It's hard to justify putting school teachers in a tax shelter within a tax shelter.
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 Services
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."