10/01/04 - 403(b) Plans for Not-for-Profit Employees

By: Frank Armstrong, CFP, AIF

What is a 403(b) plan?

Special plans for employees of non-profit institutions are called 403(b) plans. They are a close relative of the better-known 401(k) plan but with a few interesting twists. These plans are available to public schools, hospitals, public and private universities, churches and other non-profit organizations qualified under §501(c)(3), employer-sponsored §403(b) plans are funded with both employer contributions and employee salary reduction contributions. Employer contributory plans (other than those maintained by governmental agencies) must meet the requirements of the Employee Retirement Income Security Act of 1974 (ERISA).

Unlike corporate retirement plans, the sponsor usually doesn't run the plan as a trust. Most institutions contract with multiple providers to offer 403(b) benefits choices to their employees. The employee selects from the employer's providers and chooses from the investment options offered by that provider. The employer then makes contributions to the provider on behalf of the employee. After that, the sponsor usually washes their hands of the whole deal.

For historical reasons 403(b) Plans are often called Tax Sheltered Annuities (TSA). This is very unfortunate because there is no requirement to fund a 403(b) Plan with an annuity at all. Let me say that differently. There is no excuse to fund a 403(b) Plan with an annuity! Any mutual fund family could qualify as an offering, and mutual funds would almost always be a far better choice. There is simply no conceivable reason to pay an additional cost for an insurance company's Mortality and Expense (M&E) charge inside a tax qualified plan.

A few institutions offer outstanding programs. These employers have done their homework and selected very high quality providers that offer low cost funds, adequate investment choices to build a sophisticated asset allocation plan, superior service and meaningful education for their employees. Not all employees are so fortunate.

At the low end it gets pretty raunchy. Little thought and no objective standards are applied to the selection process for providers. Once providers are selected by the sponsor, their commissioned salesmen emerge from under their rocks to enroll their unwitting victims. They swarm like so many vultures in hospitals, schools and colleges, posing as professional retirement counselors. You know the rest of the story: The companies with the highest costs pay the highest commissions and attract the most ruthless vultures. Insurance company salespeople misrepresent annuities as the required product for the plan. Employees end up with high cost low quality products that unfortunately come with the strong implied endorsement of their employers. Meanwhile, some of the best value products, like Vanguard Funds, cannot afford vultures to lounge around campus.

Quality retirement plans are not necessarily a high priority for non-profits

Far too many employees of America's non-profit institutions endure 403(b) retirement plans that are substandard and dirt poor. Too often, plan providers are selected without due consideration or worse yet, as a political plum. Disinterested administrators leave participant education and enrollment to product vendors who promptly sell high cost inappropriate products to unsuspecting employees. The salesmen make out like bandits while the employees suffer dismal performance weighed down by exorbitant fees.

Where employers abdicate their responsibilities as fiduciaries and delegate education and enrollment to plan providers, results can be far from happy. Provider salesmen with severe conflicts of interest are turned loose on trusting employees with the implied endorsement of the employer. This is the functional equivalent of inviting the foxes to dine on the chickens.

Is your plan broken?

A broken plan has some or all of the following problems:

• High commission, high cost products. Many products commonly marketed to 403(b) plan participants have annual costs exceeding 3%. It is not at all unusual for employees to be told that only high commission annuities can fund their plans. Nothing could be farther from the truth. There is almost no rational justification for the use of so-called Tax Sheltered Annuities (TSAs) in a 403(b) plan. Noload mutual funds would far better serve the retirement needs of participants.
• Surrender fees and/or withdrawal restrictions that trap an employee who wishes to switch to lower cost, more effective provider plan.
• Investment choices may be so limited that it is impossible to properly diversify the portfolio or integrate it with the employee's other assets and financial planning.
• Information and education is inadequate to assist employees to make informed choices.

Your options to upgrade your 403(b)

Employees with substandard 403(b) plans have at least three options:

• If the plan offers multiple providers, they may be able to switch their accounts to a better provider.
• Like employees in private industry, they can petition their employers to provide better options and suppliers. Depending on the employer, this may or may not be successful.

However, unlike an employee trapped in a poor 401(k) plan, in some cases, the employee can simply open a self-directed 403(b) account with a friendly discount brokerage house and transfer his account balance. The employee is then free to choose almost the entire menu of investment options offered by the brokerage, and can even hire an investment advisor to assist if they so desire.

This option, a 90-24 Transfer, is unique to the 403(b) participant. While the employer controls a 401(k) plan, a 403(b), on the other hand, is considered to be an individually controlled plan. This means that it is technically owned and controlled by each individual who participates. While an employer is permitted to limit the investment options they offer, they are technically not allowed to limit the participant's overall options. For this reason, the IRS issued a private letter ruling in 1990 to permit employees to transfer their money from one 403(b) plan to another without separating from service.

The employee should be careful not to close his present plan. In some cases, he may have to leave a token balance in the plan to keep it open. The employer will not make contributions directly to the transferred plan. He should use his existing plan to accumulate contributions until he makes any additional transfers to the new plan. Of course, any contributions temporarily held in the employer's plan should be directed to no-load, no surrender fee options until transferred out to avoid additional costs.

Not all plans allow a 90-24 Transfer. This can cut both ways. In the case of a well designed plan it prevents the vultures from diverting their retirement plan to high cost, poorly designed products. In the case of a poorly designed plan, it prevents the employee from seeking lower cost, more effective alternatives.

Additional considerations:

• If the investment is currently in annuities or back end loaded mutual funds, the employee may be charged surrender fees on all or part of them when he transfers them out. See the fund's or annuity's prospectus for details. Painful as it might be, it's often a better alternative to pay the surrender charge than to remain in a substandard plan.
• A 403(b) plan may not be rolled into an IRA while an employee continues in service. It may be, if the employee wishes, after the employee separates from service. However, the IRA may not enjoy all the protections against creditors that a 403(b) plan provides.
• If the employee changes employers, she may transfer her assets to another 403(b) plan unless the current plan documents specifically prohibit it. Most plans do not. However, this transfer only makes sense if the new employer's plan is better than a well designed IRA.

The bottom line:

Teachers, doctors, nurses, pastors, and other workers for America's non-profit enterprises deserve the best retirement plans. Fortunately, if their employers won't give it to them, they may have a remedy. A 90-24 Transfer is a great way to fix a broken 403(b) plan.

Fixing a broken 403(b) plan can yield enormous benefits. For instance, assume an employee with a total $5000 annual contribution over 30 years. If the employee were able to increase his rate of return by 2% by simply cutting administrative costs, the increase would be staggering. At 7% compound return, the total after 30 years would be $505,365.21. However, at 9% the balance grows to $742,876.09, an increase of 47%.

Don't just accept the status quo. Investigate all your options. You can take control of your investment account, lower costs, obtain access to the highest quality investment products, and/or work with an independent investment advisor to design and monitor a plan tailored to your exact needs.

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