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| Fiduciary Focus: Fleecing 403(b) Plan Participants (Part 3) |
| by
W. Scott Simon
| 06-07-07 |
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In April's column, I wrote: "Large insurance companies that offer annuities [in 403(b) plans] charge schoolteachers unconscionable fees ranging from 200 to 500 basis points in exchange for poorly performing investment products and services provided by salespeople disguised as 'financial planners.'"
Since one reader characterized that range of 200 to 500 basis points as a "gross misstatement," I set out to show in May's column that 403(b) plans not only have explicit costs but also implicit costs, which such readers seem to outright ignore as if they don't exist.
But alas, all those costs (and more) do, in fact, exist: 1) explicit costs (for variable annuities only), which can range from 250 to 335 basis points (or more if a rider for living benefits is added, for example), are composed of mortality and expense fees of 100 to 185 basis points and a mutual fund annual expense ratio of 150 basis points, and 2) implicit costs, which can range from 125 basis points to more than 1,000 basis points, are composed of brokerage commissions of 45 basis points paid on transactions, bid-ask spread costs of 40 to 1,000 basis points and market impact costs of 40 basis points. Based on this, I came up with an estimated grand total of 375 to 460 basis points (or more) which, though I didn't advance beyond 10th grade algebra, I believe is in the more expensive part of the neighborhood of that gross misstatement of 200 to 500 basis points.
"Per Head" Administrative Charges
But wait (as the infomercial goes), there's more! The "more" is an annual administrative charge of $25 or $30 borne by a teacher's 403(b) account (which ends only when an account grows typically to $30,000). This kind of charge has a particularly lethal effect on school teachers who are in the early stage of their careers and therefore are not usually deferring a lot of money. For example, suppose that a teacher defers $100 per month into its 403(b) account for five years, the account grows at 8% per year and the teacher is assessed an annual per head charge of $25:
Year 1: $25 ÷ $1,200 = 2.08%
Year 2: $25 ÷ $2,496 = 1.00% ($25 ÷ $1,200 + year 1 plus earnings)
Year 3: $25 ÷ $3,896 = 0.60% ($25 ÷ $1,200 + prior two years plus earnings)
Year 4: $25 ÷ $5,408 = 0.40% ($25 ÷ $1,200 + prior three years plus earnings)
Year 5: $25 ÷ $7,040 = 0.36% ($25 ÷ $1,200 + prior four years plus earnings)
The average annual administrative charge comes to 91 basis points (2.08% + 1.00% + 0.60% + 0.40% + 0.36%) ÷ 5 = 0.91%. That is, nearly one additional percentage point of costs--in addition to something within the range of 375 to 460 basis points--must be borne by teachers least able to afford it in the early stage of their careers. The addition of 91 basis points increases the range to 466 to 551 basis points. You can bet that the insurance companies following such a wonderful business model are thinking only one thing: "Cha-Ching!"
Surrender Charges
I mentioned, but didn't discuss, the costs of surrender charges in last month's column. These charges, more formally known as "contingent deferred sales charges," are imposed by insurance companies when a person decides to terminate an annuity. A surrender charge is normally expressed as a set of percentages of account assets that declines over time. For example, a colleague informed me last month that he had recently run across a defined benefit plan in which a doctor was sold a variable annuity by a (young) agent of a very large and well-known insurance company. The annuity featured a nine-year surrender period with declining charges of 8%, 8%, 8%, 8%, 7%, 6%, 5%, 4%, and--Ta Da!--only" 3% in the ninth year. Oh yeah, the costs of this particular gem of a product amounted to nearly 500 basis points.
The Negative Compounding Effect on Accumulating Wealth Caused by "Lost" Money
I also mentioned in last month's column, but didn't discuss, the negative compounding effect on accumulating wealth caused by "lost money." It should be readily apparent to anyone that sundry costs, expenses, charges, commissions and fees (whether totaling 200, 300, 375, 460, 551, or more basis points) are damaging, over time, to the accumulating wealth of a 403(b) account. Few are aware, however, of the additional yet invisible damage to that wealth inflicted by the negative compounding effect of money used to pay for these costs, expenses, charges, commissions and fees.
This money can be thought of as "lost" because it is immediately gone forever and can never join its brethren in helping compound the future wealth of a 403(b) account. The total adverse impact of such costs, expenses, charges, commissions and fees is therefore composed not only of their immediate visible blow on current wealth but also their invisible blow on future accumulating wealth. Consider how the terminal wealth of a current $50,000 403(b) account growing at 8% annually can be dramatically different due to costs:
| 403(b) Costs |
20 years |
30 years |
40 years |
| 1.25% |
$192,143 |
$376,662 |
$738,379 |
| 3.00% |
$135,632 |
$223,387 |
$367,921 |
| 4.00% |
$111,129 |
$165,675 |
$246,994 |
Notice that over 40 years, a 403(b) account with low costs (1.25%) generates nearly $500,000 more than one with high costs (4.00%). Even in some parts of California that's considered a lot of money. And who do you suppose that $500,000 goes to in the high cost account?
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| W. Scott Simon is an expert on the Uniform Prudent Investor Act and the Restatement 3rd of Trusts (Prudent Investor Rule). He is the author of two books, one of which, The Prudent Investor Act: A Guide to Understanding is the definitive work on modern prudent fiduciary investing. Simon provides services as a consultant and expert witness on fiduciary issues in litigation and arbitrations. He is a member of the State Bar of California, a Certified Financial Planner, and an Accredited Investment Fiduciary Analyst. Simon's certification as an AIFA qualifies him to conduct independent fiduciary reviews for those concerned about their responsibilities investing the assets of endowments and foundations, ERISA retirement plans, private family trusts, public employee retirement plans as well as high net worth individuals. For more information about Simon, please visitPrudent Investor Advisors, or you can e-mail him at wssimon@prudentllc.com The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar. |
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