Fiduciary Focus: Fleecing 403(b) Plan Participants

Morningstar Advisor Magazine June/July 2010 Issue

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Fiduciary Focus: Fleecing 403(b) Plan Participants

by W. Scott Simon | 04-05-07

Continued from page 1.

Annuities: Fixed and Variable
Fixed annuities or variable annuities offered as investment options in a tax-deferred retirement plan such as a 403(b) plan (or 401(k) or 457 plans) are typically invested in baskets of a half dozen mutual funds wrapped inside a variable annuity policy written by a life insurance company.

With a fixed annuity inside a 403(b) plan, an insurance company is responsible for investing money in a tax-deferred account and guarantees a fixed rate of interest during the accumulation phase prior to an annuitant's retirement. There is also the guarantee upon retirement of periodic payments for some definite period such as 20 years, or an indefinite period such as the annuitant's lifetime or the lifetime of the annuitant and its spouse.

With a variable annuity inside a 403(b) plan, the annuitant (not the insurance company) is responsible for investing money in a tax-deferred account, typically in a range of mutual funds selected by the annuitant. A variable annuity's value, and therefore the size of the payments to the annuitant, fluctuates depending on the performance of the mutual funds in the account. Note that the life insurance associated with a variable annuity doesn't pay out a huge lump sum upon the annuitant's death but only the total contributions made by the annuitant plus any growth earned in the account.

Two, Two Tax Shelters in One!
Annuities are very appealing to investors because they are tax shelters. That is, investors can invest their money and any resultant interest, dividends, and growth in capital are sheltered from taxation. A tax-deferred retirement plan such as a 403(b) plan or 401(k) plan is, by definition, also a tax shelter. But an investor receives no additional tax advantage by investing in annuities inside a tax shelter. Don't take my word for it though. Just read the warning issued by the U.S. Securities and Exchange Commission: "If you invest in a variable annuity through a tax-advantaged retirement plan (such as a 403(b) plan), be aware that you receive no additional tax advantage from the variable annuity." (Bold in the original.)

When a school teacher buys, for example, a variable annuity inside a tax-deferred retirement plan such as a 403(b) plan, he or she not only pays the underlying expenses inside the mutual funds but also what is known as a "mortality and expense" risk charge. An insurance company, therefore, charges the teacher two sets of costs when it sells the teacher an annuity inside a 403(b) plan. The expenses of the mutual funds contained on the menu of available investment options offered to plan participants by insurance companies are, of course, bloated to ensure that the mutual fund families have enough "revenue-sharing" payments to direct the companies' way.

The Toxic Brew of High Costs, Poorly Performing Products, and Problematic Services
The problem in the K-12 403(b) plan market is not the annuity as an investment vehicle per se. In fact, an annuity can be a useful vehicle for accumulating assets for retirement or as a way to generate some future income stream. Low-cost provider TIAA-CREF, for example, has recently entered the public school segment of the 403(b) plan market; it is now listed as a provider for the Los Angeles Unified School District. It seems that third-grade teachers will finally get exposure to the low-cost products that university professors have enjoyed for some time now. (I swear on a stack of Morningstar reports that I have no financial interest in TIAA-CREF or its products.)

No, the real problem here is that the great majority of assets in 403(b) plans (which are tax shelters) are invested in high-cost fixed and variable annuities (which are tax shelters). Large insurance companies that offer such annuities--the usual suspects--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." This is just about the ultimate in fleece jobs since under that kind of investment cost structure it's nearly impossible for plan participants to accumulate much of a nest egg. As Rex Sinquefield reminds us, "Bad performance and service are not cheap; you have to pay dearly for them."

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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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