Navigating the (Often-Confusing) 403(b) Landscape

In many respects, 403(b) plans--retirement savings plans for nonprofit entities such as museums, charitable organizations, and public schools--are just like 401(k) plans. Participants contribute a portion of their paychecks, and the savings grow tax-deferred (or even tax-free--many 403(b) plans now offer a Roth option). The contribution limits are the same for both types of plans.

A crucial difference, however, is that many 403(b) plans venture beyond the usual 401(k) staples of index funds and target-date vehicles and into more costly products, including variable annuities. We recently interviewed Dan Otter, whose website, 403bwise.com, aims to help investors make sense of the often-confusing 403(b) marketplace. Otter discussed the 403(b) landscape and shared tips for 403(b) participants aiming to sift among a confusing array of choices.

Christine Benz: Say I've just started a new job with a 403(b) plan on offer. What are the key factors I should be looking at as I evaluate the quality of the plan? What are the red flags that should alert me to avoid a plan?

Dan Otter: I'd look at two factors: 1) the cost of the investments and 2) the availability of index mutual funds and target-date mutual funds.

Unfortunately, too many 403(b) plans, particularly at the K-12 level, are limited to variable annuity "choices." These insurance products generally charge about 2.25%. That's way too much to pay for an investment. There's a wealth of empirical data supporting the impact of fees on return. This chart says it all.

I've become a big supporter of target-date funds. They are so simple and logical. I love the fact that the investor only has to make one decision: picking a fund aimed at a date in the future they intend to retire. This type of fund automatically becomes more conservative the closer it gets to that date.

Benz: Are there any expense benchmarks that I should be paying attention to? What's too much to pay?

Otter: I strive to never pay more than 0.5% (50 basis points) in total--any more than that and you start to lose the advantage of the tax deduction. With variable annuity products, there's something called a mortality and expense charge (a.k.a. M&E); these charges average in the range of 1.25% per year. In large part, M&E charges go to compensate the salesperson selling the product. It is important to point out that this fee is in addition to the fees charged by the underlying investment, typically a mutual fund. You can see how easy it is get north of 2% in fees with variable annuities.

Another toxic feature of many variable annuity products are surrender charges. These last seven years, on average, and cost participants a percentage of their balances if they wish to move into another choice offered by their employer. Some companies apply a rolling surrender charge. This means that each new contribution locks that money into a new seven-year time period. It is often very difficult for participants to find the true cost of variable annuity products. As you can imagine, salespeople are not going to highlight M&E charges and surrender fees. In many cases a participant will need to look at the prospectus to find this fee and surrender charge information. The state of California makes available a terrific resource, 403bcompare.com, that any teacher with access to a computer can use to find the fees charged by most companies offering 403(b) products.

Benz: Are 403(b)s drifting away from annuities, or are they still pretty prevalent?

Otter: I do believe that s-l-o-w-l-y 403(b) plan sponsors are realizing the benefit of moving away from annuity products. As this table shows, however, the 403(b) market is still dominated by annuity products. The good news is that companies previously known for high fees are beginning to roll out lower-cost investment offerings. For example, ING has something called Educators Direct, which is made up of target-date retirement funds. I believe they see the writing on the wall.

Benz: If I've done my homework and determined that my plan is horrible, do I have any recourse apart from just avoiding the plan? Who's making decisions about the plan, and who can I complain to if I have a problem? Do I have a realistic shot at enacting change? Are the individuals charged with overseeing the plan required to be fiduciaries?

Otter: Sadly, this is the case for far too many 403(b) plans. Assembling the lineup varies by employer. Some schools are part of a consortium; some choose individually. Public 403(b) plans are not subject to ERISA, so the fiduciary responsibility is pretty minimal. Here's an overview of the new regulations that went into full effect at the beginning of 2010. 

In any case, I recommend starting with the human resource department. Ask questions. Ask why these particular investments were chosen. Ask if any attention was paid to cost of investments. I would share this fee chart. The people making the decisions are also participants. It's in their interest to have better choices. Enlist co-workers in the effort.

If all else fails, I recommend starting a Roth IRA. The beauty of this retirement plan is that an individual can invest with any financial company they want. This means they can have access to the likes of Fidelity, TIAA-CREF, T. Rowe Price, Vanguard, and USAA. These firms are known for offering high-quality services and products at reasonable prices. The downside, of course, is as of 2012 an individual under 50 can only contribute $5,000 a year. But for many teachers just starting out, this is a significant amount. The other big difference is that with a Roth IRA, the contributions are made with aftertax money, so contributions do not reduce taxable income. However, eligible withdrawals are never taxed.

Benz: 403(b) plans also can have multiple vendors, right? On the surface, having more choices seems like a positive, but are there drawbacks?

Otter: Research is pretty clear that the more choices in a retirement plan, the smaller the participation rate. Salespeople love to trumpet "choice," but the truth is most 403(b) plans are limited to lots of bad choices. The problem is that too many employers operate an "any willing provider" environment. This means they often permit any company that wants to offer products to do so. This is in contrast to the controlled access model in which the employer vets companies on criteria including fees and sales practices. The result? If done right, participants will have several high-quality low-cost choices, and the sales environment can be replaced with an education environment. Research from the TIAA-CREF Institute shows that teachers in a controlled access model accumulate more money for retirement

Benz: This is a huge question, but what are the key pitfalls for 403(b) investors to avoid?

Otter: First, investing in expensive products, and second, not learning how the plan works before investing. Participants should spend time at www.403bwise.com and with other resources educating themselves before starting. I get many e-mails from participants stuck in products with surrender charges because they trusted their employers or the salesperson. Individuals must be active participants in the investing process.

Benz: 403(b) plans can now offer a Roth option. What do I need to know about this, and how can I assess whether making Roth contributions is the way to go?
 
Otter: Its tax treatment is the same as the Roth IRA: contributions don't reduce taxable income, but eligible withdrawals are never taxed. A Roth 403(b) can be a good way to diversify your tax obligations--pay some taxes when you make your contributions and pay some taxes when you begin withdrawing money in retirement. It really comes down to the individual. Do they need the upfront tax deduction offered by a regular 403(b) or would they rather have tax-free withdrawals down the road? The good news is that a participant can contribute to both a regular 403(b) and a Roth 403(b). Total contributions to both plans cannot exceed the year's contribution limit ($17,000 in regular contributions as of 2012 for those under 50). Not all employers offer a Roth 403(b), though, and nor are they required to do so.