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Fiduciary Focus: Fleecing 403(b) Plan Participants (Part 2)

The horribly high costs of most investment products offered in 403(b) plans.

W. Scott Simon, 05/03/2007

Well, well, well. I received more e-mail from last month's column than any other that I've written for Morningstar. The majority of e-mail messages were from those who bore the terrible brunt of (mostly variable) annuities including high and hidden fees, poor performance, and the inability to jettison in a cost effective way such "blood suckers" (in the words of one such e-mailer). If anything, this group thought that my column was way too tame in the way that it discussed annuities.

A minority of e-mails came from those who make (some or all of) their living selling annuities. This group wasn't happy with me at all. One reader wrote that the column was a "total waste of [Simon's] and my time." Other comments that I received: "I find your article to be very uninformed"; "[Your assertion about high fees is] a gross misstatement"; "You do the public a great disservice by writing such an article that lacks responsibility"; "You, Mr. Simon, are a poop-head." (Just kiddin' about that last one; one of my little nephews thought it would be cool if they said that.) After all this vituperation, at least I can always count on my mother for support. Right, Mom? Uh, Mom, are you still there? Harry Truman once said that if you're a politician in search of a real friend, buy a dog. So surely my faithful dog, Spot, won't turn on me. Okay Spot, please stop baring your fangs.

Breathe, Breathe Slowly
Let's all back off for a bit, take a breath and relax. First of all, I'm not anti-annuity. As I said in last month's column: "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." It's clear (even to me) that with the impending tsunami of the baby boomers rolling into retirement (and semi-retirement), annuities will play a large and important role. Much research is now being conducted to create new annuity products that will help these people live a more comfortable life.

Now, Hyperventilate
The real problem with annuities in the 403(b) market stems from the absence of a regulatory system that requires school districts to actually assume fiduciary responsibility for the investment selection, expenses, and education involving the 403(b) plans they sponsor. (Such responsibility exists more so in the large hospitals and other non-profits market, but much less so in the K-12 market.) School districts, in the main, sponsor these plans as an accommodation or arrangement only.

(In my state of California, for example, state law requires school districts to give access to any provider licensed to sell a product; this is known as the "hog wild" model. Any sponsor that actually does want to provide some modicum of fiduciary responsibility by going to a "RFP model" with the ability to truly screen vendors is therefore prohibited from doing so.)

School districts select providers based on very little investigative criteria and then place them on a list from which school teachers make their investment selections. Teachers naturally assume that their plan sponsor has conducted meaningful due diligence on the providers.

There's not a regulator or a plan sponsor in sight to care about the travesty of this system and its inevitable result: a 403(b) market dominated by providers selling, for the most part, a lot of junky, high-priced, poorly performing (annuity and non-annuity mutual fund) products to school teachers in 403(b) plans. One reader opined that such products offered in 403(b) plans are little more than "an insurance company income stream with no efforts."

That notion suggests the rest of the problem: In the process of delivering investment products to public school teachers (and employees of non-profits) enrolled in 403(b) plans, the main focus is on the convenience and (unreasonable) profitability of the insurance companies that distribute such products. Little more than lip service is paid to what's best for the welfare of plan participants. The process of delivering investment products to public school teachers (and employees of non-profits) in 403(b) plans has become distorted to the point of complete backwardness: providers come first, while teachers (and employees of non-profits) come in a distant second.

The consequences of this distorted process include such absurd and financially harmful (to plan participants but not providers) business practices as seven-year, 14-year, and more annuity surrender fees, two-tiered annuity contracts bearing surrender charges that end only when participants annuitize them (the provider's goal being to retain any balances for participants who die at normal mortality or sooner), or rolling over an annuity into an IRA but having to wait for it to be paid out in five equal annual installments--after paying on the annuity for 20 years. Such business practices that many providers engage in clearly frustrate the portability provisions of EGTRRA, which are applicable to all types of retirement plans, including 403(b) plans.

The Horribly High Costs of Most Investment Products Offered in 403(b) Plans
The worst business practice of many providers, though, involves the horribly high costs of the investment products they offer in 403(b) plans. And yet those such as the following reader doubt (or don't understand, or don't want to understand) that plain fact: "Unless you have data to support your statement [that insurance companies offer annuities charging fees ranging from 200 to 500 basis points], then you should retract it as a gross misstatement. I have never seen any annuities from the top companies that have fees anywhere near that range. My unofficial estimate is that total mortality and expense, plus administrative fees range from 1.00-1.85%."

I think that part of the problem in failing to understand the enormous amount of fees packed into many of these products is that most of the advisors selling them have been trained by insurance companies to focus on their benefits--not their detriments such as punishingly high fees. Many of these people, with all due respect, are therefore blinded to how managed money really works. For example, the cost of one particularly egregious product, the NEA Valuebuilder annuity, can easily reach 500 basis points once all expenses are understood properly. The national media has spotlighted this subject for nearly two years now; just Google it and you'll see that I'm not making up this stuff. Another such example is the product sold by the New York State United Teachers that caught Elliot Spitzer's eye. Data from Cerrulli, LIMRA, and Spectrum all support my 200-500 basis points assertion. I'm sure that there are still many Doubting Thomases, so now let's examine these various costs a bit more closely.

Explicit Costs
Explicit costs include 1) (for variable annuities only) mortality and expense fees (M&E) of 125-145 basis points (this is the industry average; note that the "gross misstatement" critic admitted to a wider range of M&E fees: 100-185 basis points). M&E is supposed to cover mortality and expense, but of course, it mostly covers profit. This is clear once you understand that the insurance company actuaries all use the same numbers for mortality; yet the high cost providers charge 125-145 basis points for M&E while the low costs providers charge about 25-30 basis points. Explicit costs also include 2) a mutual fund annual expense ratio of about 150 basis points (this is the cost of the average mutual fund; it includes, for example, investment management fees and 12-b(1) fees). The explicit costs associated with a variable annuity on the low side are, therefore, 250 basis points (the M&E fee of 100 basis points plus the fund annual expense ratio of 150 basis points). The high side is 335 basis points (the M&E fee of 185 basis points plus the fund annual expense ratio of 150 basis points). Both the low side and high side of explicit costs can increase if riders for living benefits are elected--which is being done more and more now.

Implicit Costs
Implicit costs include: 1) brokerage commissions paid on transactions of 45 basis points. This cost is not included in a fund's annual expense ratio but instead in a separate, obscure document called a Statement of Additional Information. Implicit costs also include 2) bid-ask spread costs (these costs provide a "market maker" with a profit for providing liquidity in a market) of 40 basis points (for the most liquid stocks) to 1,000 basis points (for the least liquid stocks), and 3) market impact costs of 40 basis points (these costs arise from the impact on the market price of a stock when it is bought or sold). The implicit costs associated with a variable annuity on the low side are therefore 125 basis points but can all the way up to more than 1,000 basis points. Let's not forget that many of the mutual funds used in annuities are actively-managed and, therefore, have much higher costs than passively managed mutual funds (i.e., index funds and asset class funds).

The Bottom Line
Now to total things up: Explicit costs of 250-335 basis points plus implicit costs of 125 basis points (I'll ignore the 1,000 basis points, since that's just too scary) for a grand total of 375-460 basis points. By the way, did I mention the 1) cost of surrender charges, 2) the cost of additional investment advisory services that might, just might, sneak in somewhere, 3) commissions received for buying and selling to retail buyers (which being explicit costs are different than the implicit brokerage commissions earned on transactions internal to a mutual fund), or 4) the cost of the increasingly negative compounding effect caused by lost money?

In a world where two of the most successful investment gurus of all time--Sir John Templeton and John Neff--outperformed the market by an annual average of only 200 to 300 basis points over 30-plus years of investing, the risk posed to participant retirement lifestyles by 200-500 basis points (or 375-460 basis points) of costs becomes painfully clear.

Matthew D. Hutcheson, a prominent and highly respected independent pension fiduciary, testified on March 6 before the Committee on Education and Labor of the U.S. House of Representatives. His testimony that 401(k) fees typically range between 300 and 500 basis points was criticized by some in the mutual fund and insurance industries. Sound familiar? Hutcheson was spot on in his testimony about this issue and should be praised, not castigated, for bringing it to the attention of the Congress.

The issue isn't that Hutcheson is trying to do away with mutual funds and annuities. Rather, the issue is to shed light on these investment products so that sponsors and participants alike have a fighting chance to understand their true costs. If that should come to pass, the "silent hand" of Adam Smith's free markets can operate more efficiently to help bring down these scandalously high costs.

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