Why You Should Watch Out for 403(b) Plans
Financial experts and activists Dan Otter and Scott Dauenhauer discuss the major pitfalls of 403(b) retirement plans for educators.
On this episode of Morningstar's The Long View podcast, Dan Otter and Scott Dauenhauer discuss their website 403bwise and their work with education and advocacy for educators and their retirement plans.
Here are a few excerpts from Otter and Dauenhauer's conversation with Morningstar's Christine Benz and Jeff Ptak:
Why Are 403(b) Plans So Bad?
Ptak: We wanted to talk about why 403(b)s are so bad. I don't think there's any sort of delicate way to put it. We wanted to discuss some of the key problem areas in the 403(b) market. But before we do that, let's discuss why people should care. Some people might think teachers usually have pension plans, and even teachers might adopt that mindset themselves that their 403(b)s aren't the main financial engine of their retirements. So, why care that much? Do you think that's why 403(b)s are so poor in so many cases?
Otter: No. As I mentioned earlier, I think ERISA is a big driver of the problems. Employers are not required to offer a great plan. So, consequently, they don't. But there are few teacher pension plans that will pay out 100% of a teacher's final salary in retirement each year. Pension benefits have been reduced across the board, especially for new teachers. So, we would argue that the 403(b) is even more important. But here's the irony. I think it also comes down to education, the lack of education. Teacher programs are simply not teaching this to teachers. So, they come onto campuses completely unaware, and what happened to Scott's wife and what happened to me is still happening across schools around the country. And also, school districts are not providing education. And sometimes they're making it worse. Sometimes at new teacher orientations, they're having these high-cost companies "put on education" for the new teachers.
Pension Penetration and Education
Benz: Scott, Dan just noted that some districts have scaled back their pensions. How commonplace are those efforts to reduce pension benefits? And I guess a related question is, do you think we'll eventually see pension penetration ebb away in the education space, just as we've seen it happen in the private sector over the past several decades?
Dauenhauer: Generally, pensions are dealt with on the state level, although there are a few school districts that do have their own pension systems. Chicago, is one of them; New York City, they also have it. Chicago was famously underfunded, which I think leads into that second question of yours. I actually don't think that pensions are going away for educators. I think they're here to stay. I don't think that they're going to go anywhere. I think there might be certain states where they will go away, or they will become a lot less part of the overall benefits package. But I think they're going to be around to stay. They are getting less beneficial, though. They're getting tough to qualify for, they're more back-loaded, and I think that's a real issue. And it's one of the main reasons why teachers do need to be contributing to these defined-contribution plans or making other investments along the way, but I don't think they're going away entirely.
ERISA Does Not Require 403(b) Plans
Ptak: You mentioned earlier the fact that 403(b)s are not covered by ERISA, at least in many cases, if I've got that right. Maybe talk about some of the other key factors that cause the 403(b) space to be a Wild West compared with 401(k)s. Why is the oversight so much less in that space?
Otter: Again, I think, the main culprit is, it's not required under ERISA. But let's put some of the blame on the school districts themselves. No one says that they can't offer a great plan. So, I would put some of the blame on them. If you contrast this with nonprofit institutions, which have ERISA-based 403(b) plans--nonprofit hospitals, colleges--they offer great plans. Again, I realize more fiduciary oversight is required, but they're both 403(b) plans.
Dauenhauer: Jeff, if you wouldn't mind me jumping in on this one as well. We like to draw the parallel with 403(b)s to another government plan, a 457(b), which is offered to state and local government employees. It's a huge plan. If you know a judge, a policeman, a firefighter, anybody who works for state and local government in your city, they probably have access to a 457 plan. And those plans almost universally are way better than 403(b)s, and yet they are not governed by ERISA. The difference is, almost every single state has passed a set of fiduciary laws that apply to these programs. And most of those fiduciary laws hearken back to the same language of ERISA. So, I do think that you can have a government-run, a state, local government-run plan that is also good, because we see it every day in these governments' 457 plans.
Fiduciaries and 403(b) Plans
Benz: You note that many investment professionals in the 403(b) space aren't fiduciaries. You talked about some of the high-commission salespeople roaming the halls. Why is that? And is there any chance to enact change there to ensure that anyone selling these 403(b) plans be a fiduciary?
Dauenhauer: Well, it's a good question. That's where it gets a little difficult in this space. Part of the reason we don't have a lot of fiduciaries in this space is because of the way it's structured. Historically, 403(b) plans, at least for K-12 public schools, have been how Dan and I term "multiple vendor," meaning there's more than one vendor and there's really no vetting or very little vetting of those vendors. And because of that there's not any one vendor that can get an economy of scale. And so, it's pretty much every vendor fighting for themselves to get access to employees and to gain assets, to get contributions.
Unfortunately, what happens there is, the only products that are going to gain assets are those products that can afford to put human beings on the ground. And so, most investment professionals like myself, we're not going to go sit in a teachers' lounge. I'm not going to bring doughnuts to the teachers' lounge or sandwiches to the teachers' lounge, I'm not going to do that. Number one, I'm a financial planner. I don't have time for that. I do a lot of work. I can't just be spending time handing out doughnuts and signing up people for $50 contributions. And yet, that is the structure of how many of these 403(b) programs work. Whoever gets in front of the teacher gets the sale.
Unfortunately, the only products that can pay those people enough money to keep them doing that kind of business are products that are very low in quality and high in cost. And so, those are antithetical to a fiduciary. That's why we don't see many fiduciaries in this space. It's just not set up for that environment. I ended up getting into the space and working initially on an hourly basis with educators, and that was a really difficult thing to do, because they all assumed they were getting these services for free. And they didn't realize that these people were getting paid, and they were getting paid through commissions, and they weren't seeing this on their statements. So, it's partly the way that the plans are structured in this multiple-vendor environment. You switch that to say a single-vendor environment where all the assets are going to one recordkeeper, you then create an economy of scale that allows you to do education, to help people sign up at a much, much lower cost than you do if it's spread across 20, 30, or 40 vendors.
Who Is Gatekeeping the 403(b) Plans?
Ptak: Who are the main gatekeepers for 403(b)s in a school district? I would think it's maybe somebody that's akin to a CFO or a head of ops. And who is signing off on the providers that make it onto the menu? And then, a related question: You talk about the profusion of different providers within a district because that overgrowth is just permitted. Why haven't we seen some of the bigger players try and come in knowing that it's a fairly fragmented market, but it's one that's fairly large and potentially lucrative, and compete on price and try and sell districts on consolidating to a single provider that can deliver higher-quality service at a lower cost?
Dauenhauer: Ultimately, it's the school board who signs off on who the vendors are. But you would think that it would usually run through the CFO, and sometimes it does. But generally, the people who are in charge of putting vendors on the list are the third-party compliance administrators that school districts hire to run the plans. There's a lot of rules and regulations. And when you have multiple vendors, like, five, 10, 15, 20 vendors, there's just so much going on that most school employers just don't have the resources to manage that and keep it in compliance with the IRS. So, they end up hiring these outside compliance administrators. And they will tell you that they don't control the vendor list, but they control the vendor list. And oftentimes, it's just the school district adopting whatever that compliance administrator has. Often the people in the district could ask for a good low-cost vendor to be added to that list and oftentimes they will be added. But you usually have to ask. And sometimes when you ask, they're still not added. So, oftentimes, it's the compliance administrator, not really anybody at the school making these decisions.
As to why there's no competition or why the larger companies aren't coming in to create that competition. We have been advocating for that for years, almost two decades. In fact, one of our very first initiatives here in California was to allow for a school district to manage its vendor list. In California, you have these large vendor lists because of an odd insurance code that we have here, and we wanted that to be changed. And that the school district could just say, "We're going to have one vendor and that's it." And it's been a long time and there's been a lot of resistance to that mainly from the insurance companies. They have a very powerful lobby. Also, I won't mention the group's name, but another lobbying organization that's very, very big--they spend a lot of money to send people out to shoot down these ideas, and politicians need to get re-elected, and they need the insurance company money.
That said, we have started to see a shift from some of the insurance companies, but from some of the bigger vendors as well toward this single-vendor model going into a school district and getting them to consolidate. We've seen it in Montgomery County Public Schools, up in Anchorage, and the latest one, which is I think momentous, is the Chicago public schools. They just this year consolidated down--you guys might be familiar with this one, given where you're located--they just consolidated down to one vendor. And that vendor actually is AIG, but it's actually a very good program. It's one of the best 403(b) programs we've seen in a long time. We think that this trend is here to stay. But it's a lot of work to do that. And it takes some real commitment on the part of the school district. It's easier to do for a larger school district than a smaller school district. But I think that's going to be the trend. It's just going to take a while. At least, we hope it's the trend.
This article was adapted from an interview that aired on Morningstar's The Long View podcast. Listen to the full episode.