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Fiduciary Focus: Fleecing 403(b) Plan Participants (Part 4)

With new regulations on the way, here are 13 suggestions for a creating a model 403(b) plan.

W. Scott Simon, 07/05/2007

Section 403(b) was first added to the Internal Revenue Code (IRC) in 1958. In 1964, regulations were first issued that detailed some of the basic statutory provisions of section 403(b). The Internal Revenue Service is now in the process of finalizing new regulations to govern 403(b) plans. The best guess at present is that these regulations, the first in over 40 years, are to become effective Jan. 1, or shortly thereafter.

A Suggested Model 403(b) Plan
The new 403(b) regulations make clear that officials at school districts offering 403(b) plans will take on some fiduciary duties to plan participants and their beneficiaries. Smart (or even purely self-interested) officials should understand that by placing the interests of 403(b) plan participants first, they will gain the greatest fiduciary protection against lawsuits filed by the government and the plaintiffs' bar. (I know, I know, such officials are protected by governmental immunity laws, contractual indemnity clauses and insurance policies. Yet I don't know of anyone, including school officials, who likes to prepare for, and be subjected to, depositions and the other niceties of modern litigation.)

The truly wonderful thing about placing the interests of 403(b) plan participants first is that it also actually produces the best outcome for them. A "win-win" if there ever was one. To help ensure that outcome, though, school district officials must jettison the absurdities currently plaguing so many 403(b) plans. What follows, then, are some suggestions for creating a model 403(b) plan.

1. Get rid of the multi-provider model and adopt the single-provider model. The multi-provider 403(b) model, which is the most prevalent by far at school districts, allows teachers to choose their investment options from among more than one retirement plan services provider such as an insurance company or mutual fund company.

The multi-provider model can be confusing to teachers (or anyone else with a pulse) and often generates the "deer in the headlights" phenomenon: teachers have so many investment options they make no selections at all, or make them by throwing darts. This model has reached its logical absurdity in my state of California where, as a result of adoption of insurance code section 770.3, California teachers get to choose from (at last count) 123 providers - each of which has a glut of investment options.

The multi-provider model also balkanizes the 403(b) assets held by teachers into separate insurance contract accounts held at separate insurance companies. Schools districts with no fiduciary duties don't need to keep track of all that money so they have no incentive to try to get a low cost deal for teachers.

The single-provider model, on the other hand, allows school districts greater purchasing power, thereby resulting in lower and more transparent investment costs for teachers; this enhanced employee benefit gives districts a competitive edge in recruiting teachers. This model also offers a centralized way to provide plan documents, monitoring and reporting of participation rates, monitoring and reporting of participant contributions and withdrawals, a full range of investment options and customized and consistent communication materials, all of which help reduce the administrative burden at school districts.

2. Get rid of annuities and offer only mutual funds. Annuities and other insurance products have their place--just not in 403(b) plans (or 401(k) plans or 457(b) plans for that matter). I have, for the record, purchased lots of insurance products and believe fully in the idea of insurance. I just don't think such products should be on the menu of investment options in retirement plans. They are just too costly. I detailed in last month's column the fact that investment products offered by insurance companies in 403(b) plans cost between 200 and 500 basis points. In his testimony before a congressional committee in March, noted independent fiduciary Matt Hutcheson was less charitable in his estimate of 300-500 basis points. Given this, it just seems crazy for school districts to offer teachers investment options that have an added layer of fees. It's not that such options have no value at all; rather, it's that they do not have value enough to justify their (oftentimes) grossly higher costs.

Compounding this problem is the fact that these costs are usually hidden--because they're high. A cost, under any body of fiduciary law, must be reasonable in relation to the service or product received in return. If a cost is hidden, how is it possible to determine whether that cost is reasonable in relation to the service or product received so that the recipient knows it's getting full value?

Insurance companies favor this kind of obfuscation because it allows them to get away with charging higher costs than would otherwise be the case in a cost-transparent environment. A recent example of this absurdity involved one of the large insurance companies active in marketing retirement plans to school districts. The Los Angeles Unified School District (LAUSD), led by a very well-informed advisory committee, insisted that the insurance company disclose to plan participants a revenue-sharing fee in the district's 457(b) plan. An insurance company vice president refused, stating that "I'm afraid the revenue-sharing would just confuse people."

Apart from the contempt that statement reveals for those who are educating our next generation, perhaps this person could (a) actually try to make revenue-sharing understandable to teachers or (b) better yet, advise his company to do away with its revenue-sharing fees altogether. No school district official should have to spend time debating the intricacies of such nonsense with insurance companies or any other retirement plan services provider. (LAUSD eventually prevailed in this debate.)

Investment products offered by non-insurance retirement plan services providers (i.e., brokerage firms and mutual fund companies) in 403(b), 401(k) and 457(b) retirement plans are generally less expensive but there are still too many of them that are too costly, especially considering their general resistance towards the idea of accepting any fiduciary responsibility. Some of these providers will accept fiduciary responsibility if a 403(b) plan is large enough, but historically they haven't been too keen to do so. The exemption that brokerage firms have hidden behind, the so-called "Merrill Lynch Rule," was struck down by the United States Circuit Court of Appeals for the District of Columbia a few months ago, and this may have a positive impact on the 403(b) investing culture.

3. Be more responsible and offer fewer mutual funds, not irresponsible by offering more mutual funds. An exhausting array of studies has shown that the more choices (of anything) people are given, the less confident they are in their selections - if they even make them. I just ran across the winning bid for a menu of investment options in a 457(b) plan at a large school district comprised of 20 individual mutual funds and two "portfolios." Each of the individual funds was separated into one of 5 or 6 asset classes, resulting in 3-4 funds in each asset class. I guess the idea is that a plan participant should select a fund from each asset class since the funds in each are clearly duplicative (more or less) of one another.

I cannot count the times over the years that friends have called for advice because they haven't a clue when faced with this kind of selection "process." Many retirement plan service providers, as Matt Hutcheson noted in his congressional testimony in March, "understand and count on participants making imprudent investment decisions." "The more fund choice is offered, the more mistakes participants make. [Participants] tinker with the investments within their accounts, incurring hidden trading costs that reduce their returns. The current [retirement plan] environment encourages mistakes, for no good or necessary reason. [Many retirement plan service providers] rely on [participant] ignorance to generate revenue. This is a substantial and hidden cost about which participants are almost universally unaware." It's this current environment that leads me to suggest that school districts offering 403(b) plans should provide perhaps no more than 10-12 individual mutual funds, each of which is broadly diversified, low cost and actually differs from the other funds offered within a portfolio context.

4. Be even more responsible and offer portfolios of mutual funds, not individual mutual funds. Let's remember that Nobel laureate Harry Markowitz is the father of modern portfolio theory, not modern investment theory. It was the Employee Retirement Income Security Act of 1974 (ERISA) which first applied key tenets of modern portfolio theory to the investment and management of assets by investment fiduciaries (see Labor Reg. § 2550.404a-1).

Modern portfolio theory also provides the underpinnings of the 1992 Restatement 3rd of Trusts (Prudent Investor Rule), the 1994 Uniform Prudent Investor Act, the 1997 Uniform Management of Public Employee Retirement Systems Act, the 2006 Uniform Prudent Management of Institutional Funds Act (and its predecessor, the 1972 Uniform Management of Institutional Funds Act).

A basic tenet of modern portfolio theory is that properly constructed portfolios of investments are more conducive to wealth accumulation than individual, stand-alone investments. The "proper" construction of a portfolio involves assembling mutual funds that have dissimilar price movements to each other. This produces a portfolio with reduced risk which not only decreases loss but can also simultaneously increase return. This kind of portfolio is greater than the sum of its parts.
 
5. Be super responsible and offer a prudent range of model portfolios comprised of low cost, passively managed mutual funds. The ideal conditions for achieving investment success are created by disciplined application of three major themes found in modern prudent fiduciary investing: broad diversification of risk, low costs and (for taxable investors) low taxes. Over the years, I have detailed in this column (some would say in an ad nauseam way) why passively managed mutual funds (i.e., index funds and asset class funds) are the best way to apply these themes in a practical way.

It's not hard to understand, of course, that every dollar saved in investment costs and taxes goes straight to the bottom line to increase return. It's also true (though little understood) that broad diversification of risk can help increase return because of reduction of loss. Maximum reduction of loss, through broad diversification (both "horizontally" across the portfolio itself and "vertically" within each mutual fund held in the portfolio), occurs as a result of minimizing a portfolio's exposure to (bad) uncompensated risk so that the only risk remaining is (good) compensated risk.

The most effective and efficient way for a participant in a 403(b) plan (or any retirement plan) to reduce loss and thereby increase return is to invest in an automatically rebalanced model portfolio appropriate to the participant which is comprised of institutional level asset class mutual funds and index mutual funds, providing market level returns at market level risk. Offering a range of prudent model portfolios of passively managed funds also generates reliable returns relative to model portfolio and asset class performance benchmarks, which greatly simplifies monitoring and reduces its costs.

Such portfolios are rarely changed but when they are it's because (a) academic research has determined the existence of a new asset class and the investment provider adds a corresponding asset class fund to the portfolio to achieve even broader diversification of risk (which, again, decreases loss and thereby increases return) or (b) the provider replaces an existing higher cost fund in the portfolio with an equivalent lower cost fund (which increases return). Passive investing gives plan participants the best bang for their buck.

The demonstrably inferior alternative, investing in actively managed mutual funds, invites big trouble: the higher costs and risks inherent in active investing. There's also the constant heartburn caused by managers who haven't performed up to snuff for whatever reason (whether it be the current price of oil or that the Giants have been winless in a World Series since 1954) and the (costly) need to keep replacing them, or soap operas at mutual fund companies over the (rumored or not) departure of a superstar fund manager and what that might do to a school district's 403(b) plan.PAGEBREAK

6. Be super-duper responsible and offer a menu of prudent model portfolios comprised of low cost, risk-based passively managed mutual funds. Fiduciaries of many retirement plans have jumped on the band wagon of age-based "lifecycle" fund portfolios. These portfolios are invested with an eye towards the target date that a particular plan participant will retire, say, 2030. As the portfolio advances in time towards that date, the portfolio will grow more conservative by adding more bonds and shedding more stocks as the retirement date draws nearer.

The problem with age-based fund portfolios is that two people of the same age (42 in this example) could have $50,000 and $500,000 in their respective retirement accounts. Perhaps the participant with the larger account should become more conservative in its investment strategy as time goes on but is that a reasonable strategy for the participant with the smaller account? On the contrary, it may be that this participant should become less conservative by adding a greater stock component to increase long term return in order to catch up. Most age-based fund portfolios are actively managed and are therefore subject inherently to higher costs and risks.

Better fiduciary conduct is to offer 403(b) participants a menu of prudent risk-based "lifestyle" fund portfolios. Each participant determines which portfolio is appropriate for it based on its age, and risk tolerance determined through a short online exercise. A participant tends to stay invested in a risk-based fund portfolio because it's geared towards the participant's own comfort zone vis-à-vis risk. The kind of prudent portfolios that I've suggested for a model 403(b) plan (see suggestions nos. 5 and 6) are focused on what investors can control - management of risk and reduction of costs--rather than the attempting to corral the random variable of return. This approach makes risk-based fund portfolios a more rational choice for participants in 403(b) plans.

7. Don't allow revenue-sharing. Revenue-sharing is a legacy of the cost structure that needs to be in place to support a very inefficient system of gathering assets and a very inefficient system of distributing 403(b) benefits on the basis of individual contracts with individual participants. The current system is based on a retail model, not a wholesale one that could efficiently provide a true group benefit. There's no institutional aspect about the current system: no institutional provider and no institutional client.

All my previous suggestions have been made with the intention of simplifying a 403(b) plan. To further simplify a 403(b) plan, get rid of revenue-sharing; there is no need for it. Insurance companies and other retirement plan services providers have bamboozled school districts into thinking that revenue-sharing is a way of life in 403(b) plans; it isn't. There's just no need for school district officials to have to deal with insolent insurance salesmen such as the one in the Los Angeles Unified School District example noted previously.

Now, there's nothing illegal about revenue sharing per se. The problem, rather, lies squarely with retirement plan services providers that aren't transparent about revenue-sharing fees and refuse to be forthcoming about them. This refusal implies that there's something rotten in the state of Denmark. That's why I wonder: isn't it a bit ridiculous for any retirement plan services provider in the 21st century to purposely hide its fees? Even the hint of fee camouflage and a provider saying that it's impossible to know what is being shared on a fund basis is simply absurd. Think about it: why would anyone want to do business with a retirement plan services provider that claims it has no way of knowing how much money it's really making? Any company that spews this kind of nonsense should be immediately removed from consideration as a retirement plan services provider by school district officials.

8. Get rid of unnecessary costs and fees. Jettisoning annuities as investment options in 403(b) plans (see suggestion no. 2) gets rid of mortality and expense risk fees, death benefit charges, administrative fees and surrender charges. There's also no need to pay commissions on investment products, any revenue-sharing fees (including sub-transfer agent fees, shareholder servicing fees and 12(b)-1 fees) or allow excessive brokerage commissions under SEC rule 28(e) "soft dollars" trading revenue since the prudent portfolios I've suggested for a 403(b) plan (see suggestion nos. 5 and 6) need to pay for little or no "research." In addition, don't pay finder's fees or placement fees.

9. Don't allow a self-directed brokerage option (SDBO) or give plan participants the ability to borrow from their 403(b) accounts. Let the small minority of plan participants demanding a SDBO in order to trade exotic mutual funds or annuities do it in their own personal non-retirement plan accounts. A SDBO is a plan expense that other participants shouldn't have to subsidize. Sometimes the cost of an SDBO is actually wrapped into the overall cost of a 403(b) plan; that's a very big no-no.

Officials at many retirement plans give in to the small but loud minority of participants that want the ability to borrow from their 403(b) accounts. This capitulation is often a response to those who insist that participants won't enroll in a 403(b) plan unless they can get their money out through a loan. That's a lot of baloney. Those who scream loudest for loans are the same ones who should avoid them like the destroyer of accumulating wealth that they are. This is yet another plan expense that other participants shouldn't have to subsidize. Just say no to loans.PAGEBREAK

10. Enroll, educate and advise plan participants online. I'm a member of the State bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst®. To continue keeping the acronyms of these designations next to my name requires that I complete continuing education, which I do - all online. So why not enroll, educate and advise 403(b) plan participants via the internet? After all, teachers are among the most internet-savvy folks around.

Studies show, however, that investors don't utilize, for example, online investment education very much. This can be overcome by tying the use of online investment education to mandatory continuing education credits for teachers just as it's done in the financial services industry.

This requirement should be augmented by a voice response system, a 24/7 call center to handle non-investment questions (e.g., what's my pin number?) and a call center staffed by salaried financial professionals delivering impartial investment advice without selling any investment products. Schools districts are generally reluctant to pay for this kind of education. Instead, the (surprisingly modest) cost for such education can be priced (in a fully disclosed way) into a 403(b) plan which allows school districts to avoid paying for the education. All school districts have to do is offer such educational efforts and get behind them but they don't have to pay for them.

11. Provide 403(b) plan participants with automatic enrollment and escalating enrollment via the Internet. Suggestion no. 10 can be supported further by a centralized online information system that automatically enrolls participants in their plan (unless participants overcome human inertia and actually take the time to opt out of the plan) and escalating enrollment by which the deferral rates for participant accounts are increased automatically (unless participants overcome human inertia and actually take the time to opt out of such increases).

12. Develop a Request for Proposal (RFP) and Investment Policy Statement (IPS). The use of a RFP brings rationality to the process of finding the right retirement plan services provider for a 403(b) plan. A well developed IPS is the roadmap to a plan so it should be so clear and complete that a competent stranger could read it and understand how the plan works.

13. Despite the fact that public school districts are exempt from ERISA, require the winner of the RFP to accept ERISA section 3(38) fiduciary responsibility. School district officials should require any winner of an RFP to accept via contract ERISA section 3(38) fiduciary responsibility for the selection and monitoring of a 403(b) plan's investment options. This delegation allows school officials to unload much of their responsibility and most of any associated liability onto the winning retirement plan services provider who will then owe fiduciary duties to the 403(b) plan fiduciaries (and participants and beneficiaries by implication), not just to the funds offered by the plan.

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