Making More of Your 403(b)

More than six million workers make use of this quirky tax-deferred savings tool. Here's how they can get a better deal.

by Lynn O'Shaughnessy

If you're a teacher, doctor, nurse, church choirmaster, or anyone else who toils for a nonprofit institution, you may sometimes wonder if your retirement plan was assembled on another planet. That's because the main savings vehicle most likely offered to you is the 403(b), a plan that one industry expert describes as "weird" and "bizarre."

If it's any comfort, the government didn't set out to make the 403(b) so convoluted--it just turned out that way. From the time it was created in 1954 by a provision in the Internal Revenue Code, the 403(b) has been a plan in transition, constantly tweaked to meet more needs.

What exists today is, indeed, a bit unusual, but it's also the best retirement hope of more than six million Americans. As with the 401(k), which serves employees of for-profit enterprises, 403(b) contributions can be made pretax, and money compounds tax free while it's in the plan. Both plans permit the same annual tax-advantaged contribution--this year, $10,500.

But that's where the similarities end. What sets the 403(b) apart is everything else about it. For example, the 403(b) often allows "catch-up" contributions for late starters, while 401(k)s don't. But there are also drawbacks that can make successful 403(b) investing a real challenge.

For starters, the 403(b) is not really a "plan" at all but an arrangement between an employer and an outside provider--typically an insurance company--that supplies investment products to the organization's employees.
That difference stems from the fact that in a qualified plan like the 401(k), the administrator must file a plan document with the IRS and supplement that with annual federal filings. In 403(b)s where only the employee is making contributions (that's the case for many educational institutions), there's no plan per se, just that service arrangement under a 403(b) umbrella. There are no federal filings, so administrative costs are low--an important consideration for most schools.

The unfortunate consequence of that arrangement is that, unlike many coddled 401(k) investors, 403(b) savers are generally sold their investments by insurance agents. Many agents have steered clients into their own stock-in-trade investment product, the annuity. Of the $422 billion invested in 403(b) accounts, 52% of it sits quietly in fixed investment annuity contracts, according to Spectrem Group, a financial-services consulting firm in San Francisco. That's down from 68% in 1992, but it still relegates an outsize share of retirement money to subpar performance.

Part of the problem is that some 403(b)s don't offer better alternatives, but the larger issue is the lack of good information on investment choices. Instead, the lion's share of education (and press coverage) goes to 401(k) investors, who enjoy plentiful books and pamphlets on their plans plus countless Web sites devoted to 401(k) investing strategy. It's no surprise, then, that 403(b) investors feel left out. That's unfortunate because many 403(b) participants grapple with even tougher decisions than their 401(k) counterparts.

If you've ever tried to decipher the fee structure of an annuity (think redemption fees, surrender charges, subaccount fees, etc.) you'll appreciate what 403(b) savers are up against--and that's before any discussion of portfolio strategy or asset allocation. Says Shane Chalke, president and founder of AnnuityNet.com, an Internet annuity provider: "Many people with little investing savvy--employees of nonprofit groups--must choose from among the most complicated investing products around."

Fortunately, some people choose well nonetheless. Take Michael McCormack, the athletic director at Christian Brothers High School in St. Louis, Mo. He's been faithfully putting money into his 403(b) every month since 1982, when he was a young assistant principal at a rural Iowa school district. A social studies teacher encouraged him to sign up for a variable annuity, which put him into equity funds. "Saving this way gives me a break on taxes each year, in addition to growth," says McCormack, the father of four children. Each year, his financial planner reviews his asset allocation to make sure it's on target. "By the time I retire, I'll have a nice little nest egg."

The federal government is quite particular about who qualifies for a 403(b). If you occupy a cubicle at IBM or a similar corporation, you're not eligible. The accounts are reserved for educators, hospital personnel, and people on the payrolls of charities and churches. Beyond that, just who qualifies can be reduced to hairsplitting. A blood bank worker or a symphony musician could qualify, but somebody working for a chamber of commerce or a veterans hospital couldn't. (If you're looking for a logical explanation for this, don't.) A 1996 federal law lets nonprofits, excluding government entities, offer 401(k) plans instead, but there have been few takers.

Despite an open market in the 403(b) business, a mere 15% of total assets is invested in mutual funds. Big fund companies fight tooth and nail for other markets but generally concede the 403(b) market to the insurance industry--and those annuities.

In one respect, annuities can be good choices for retirement. A retired teacher with an annuity, for instance, can opt to receive her money in monthly checks that she can't outlive. The insurance company assumes the risk that the teacher will live longer than anticipated. If the teacher sprints past the actuarial predictions, she can end up pocketing far more money than her savings alone would have financed.

"With people living longer and longer, it's important to have at least a portion of assets allocated to an annuity that guarantees payments for the rest of somebody's life," asserts Mark Mackey, the president of the National Association for Variable Annuities, a trade organization.

Annuities, however, are far from ideal. First, why would tax-sheltered 403(b) investors want to pay for a tax-sheltered product like an annuity? Annuity fees are often stiff, including sales commissions that can range from 5% all the way to 12% or so.

Unneeded insurance coverage also boosts costs. Annuities provide death-benefit coverage, which mutual funds don't offer. While this coverage comes in many flavors, here's how the basic insurance works: Let's say someone invests $50,000 in a 403(b) annuity over the years, but when she dies the value of the account has slumped to just $45,000, thanks to a wretched stock market. Since the money is insured, the heirs would be entitled to the $50,000.

Skeptics like Janet Briaud, a certified financial planner in Bryan, Texas, insist that this insurance coverage is merely cosmetic. After investing for many years, the value of just about any portfolio should far exceed contributions. "What you're getting is a guarantee that you'll get your money back later," says Briaud, who estimates that 60% of her clients have 403(b)s. "Getting your money back is not a good deal. I certainly wouldn't pay for that kind of insurance."

TIAA-CREF, the nation's biggest 403(b) provider, happens to agree with critics like Briaud. "We are the first to admit that minimum guaranteed death benefits are not a great value," says Michael Heller, TIAA-CREF's vice president of actuarial pension services. In fact, TIAA-CREF doesn't offer the insurance in its 403(b) annuities.

Beyond such quirks, the big question remains: Why do annuities remain so popular with 403(b) investors? It's simple: Insurance agents enthusiastically promote, explain, and sell them--in person. An agent will gladly meet with nurses in a hospital cafeteria or sit with a teacher in her living room. Representatives from Vanguard or Fidelity Investments, who don't work on commission, aren't going to pay a house call to a fourth-grade teacher struggling with investment choices.

Paul Heller, who heads the Vanguard Group's defined-contribution division, says having 403(b) sales rigged in favor of insurance products hurts investors. "I think it's sinful," says Heller of the sales process. "So many people make investing decisions based on some relationship. They think to themselves, 'This seems like a pretty good guy; he seems to know what he's talking about.' They don't realize, however, the full agenda."
If you're eligible to participate in a 403(b) plan, you owe it to yourself to grill all the contenders before deciding where to park your money. If you're unsure how to proceed, seek the help of a certified financial planner, who can review your options objectively. Do-it-yourselfers will want to see if their local library carries Morningstar's Variable Annuity and Life Performance Report, which evaluates the underlying investments of many annuities.

It's even more important to do your homework because your employer isn't doing much, if any, screening for you. While a corporation will typically select one 401(k) provider, a school district or university may welcome aboard just about any interested insurer or mutual fund firm. Instead of just one choice of investment provider, a professor might be confronted with a dozen.

Of course, this flexibility can be an advantage for someone who wants to invest in a variable annuity that's not currently offered by an employer. McCormack, for instance, has carried his American Express variable annuity with him from Iowa to two employers in St. Louis. In both cases, his new employers did not initially offer the product but added it to their 403(b) rosters for him. Currently, he has his annuity money divided equally among American Express New Dimensions, AIM Growth and Income, Templeton Developing Markets , and a fixed account.

Before committing to any 403(b) investment, ask the following questions:
1) Will I be penalized for pulling my money out? "This is the most important question you can ask," says Marianne Shine, a certified financial planner in Deerfield Beach, Fla. Annuities typically penalize investors who bail out. During the first few years of the contract, you may have to pay surrender charges if you transfer your money elsewhere. Often the surrender fees start at 7% or 8% and decline by a percentage point every year.

If you switch employers and move the money out of an annuity with a surrender charge, you will have to pay the penalty. By the way, you can't roll 403(b) assets into a 401(k) if you switch into the private sector.

Certain surrender fees, however, refuse to vanish. You'll typically discover this nasty surprise with "two-tier" annuities. With one of these, you'll pay a penalty if you decide not to annuitize your payments upon retirement. If you prefer to withdraw your money and invest it elsewhere, you can, in some cases, face a 20% or higher penalty. Unless you're approaching retirement age, it's best to flee from a two-tier annuity, Shine advises.

2) What are my investment choices? The underlying investments within a variable annuity will be mutual funds. An insurance agent will probably refer to them as "subaccounts." What is the performance record of these funds? How does each compare with its appropriate benchmark? If a large-cap growth fund has consistently underperformed the Standard & Poor's 500 Index, for example, stay away.

3) What annual fees will I pay? You should check the yearly expense ratios for annuities as well as traditional mutual funds. Fees can dramatically erode returns over time.

4) How is an insurance company rated? If you are investing in a fixed annuity, you need to know how financially sound the insurance carrier is. You'll want to review the ratings from at least two insurance-rating services such as A.M. Best, Moody's, and Duff & Phelps. You might assume that your money is protected within a fixed annuity, but there's no real guarantee. That's because the money in a fixed annuity is not segregated and therefore can be at risk if the insurer declares bankruptcy.

If you don't like what you see when you examine your 403(b), don't despair. Look for escape hatches. Depending upon your employer's plan, you can switch to an annuity offered by a different insurer or to traditional mutual funds. Sometimes it's as easy as filling out a simple transfer form. Or, just as McCormack did, you may be able to expand your options simply by asking. A school board or charity, for instance, may not offer no-load funds from Vanguard, Fidelity, T. Rowe Price, or Strong, all of which participate in the 403(b) market, simply because nobody has ever asked for them.