day of my near-fatal encounter with that jarring
notice in the hospital elevator.

The public school grades K-12 segment of the 403(b) market is a large one. Most
public school teachers contribute to a defined benefit plan over their career and in
return receive fixed periodic payments (usually indexed for inflation) during
retirement. Many public school districts, therefore, see 403(b) plans as a mere
supplement to traditional pension plans. In addition, districts by law have no fiduciary
responsibility to teachers to ensure that they receive the kinds of protections afforded
participants in 401(k) plans.

Teachers, as a result, receive little guidance as to how to invest in 403(b) plans–or
even to invest in them at all. For example, in my state there are just more than 3,000
teachers–a mere pittance of the total eligible–who have invested in the 403(b) plan
sponsored by the California State Teachers Retirement System. Nonetheless, the K-12
segment of the 403(b) market is expected to experience the most growth in the
foreseeable future. One reason is that some teachers’ pension plans are under-funded
(some significantly), which is a problem that now plagues many other public employee
pension plans around the country. Another reason is that it can take years for a
teacher to fully qualify for a defined benefit plan. In the meantime, any additional
money that can be accumulated in a “mere supplement” 403(b) plan can turn out to
be significant: up to $15,500 for 2007 plus a “catch-up” of up to $5,000 for
participants age 50 or older.

The dominant providers of investment options for 403(b) plans in this segment are
large insurance companies such as AIG VALIC, ING, MetLife, and AXA. One reason for
this dominance is that from 1958 until 1974, only insurance products were permitted
as investment choices in 403(b) plans. These choices come in the form of contracts
between insurance companies and plan participants known as fixed annuities and
variable annuities.

Annuities: Fixed and Variable

Fixed annuities or variable annuities offered as investment options in a tax-deferred
retirement plan such as a 403(b) plan (or 401(k) or 457 plans) are typically invested
in baskets of a half dozen mutual funds wrapped inside a variable annuity policy
written by a life insurance company.

With a fixed annuity inside a 403(b) plan, an insurance company is responsible for
investing money in a tax-deferred account and guarantees a fixed rate of interest
during the accumulation phase prior to an annuitant’s retirement. There is also the
guarantee upon retirement of periodic payments for some definite period such as 20
years, or an indefinite period such as the annuitant’s lifetime or the lifetime of the
annuitant and its spouse.

With a variable annuity inside a 403(b) plan, the annuitant (not the insurance
company) is responsible for investing money in a tax-deferred account, typically in a
range of mutual funds selected by the annuitant. A variable annuity’s value, and
therefore the size of the payments to the annuitant, fluctuates depending on the
performance of the mutual funds in the account. Note that the life insurance
associated with a variable annuity doesn’t pay out a huge lump sum upon the
annuitant’s death but only the total contributions made by the annuitant plus any
growth earned in the account.

Two, Two Tax Shelters in One!

Annuities are very appealing to investors because they are tax shelters. That is,
investors can invest their money and any resultant interest, dividends, and growth in
capital are sheltered from taxation. A tax-deferred retirement plan such as a 403(b)
plan or 401(k) plan is, by definition, also a tax shelter. But an investor receives no
additional tax advantage by investing in annuities inside a tax shelter. Don’t take my
word for it though. Just read the warning issued by the U.S. Securities and Exchange
Commission: “If you invest in a variable annuity through a tax-advantaged retirement
plan (such as a 403(b) plan), be aware that you receive no additional tax
advantage from the variable annuity.” (Bold in the original.)

When a school teacher buys, for example, a variable annuity inside a tax-deferred
retirement plan such as a 403(b) plan, he or she not only pays the underlying
expenses inside the mutual funds but also what is known as a “mortality and expense”
risk charge. An insurance company, therefore, charges the teacher two sets of costs
when it sells the teacher an annuity inside a 403(b) plan. The expenses of the mutual
funds contained on the menu of available investment options offered to plan
participants by insurance companies are, of course, bloated to ensure that the mutual
fund families have enough “revenue-sharing” payments to direct the companies’ way.

The Toxic Brew of High Costs, Poorly Performing Products, and Problematic

The problem in the K-12 403(b) plan market is not the annuity as an investment
vehicle per se. In fact, an annuity can be a useful vehicle for accumulating assets for
retirement or as a way to generate some future income stream. Low-cost provider
TIAA-CREF, for example, has recently entered the public school segment of the 403(b)
plan market; it is now listed as a provider for the Los Angeles Unified School District. It
seems that third-grade teachers will finally get exposure to the low-cost products that
university professors have enjoyed for some time now. (I swear on a stack of
Morningstar reports that I have no financial interest in TIAA-CREF or its products.)

No, the real problem here is that the great majority of assets in 403(b) plans (which
are tax shelters) are invested in high-cost fixed and variable annuities (which are tax
shelters). Large insurance companies that offer such annuities–the usual suspects–
charge schoolteachers unconscionable fees ranging from 200 to 500 basis points in
exchange for poorly performing investment products and services provided by
salespeople disguised as “financial planners.” This is just about the ultimate in fleece
jobs since under that kind of investment cost structure it’s nearly impossible for plan
participants to accumulate much of a nest egg. As Rex Sinquefield reminds us, “Bad
performance and service are not cheap; you have to pay dearly for them.”

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™. The author’s views expressed in this article do not necessarily reflect the views of Morningstar.

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