403(b) Plans Not Adding Up

Ben Franklin said "a penny saved is a penny earned." This simple but powerful adage underlies any savings and investment program, whether established by someone on their own or whether they participate in a private retirement plan such as a 401(k) plan. The lower the costs of investment options incurred when making contributions to a nest egg (a penny saved), the more money that becomes available to invest and grow that nest egg (a penny earned). In the context of a retirement plan portfolio, this adage ignores that crazy little thing called risk, but this month's column focuses generally on costs.

Franklin's adage also applies to, say, retirement plans in the public sphere, such as 403(b) plans made available to educators by public school districts. It's no secret that many educators participating in 403(b) plans are forced into suboptimal investment options, such as high-cost annuities and mutual funds. Why? Because in many states like California and Texas, school districts can offer educators just about any looney insurance company-issued financial product no matter how high their costs may be and how imprudent they are. In such states, the bad guys rule the roost and the good guys--low-cost providers--stay away because they refuse to sign school district hold harmless agreements, which legally shield districts from unforeseeable events that may negatively impact a provider.

One aspect of the product delivery system devised by insurance companies is to turn loose pizza-peddling salespeople on educators in school lunch rooms and ambush them. These peddlers of some of the worst financial products devised by humanity pose as "financial advisors" to offer seemingly "free" products whose real costs are hidden (and therefore high) in the fine print.

Educators are bamboozled by other misleading sales tactics, such as, "We're approved by the school district," or "The school district asked me to personally meet with you," and other official-looking messages sent through school district email. Such communications, seemingly endorsed by a trusted source, are meant to fool educators into purchasing unnecessarily high-cost annuities, expensive mutual funds, and, yes, even cancer insurance.

Many educators in California, for example, don't realize that the average California State Teachers' Retirement System or California Public Employees' Retirement System pension covers only about 50% of the income they will need in retirement. Nor are they aware that when they're contributing to CalSTRS, they don't pay into Social Security, which means they won't be credited with Social Security benefits during that period of nonpayment.

So while investing in a CalSTRS/CalPERS (or any) pension is a great start, it's only half the story. The other half should include investing in a 403(b) plan that can nicely supplement a pension. This notion can be summed up by the equation: CalSTRS or CalPERS + a 403(b) plan = retirement income when no longer working.

While enrolled in a 403(b) plan, a participant may contribute up to $19,000 annually or up to $25,000 each year, if they are age 50 or over. Contributions are deductible on a participant's income tax return in the year in which they're made. Those contributions, and any earnings and interest they generate, grow tax-free. Withdrawals in retirement will be taxed at the tax bracket a participant is in for the year in which the withdrawal is taken.

Instead of being fleeced by high-cost 403(b) plans, what would a truly great 403(b) plan look like? A 403(b) plan featuring investment options low in costs (and, yes, broadly and deeply diversified to reduce risk), one that would place the interests of too-often abused educators first before those of, say, giant insurance companies and their pizza-pushing progeny.

A private study recently simulated the impact of low fixed costs compared to high asset-based costs, and their respective effects on the increasing balances in a 403(b) plan over the course of an educator's career, typically 25 years. The study's chief findings: The 403(b) plan with low fixed costs was nearly four times less expensive for an educator over a 25-year career than the average mutual fund-based 403(b) product with high asset-based costs, and four times less expensive than the average annuity-based 403(b) product with high asset-based costs.

The moral(s) of the study:

• Low costs are good
• Low fixed costs are even better
• High costs are bad
• High asset-based costs are even worse

The secret sauce of a truly great 403(b) plan is a low fixed costs pricing structure which results in greater compounding of wealth than the products in many 403(b) plans that feature high asset-based costs. It's critical for school districts to understand how much high--and ongoing--asset-based costs can erode savings in a 403(b) plan over an educator's career. School districts that do understand this concept and adopt a truly great 403(b) plan for their educators would make Ben Franklin proud.

Other features of a truly great 403(b) plan should include:

• A formal endorsement and thorough vetting of the plan by the union representing educators
• The union should derive no revenue whatsoever from such an endorsement
• The plan should be governed by the fiduciary standards of loyalty and care which legally require that the interests of plan participants come first--not those of nonfiduciary "financial advisors"
• No minimum amount required to begin contributing to the plan
• No annuities offered by the plan whether fixed, variable, or equity indexed
• No commissions (a high proportion--70%--of products offered in 403(b) plans bear a commission)
• No surrender charges (60% of products offered in 403(b) plans bear a surrender charge)
• No "managed accounts," which can increase costs from 25 to 75 basis points
• Low fixed dollar administrative costs
• Low asset-based investment costs
• Transparent, low cost, high-quality institutional investment options with no fine print, hidden costs, or restrictions
• The plan should be widely available in a state's school districts, thereby allowing continued contributions even when changing jobs within the field of education
• The ability to move assets to the plan from a 403(b) plan or other plans at previous employers
• The ability to move assets to the plan from a 403(b) plan currently invested in at a school district
• Investment options should be recommended and monitored by an independent consulting firm with no conflicts of interest with plan participants
• Allowance of loans for emergencies as well as hardship withdrawals
• The ability to reinvest in another plan investment option at any time
• If leaving the teaching field, the ability to keep assets in the plan or roll them over to a new plan
• Even after retirement, the ability to keep assets in the plan or roll them over to an IRA
• Annoying, high-pressure salespeople would not exist

Access Scott's article archive here. W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement (Third) of Trusts. He provides services as a consultant and expert witness on fiduciary investment issues in litigation, arbitrations and mediations, which are described here. For more information, visit Prudent Investor Advisors or email wssimon@fiduciary-experts.com. The views expressed in these articles do not necessarily reflect the views of Morningstar.