Millions of California public school employees supplement their defined benefit pensions by participating in defined contribution plans conforming to Section 403(b) of the Internal Revenue Code. Unfortunately, many plan participants experience subpar returns and flexibility because they are sold retirement products with high fees and/or stiff surrender charges. In California, state law prevents school districts from guiding teachers away from these costly options. This situation deserves attention from public pension reformers because poor 403(b) investment performance can impact retirement security for participants and undermine the case for expanding defined contribution plans and other alternative plan designs in the context of primary public sector retirement plans.
A Little History
As Daniel Alexander of RetireAware explained to this author, IRS Section 403(b) is substantially older than 401(k), and thus contains provisions that benefit insurance companies at the expense of teachers and other school employees. When Section 403(b) was added in 1958, there was no concept of tax-deferred savings accounts. Instead, all 403(b) plans were tax sheltered annuities offered by insurance companies. Annuities, like other insurance products, were typically sold by agents who received large commissions on each policy. As a result, annuities tend to have high costs, which are often hidden within the complex provisions of these contracts.
The 1974 Employment Retirement Income Security Act (ERISA) created 401(k) plans for private sector plans and allowed plan participants—like those in 403(b) plans—to invest retirement funds on a tax-deferred basis, but without having to buy expensive insurance products. Despite this development, insurance companies continued to sell annuities to school employees, even though their tax shelter provisions were now redundant. As the Securities and Exchange Commissions warns 403(b) plan participants:
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. Investors typically pay for each benefit provided by any given product. Be sure you understand the impact of these costs and all other fees and expenses.
In California and some other states, insurance providers were able to maintain a large share of the 403(b) market by getting legislatures to adopt “any willing provider” provisions like Section 770.3 of California’s Insurance Code, which prevents school districts and other government employers from negotiating terms with insurance providers. Instead, they must remit payroll deductions to whichever provider an employee chooses.
Further, mutual fund companies were slow to enter the California 403(b) market after the passage of ERISA. Even as of early 2019, neither Fidelity nor Vanguard were among the 27 companies offering 403(b) products to teachers in Los Angeles Unified School District (LAUSD), the state’s largest.
In his book Fighting Powerful Interests, retired teacher and reformer Steve Schullo offers a possible explanation. LAUSD and other school districts fear liability arising from errors in making and applying payroll deductions. To avoid this liability, they require financial product providers to sign “hold harmless” agreements under which the responsibility is shifted away from the district. Taking on this liability may not make sense for mutual fund companies that are earning very low margins on each plan participant.
Good and Bad 403(b) Choices
As a result, many teachers continue to place their 403(b) assets in expensive variable annuity products, largely due to the efforts of insurance agents who are compensated on a commission basis. The largest 403(b) provider for LAUSD is National Life Group with almost 10,000 participants and close to $400 million of assets. One of National Life’s products, SecureChoice Platinum, has a surrender fee of 15% – meaning that a participant who wants to withdraw his or her money immediately will only receive 85 cents on the dollar. Holders are thus locked into a product whose returns are capped at 3%.
The sales commission for SecureChoice is up to 11%, so if an agent is able to convince a teacher to switch a $40,000 account into this product he or she might earn as much as $4400. As a result, insurance agents are a common sight at LAUSD schools, where they roam classrooms and teacher lounges seeking clients.
Steps have been taken to help teachers choose better retirement products, but more needs to be done. The California Teachers Association, the state’s largest teacher’s union, offers a 403(b) plan to its members that include several fund options with annual expense ratios of 0.11% or below and no surrender fees. Unfortunately, it is not a good option for teachers with smaller accounts or for those just starting out because it also charges a flat $95 annual recordkeeping fee and a one-time $10 enrollment fee.
The California State Teacher’s Retirement System (CalSTRS) also offers a 403(b) option known as Pension2. Like CTA’s Retirement Savings Plan it offers numerous low-cost fund options. Administrative fees are 0.25% of the participant’s account balance, making Pension2 a good choice for new teachers.
But Pension2 lacks a motivated sales force and only attracts a small fraction of 403(b) accounts. According to recent LAUSD statistics, less than 2,500 teachers had just below $200 million invested in Pension2 – well below National Life and a couple of other insurance companies marketing to LAUSD educators. CalSTRS also offers teachers an online tool to compare 403(b) products at https://www.403bcompare.com/, but it would appear that many plan participants are not taking advantage of this service.
Finally, the IRS also allows school districts to offer their own defined contribution retirement plans under section 457(b) of the tax code. Perhaps because 457(b) plans do not allow participants to borrow against their account and have more restrictive withdrawal rules, they have proven to be less popular than 403(b) plans.
Reform advocates like Dan Otter, who runs the 403bwise web site, would like to see California repeal Section 770.3 of the Insurance Code. Removing this provision would enable school districts to choose the 403(b) providers that could sell retirement products to their employees. They could thusly exclude insurance companies and place all employees into low-cost mutual fund based options.
On the other hand, fewer choices and less engagement by sales agents could lead to fewer teachers enrolling in 403(b) plans. In a study for the National Tax-Deferred Savings Association, Jason Fichtner found a correlation between the number of 403(b) products offered within a district and the percentage of employees enrolling. It may be the case that the insurance salespeople are getting some teachers to enroll who would otherwise not save for retirement. The question then becomes whether investing in a low return, high-cost retirement product is better than not investing at all.
Since some teachers may answer yes, it would be shortsighted to ban insurance products completely from California school district 403(b) plans. Still, it seems reasonable to give school districts more ability to guide teachers toward lower-cost retirement savings options. Perhaps the state should allow districts to default new participants into Pension2 and then require them to read and sign a disclosure if they decide to switch to a higher cost product.
With over $900 billion in total assets nationally, the 403(b) is a category pension reformers cannot afford to ignore. If we want to expand retirement plan design options and develop attractive alternatives to underfunded defined benefit plans, we should make sure that these savings options offer greater choice and value for money.