403(b)s Becoming More Like 401(k)s--With One Big Exception

Pop quiz. Clear your desk and take out a sheet of paper and a pencil. Here's your question: What is the difference between a 401(k) and a 403(b) retirement plan? The answer, it turns out, is more complicated than many investors--and even 403(b) participants--might think.

Similarities on the Surface
The 401(k) and 403(b) retirement plans are often lumped together because of their general similarities; 457 plans, which are primarily offered to state and local government employees, also share many of these features. In each case employees set aside a portion of their pretax (or posttax if the plan offers a Roth option) income to save for retirement, often with the employer matching at least part of the contribution amount. Annual contribution limits and the age at which distributions may be taken without penalty are the same for both plan types. Although the 401(k) is standard in the business world, the 403(b) is standard in the not-for-profit world--notably among school teachers and college employees, but also among those who work for charities and religious institutions. In fact, college and university employees accounted for 44% of the $882 billion held in 403(b) plans in 2012, followed by public and private K-12 teachers at 33%, health-care workers at 20%, and other not-for-profit employees at 4%, according to data from the Spectrem Group, a retirement research and consulting firm.

Annuity Structure Adds to Expenses
However, unlike 401(k)s, which typically allow participants to invest from a menu of mutual funds or similar accounts through a single plan provider, 403(b)s typically offer plan participants fixed and/or variable annuities, possibly with some mutual funds thrown into the mix, and may ask them to choose from multiple providers, including insurance and investment companies. (About 44% of 403(b) plans offer both annuities and traditional mutual funds.) One problem with the annuity products found in 403(b) plans is that they often are more expensive than the investment options available in 401(k) plans.

"If someone's coming into a 403(b) (from a 401(k)) they're likely to have more vendors, chances are they're going to be weighted toward insurance products, and that means they're going to be paying more," says Dan Otter, co-founder of 403bwise.com, an independent source of information about the 403(b) industry. (To read Morningstar director of personal finance Christine Benz's interview with Otter about the 403(b) landscape, click here.)

Tim Walsh, a managing director at TIAA-CREF, says 403(b) plans have long been annuity-based because, unlike 401(k)s, which were originally designed to supplement pension income in retirement, 403(b)s were designed as core retirement plans. Walsh says 403(b)s are designed to provide income for life and to function similarly to the way Social Security works.

Unlike a mutual fund, which has a set value based on the performance of stocks and bonds held in the fund's portfolio, an annuity's payout is indefinite, providing income to the policyholder for the rest of his life.

But Otter says that fees charged for 403(b) annuity products--fees which run as high as 3% per year--can make them an expensive way to invest for retirement. Part of the problem is the way annuities are sold. Although 401(k) participants are charged fees by the mutual funds they invest in as well as by the plan itself to cover expenses, 403(b) participants investing in annuities may pay plan fees, plus a fee that goes to the insurance salesperson selling the annuity. The sales agent's fee typically runs 1.25% per year. When compounded year after year, these high fees take a substantial bite out of a retirement saver's nest egg.

As if high costs weren't bad enough, some 403(b) providers charge surrender fees on their annuity products. That means that if the participant wants to move money out of an annuity and into another investment--even one within the same retirement plan--he may have to forfeit a percentage of the account. Surrender fees typically remain in effect for the first seven years after the account is opened but that time frame can stretch to as long as 15 years. In some plans, every new contribution made to the annuity is subject to this waiting period, essentially setting the clock to zero for any new money that is added.

Not all plans operate this way. By far the biggest provider of 403(b)s is TIAA-CREF, which manages about $272 billion in 403(b) assets. Most of the company's 403(b) investment options cost less than 50 basis points (0.5%), according to a company spokesperson, and the company does not charge surrender fees on its variable annuities, though it does on some of its fixed annuity products.

Education Key for Plan Participants
Otter says the time for 403(b) participants to educate themselves on how a plan works is before enrolling (and before surrender fees are an issue), and that far too many don't fully understand their employers' plans until they are already in them. In particular, participants should familiarize themselves with how the plan's annuity products work and consider whether they are the right choice for them. Participants in 403(b)s who like the idea of annuities and the guaranteed stream of income they provide might want to consider investing money earmarked for retirement in low-cost mutual funds (either within the plan, if available, or in an IRA). Upon retirement the participant can always use these retirement assets to purchase a simple low-cost annuity, thereby reducing the drag of expenses throughout the accumulation years.

If a 403(b) participant changes jobs or retires he has the option of rolling the assets into the new employer's retirement plan or into an IRA. Another option is to leave the money where it is, which Otter recommends for those who may be forced to pay surrender charges, at least until those charges are no longer in effect.

Otter says that when it comes to researching fees, 403(b) participants often have a difficult time finding answers. He says school districts, in particular, may not provide teachers with adequate information about their 403(b) plans because they see them as supplemental to teachers' pensions. But for 403(b) participants trying to build a sizable nest egg for themselves--including the many teachers nationwide who have seen their pension benefits scaled back or could in the future--understanding plan expenses and how to minimize them could mean a difference of tens or even hundreds of thousands of dollars during a lifetime of saving.

When an employer makes matching contributions to 403(b)s, the plans generally are subject to the Employee Retirement Income Security Act and must meet certain requirements, such as providing a summary plan description that explains how the plan works and providing disclosures about fees. In that respect, these plans are on par with 401(k) plans. But non-ERISA plans, which typically do not offer an employer match and which include those covering public K-12 teachers, are less regulated, making it difficult to determine how much the plan is costing its participants, Otter says. "Generally employers do not have this information. It's up to the individual to find (out)," he says. 

Usually that means contacting the plan provider or providers. One place to research 403(b) providers and the fees they charge is 403bcompare.com, a website operated by the California State Teachers' Retirement System. ​

A Surplus of Choices, A Lack of Advice
Adding to the complexity of some 403(b) plans is the fact that they tend to offer more investment choices than 401(k) plans, which might sound good in theory but can be daunting in practice. Each year the Plan Sponsor Council of America, a group that represents employers that offer worker retirement plans, surveys its members about their 401(k) and 403(b) offerings. Results from 2011 show that nearly half of 403(b) plans offered participants more than 20 funds to choose from, including 13% that offered 50 funds or more. By comparison, less than one third of 401(k) plans offered participants 20 or more funds.

Research in the field of behavioral finance has shown that providing people too many choices can lead to paralysis or poor decision-making. But help in navigating this maze of investment options often isn't available for 403(b) participants. Only one fourth of plans offer their participants investment advice, and among the smallest plans (those with fewer than 50 participants) only one tenth do. By comparison 60% of 401(k) plans offer participants investment advice, the survey found.

How 403(b) Annuities Work
In addition to what often is a lack of fee transparency and investment guidance among 403(b)s, the fact that plans typically are annuity-based creates problems for participants who don't fully understand how annuities work. "These are sophisticated products because they're meant to be accumulation and pay-down vehicles," Walsh says.

With a 401(k), the distribution process is rather straightforward: Once retired, the participant at some point begins taking distributions from the account with the goal of making the money last for the remainder of his or her lifetime. An annuity-based 403(b) works differently, however. Once the participant retires and decides to annuitize the account, he begins receiving a fixed or variable amount of income guaranteed to last for the rest of his life. The amount of the payout is determined by how much the participant has saved and the type of annuity used.

Walsh says participants in his firm's plans typically are given the option of investing in a fixed annuity, a variable annuity, or in mutual funds. A fixed annuity offers a consistent payout for life, and Walsh says participants typically use them to cover basic living expenses such as food and shelter. A variable annuity increases or decreases in value depending on the performance of its underlying investments. Variable annuities may be invested in stock or bond funds, Treasuries, or real estate. Walsh says these are often used to provide additional income for retirees. (For information on the pros and cons of different types of annuities, see this article.) Money left in a 403(b) does not have to be annuitized upon retirement. It could be left as is and annuitized later, or rolled into an IRA.

Fixed annuities accounted for nearly half (47%) of all 403(b) assets at the end of 2011, with variable annuities accounting for another 31% and mutual funds making up just 22%. Contrast that with 401(k) plans, in which mutual funds accounted for 60% of assets, according to figures from the Investment Company Institute, and it's clear that the annuity feature is a key difference between the two plan types.

Walsh says the fact that 403(b)s are annuity-based helps participants become more comfortable with the idea of investing in a source of lifetime income. He says that well more than half of participants in 403(b)s managed by his firm annuitize assets at some point, whereas the percentage of 401(k) participants who do so is less than 10%. (Fewer than one in five 401(k) plans allow participants to annuitize their distributions in retirement, according to the Plan Sponsor Council of America survey.)

403(b)s, 401(k)s Becoming More Alike
However, the historical differences between 401(k) and 403(b) plans have diminished in recent years. Walsh says Pension Protection Act of 2006 brought the two plan types closer together in terms of regulation--what he calls "the 401-ization of the 403(b)." Among these changes, he says, is that 403(b) plans increasingly are run by a single provider rather than the multiple providers of years past.

Otter says he sees improvements in the 403(b) landscape under the new rules. "I think the trend is headed in the right direction," he says, adding "[But] I'd like to see fee-transparency disclosures required in the public 403(b) arena."

Walsh says that another way the two plan types are becoming more alike is that more 401(k) plans are adding annuities to their menu of investment options. "It's fascinating because now 401(k)s are becoming more like 403(b)s in exploring lifetime income options," he says, "so the two are sort of coming together."

Given the complexity of annuities and determining what strategy works best for each individual, 403(b) plan participants invested in annuities might consider talking to a financial advisor to help decide how best to use them. Another strategy that might make sense--especially for those offered a 403(b) with no employer match and who don't like the plan's investment options--is simply to fund an IRA by using some or all of the money you would have contributed to the 403(b). That way you have more control over how the money is invested, and you can still enjoy tax-advantaged retirement saving, though your contributions will be limited to $5,500 annually ($6,500 if you're over 50). Above all, educate yourself on how the plan works. Otter's website is a good place to start, and of course reviewing the plan documents is always a good idea.