Right now, the vast majority of 403(b) plans are loose financial arrangements with too many investment choices and very little, if any, employer involvement. A so-called non-employer-sponsored, or non-ERISA, plan is essentially an accommodation by employers to allow their employees to have pre-tax salary deferrals deposited into a tax-sheltered annuity or an Internal section 403(b)(7) custodial account established for them. Most employers eligible to offer a 403(b) plan (i.e., section 501(c)(3) organizations, public educational institutions, and certain religious institutions) permit their employees to participate in such plans on a non-employer-sponsored, or non-ERISA, basis in order to avoid fiduciary duties with respect to the selection of investments or the administration of the plan, and to avoid having to file annual returns (Form 5500) with the Department of Labor (DOL). Such a 403(b) plan can safely be described as low maintenance. But even if it's low maintenance, is it the right thing to do?
While the employers' laissez-faire attitude is understandable, many advisors and consultants in the retirement industry feel that these arrangements are simply too unstructured and unsupervised to be good for the millions of workers who participate in them. A closer look reveals that many of these arrangements are costing the participants tens or even hundreds of thousands of dollars in excessive fees and underperforming investments (that is, lost retirement savings)!
Because government and church employers are exempt from ERISA, they usually do not concern themselves with DOL rules regarding what types of 403(b) arrangements are or are not subject to ERISA. Even though exempt from ERISA, most public school districts operate their 403(b) arrangements on a non-employer-sponsored basis because they simply do not have the time or resources to oversee the countless insurance vendors vying to sell tax-sheltered annuity investments to their employees. California's Insurance Code contains a provision that the insurance salespersons contend gives them the right to solicit 403(b) eligible employees – regardless of the number of competing insurance options that are available (a contention, by the way, with which we strongly disagree). Nonetheless, the combination of motivated insurance salespeople and unassisted school teachers can give rise to situations, like the case of a very large school district in Southern California, where hundreds of insurance companies have sold thousands of tax-sheltered annuities – all under the same 403(b) arrangement. Because the tax-sheltered annuities are usually sold on an individual basis, the school district knows little or nothing of the terms of the annuity contract; after all, it is only the district's responsibility to remit agreed-upon salary deferral amounts to the appropriate insurance company.
Not Subject To ERISA, In A Safe Harbor
To prevent their 403(b) arrangement from becoming subject to ERISA, not-for-profit entities, organized under Code section 501(c)(3), must follow DOL guidance. DOL regulations provide a safe harbor that states that a program for the purchase of 403(b) annuity contracts or custodial accounts and funded solely through salary reduction agreements is not subject to Title I of ERISA provided that:
- Participation is completely voluntary.
- All rights under the applicable annuity contract or custodial account are solely enforceable by the employee, or the employee's beneficiary or legal representative.
- The employer's involvement with respect to the program is limited to certain optional specified activities (as discussed below).
- The employer is not directly or indirectly compensated for offering the program.
Most of the confusion regarding the safe harbor concerns the extent to which the employer must limit its involvement regarding the design and operation of the program. According to recent DOL guidance on the subject (DOL Field Assistance Bulletin 2007-02), without subjecting its program to ERISA, the employer may:
- Permit annuity (or custodial account) providers to publicize their products.
- Request information concerning proposed funding media, products, or annuity contractors, and compile such information to facilitate review and analysis by the employees.
- Enter into salary reduction agreements and collect annuity or custodial account payments required by the agreements, remit them to annuity contractors, and maintain records of such collections.
- Hold one or more group annuity contracts in the employer's name covering its employees and exercise rights as representative of its employees under the contract, at least with respect to amendments of the contract.
- Limit funding media or products available to employees, or annuity contractors who may approach the employees, to a number and selection designed to afford employees a reasonable choice in light of all relevant circumstances.
As with the case of school district-sponsored 403(b) plans, we have noticed the same problems appearing in the non-ERISA 403(b) plans offered by nonprofits. Because employees are being left to deal with the myriad 403(b) investment salespersons on their own, it's no wonder that most participants are paying too much in fees for their investments. Common sense tells us that it will cost the participants in a 403(b) arrangement far more for their investment products if they are purchased one participant at a time (i.e., retail) rather than on a wholesale basis. Focusing on fees alone, it is easy to see how the payment of excessive fees can have a significant impact on overall retirement savings. It is not at all unusual to see individual 403(b) plan participants paying 2% - 3% (or in some cases even more) per year in investments fees relating to their individual 403(b) investments. The following chart demonstrates the impact that fees can have:
Value after 35 years, assuming $250 contributed monthly with an 8% average annual return.
(source: Meridian Wealth Management for 403bwise)
Let's face it, how many working Americans can afford to forgo $200,000 in retirement savings? But that's not all. It gets worse. Newspapers are full of stories about the poor investments that teachers have found themselves stuck with following a sales pitch in connection with their 403(b) plan. According to the Los Angeles Times (04/26/06), one young schoolteacher found herself invested in a fixed rate annuity yielding 3% per year while her boyfriend was earning 15% per year in his 401(k) plan. Not only is a fixed-rate investment inappropriate for most employees in their twenties, this schoolteacher was surely paying excessive fees for the privilege of a grossly underperforming investment. Once again, it doesn't take a rocket scientist to figure out how much this person will end up leaving on the table due to her unfortunate investment. This story points out one of the most serious problems with most 403(b) arrangements: the average worker doesn't have much of a chance for investment success when he or she is working unassisted with dozens of annuity salespeople. With no employer sponsor and no plan fiduciaries, no one is looking out for the interests of the individual participants.
In the typical non-employer-sponsored, or non-ERISA, 403(b) plan, each employee is left to his or her own devices. Yes, each employee has a lot of freedom and full investment flexibility; on the other hand, managing such a situation on an individual basis is like herding cats. Of course, there is another way – a better way – to do this.
What To Do – Consider The Chance To Review And Maybe Regroup
Most 403(b)-eligible employers understand that their employees are investing their hard-earned money in an attempt to better save for their retirements. With this in mind, responsible employers have the opportunity now to help prevent their employees from being taken advantage of in the ways that have been described. If instead of taking a completely hands-off approach to their 403(b) programs, employers administered them in the same manner as their traditional pension and 401(k) plans, the plans' fiduciaries would be looking into the reasonableness of fees paid by participants' accounts, and the prudence of the investment vehicles offered and used. The involvement of the employer on behalf of all participants would likely assure that the various investment vehicles utilized under the plan would be purchased on a group or wholesale basis – not on an individual or retail basis. If 403(b)-eligible employers do not have the resources to properly administer or invest their plans in a prudent manner, there are a number of competent advisors and consultants who can be retained to help with these responsibilities. Furthermore, the retention of these advisers can be structured so that they either do not have built-in conflicts of interest or so that they actually serve as plan fiduciaries. In some cases, the best solution may be a non-participant-directed 403(b) plan. For a discussion on the advantages of non-participant-directed plans please see our article, A Step Beyond ERISA, (link provided at right).
403(b) plan sponsors must bring their 403(b) plans into compliance with the new IRS rules by the end of 2008. At a minimum, this will require a review of the arrangement's documentation, administrative structure and handling of 403(b) vendors. However, it also provides employers with the opportunity to determine how their employees are really doing on their own and whether the employees would be better off in an employer-sponsored, ERISA-covered arrangement – one in which the reasonableness of fees and the prudence of investments are of paramount importance. Looking ahead, we see a better future for many 403(b) programs; all it takes is a realization by employers that the current situation is not something that they really would or should want to perpetuate.