Fleecing 403(b) Plan Participants (Part 3)

W. Scott Simon

 

In April’s column, I wrote: “Large insurance companies that offer annuities [in 403(b)
plans] 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.'”

Since one reader characterized that range of 200 to 500 basis points as a “gross
misstatement,” I set out to show in May’s column that 403(b) plans not only have
explicit costs but also implicit costs, which such readers seem to outright ignore as if
they don’t exist.

But alas, all those costs (and more) do, in fact, exist: 1) explicit costs (for variable
annuities only), which can range from 250 to 335 basis points (or more if a rider for
living benefits is added, for example), are composed of mortality and expense fees of
100 to 185 basis points and a mutual fund annual expense ratio of 150 basis points,
and 2) implicit costs, which can range from 125 basis points to more than 1,000 basis
points, are composed of brokerage commissions of 45 basis points paid on
transactions, bid-ask spread costs of 40 to 1,000 basis points and market impact costs
of 40 basis points. Based on this, I came up with an estimated grand total of 375 to
460 basis points (or more) which, though I didn’t advance beyond 10th grade algebra,
I believe is in the more expensive part of the neighborhood of that gross misstatement
of 200 to 500 basis points.

“Per Head” Administrative Charges

But wait (as the infomercial goes), there’s more! The “more” is an annual
administrative charge of $25 or $30 borne by a teacher’s 403(b) account (which ends
only when an account grows typically to $30,000). This kind of charge has a
particularly lethal effect on school teachers who are in the early stage of their careers
and therefore are not usually deferring a lot of money. For example, suppose that a
teacher defers $100 per month into its 403(b) account for five years, the account
grows at 8% per year and the teacher is assessed an annual per head charge of $25:

Year 1: $25 ÷ $1,200 = 2.08%
Year 2: $25 ÷ $2,496 = 1.00% ($25 ÷ $1,200 + year 1 plus earnings)
Year 3: $25 ÷ $3,896 = 0.60% ($25 ÷ $1,200 + prior two years plus earnings)
Year 4: $25 ÷ $5,408 = 0.40% ($25 ÷ $1,200 + prior three years plus earnings)
Year 5: $25 ÷ $7,040 = 0.36% ($25 ÷ $1,200 + prior four years plus earnings)

The average annual administrative charge comes to 91 basis points (2.08% + 1.00%
+ 0.60% + 0.40% + 0.36%) ÷ 5 = 0.91%. That is, nearly one additional percentage
point of costs–in addition to something within the range of 375 to 460 basis points–
must be borne by teachers least able to afford it in the early stage of their careers.
The addition of 91 basis points increases the range to 466 to 551 basis points. You can
bet that the insurance companies following such a wonderful business model are
thinking only one thing: “Cha-Ching!”

Surrender Charges

I mentioned, but didn’t discuss, the costs of surrender charges in last month’s column.
These charges, more formally known as “contingent deferred sales charges,” are
imposed by insurance companies when a person decides to terminate an annuity. A
surrender charge is normally expressed as a set of percentages of account assets that
declines over time. For example, a colleague informed me last month that he had
recently run across a defined benefit plan in which a doctor was sold a variable annuity
by a (young) agent of a very large and well-known insurance company. The annuity
featured a nine-year surrender period with declining charges of 8%, 8%, 8%, 8%, 7%,
6%, 5%, 4%, and–Ta Da!–only” 3% in the ninth year. Oh yeah, the costs of this
particular gem of a product amounted to nearly 500 basis points.

The Negative Compounding Effect on Accumulating Wealth Caused by “Lost” Money

I also mentioned in last month’s column, but didn’t discuss, the negative compounding
effect on accumulating wealth caused by “lost money.” It should be readily apparent to
anyone that sundry costs, expenses, charges, commissions and fees (whether totaling
200, 300, 375, 460, 551, or more basis points) are damaging, over time, to the
accumulating wealth of a 403(b) account. Few are aware, however, of the additional
yet invisible damage to that wealth inflicted by the negative compounding effect of
money used to pay for these costs, expenses, charges, commissions and fees.

This money can be thought of as “lost” because it is immediately gone forever and can
never join its brethren in helping compound the future wealth of a 403(b) account. The
total adverse impact of such costs, expenses, charges, commissions and fees is
therefore composed not only of their immediate visible blow on current wealth but also
their invisible blow on future accumulating wealth. Consider how the terminal wealth of
a current $50,000 403(b) account growing at 8% annually can be dramatically
different due to costs:

403(b) Costs 20 years 30 years 40 years
1.25% $192,143 $376,662 $738,379
3.00% $135,632 $223,387 $367,921
4.00% $111,129 $165,675 $246,994

Notice that over 40 years, a 403(b) account with low costs (1.25%) generates nearly
$500,000 more than one with high costs (4.00%). Even in some parts of California
that’s considered a lot of money. And who do you suppose that $500,000 goes to in
the high cost account?

Fixed Annuities

I was taken to task by one reader for suggesting that fixed annuities have up-front
commission sales charges and bear other costs. The reader is technically correct that
fixed annuities don’t have fees (other than an annual maintenance/administration/contract
fee of $20-25). But since we’re dealing with reality, let’s stick with that for now. And the
reality is that even though fixed annuities don’t have explicit fees, they sure do
have implicit fees, which are called “spreads” in the industry.

Consider an investor earning 2.5% in a fixed annuity during a period when short term
interest rates are 5%. That investor wouldn’t be getting a good deal since there is an
implicit fee (i.e., the opportunity cost) of 2.5%. In fact, many products in the 403(b)
world start out with high teaser rates which are then dropped quickly to the minimum
guaranteed rate, all the while using an investor’s money to earn about 2% to 2.5%
over and above what the insurance company pays to the investor. I think that any
economist worth its salt would call that (i.e., the spread of 2% to 2.5%) a “cost,” and
so would any investor if it were disclosed to the investor in an understandable way.

As for the (apparent) lack of an up-front commission sales charge, does anyone
seriously believe that a fixed annuity is sold without the insurance company
compensating the salesperson who sold it? In fact, the insurance company recovers
those “phantom” commissions via the series of surrender charges imposed by a fixed
annuity. The fact that an investor “technically” doesn’t pay up-front commission loads
in a fixed annuity is merely a distinction without a difference, as my law school
professors were fond of saying.

Investing Directly in Mutual Funds in a 403(b)(7)

In 1974, Congress began to allow participants in 403(b) plans to invest directly in
mutual funds without bearing the second layer of fees imposed by an annuity. About
20% of assets in 403(b) plans are so invested today. The problem is that many of
these assets are invested through brokerage firms which pose their own problems
because they generally have high cost products as well.

A provider such as a low cost mutual fund company would seem to be a plausible
option for 403(b) plans. The problem, though, is that many school districts require
such companies to sign agreements with “hold harmless” clauses that respectable
companies simply won’t be a party to. (There are even some school districts with
contracts that hold them harmless even if they happen to abscond with 403(b)
money.) Any provider that would sign such an agreement is obviously doing so
because the profit potential is very high. And that’s why insurance companies which
can afford to lose billions of dollars sign such agreements and why low cost mutual
fund companies which cannot afford to lose such money do not.

Two, Two Tax Shelters in One, Redux

A reader e-mailed me about language in April’s column that concerned placing an
annuity (a tax shelter) inside a retirement plan (a tax shelter): “[Y]ou make a big
point about the wrongness of putting a tax shelter inside a tax shelter. Please, there is
no cost to the annuity tax shelter. It is a function of the annuity product, and does not
have a cost. It is irrelevant.” Regardless of whether or not an annuity loses its tax
deferral once it’s placed inside a tax-deferred account, the larger point made in April’s
column is that an annuity sold in a retirement plan creates a double layer of fees. In
any event, it seems to me that it would be wrong of a salesperson selling an annuity in
a retirement plan to tell a client that the annuity was providing a tax deferral.

Lifetime Income Guarantee of a Variable Annuity

A number of readers asked me why I didn’t mention the advantages of purchasing a
“living benefit” rider in order to secure the lifetime income guarantee of a variable
annuity. After all, who wouldn’t want a product guaranteeing them that they won’t lose
money? The only problems with such “guaranteed” products are that they’re quite
expensive and, in some cases, difficult to collect on. Where the variable annuity is
used for both accumulation and payout, an investor could pay the living benefit rider,
say, for 20 years and then die before it ever got to take advantage of the added
benefit. The investor gets its money’s worth only if it lives longer than the insurance
company thinks it will. The investor could, on the other hand, just invest in and
accumulate low cost mutual funds and then buy an immediate annuity upon
retirement. There’s just no need to pay the high costs of a variable annuity during a
participant’s pre-retirement, accumulation phase to get a guaranteed income payout in
retirement.

Another reader e-mailed me about equity-indexed annuities. Oh no, here we go again.
Melba! Quick! Get me my blood pressure medicine!

Note: The following sentence appeared in April’s column: “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 life insurance policy.” A reader suggested that the last
three words of that sentence–“life insurance policy”–should be deleted and the words
“variable annuity policy written by a life insurance company” should replace them. He
is right, and I now stand corrected.

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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