403(b) accounts can have troubling conditions

Significant progress is being made on two important elements of investing. A new fiduciary standard requiring stock brokers and insurance agents to act in the best interests of clients is about to be implemented. More widely applicable, management fees continue to be lowered for many shareholders in mutual funds and exchange-traded funds.

But there is a segment of the investment world that has seen scant improvement in either regard. Many government and nonprofit employees utilize 403(b) plans for retirement savings. The 403(b) is related to the 401(k) for corporate retirement plans but does not receive near the scrutiny. These retirement savings vehicles are the playground for many of the worst practices of investment product sales, particularly to the teacher audience.

In many cases, high expenses, poor performance and often nonexistent service combine for a trifecta so troubling that many eligible employees should consider not investing in 403(b) accounts at all. One challenge, especially for teachers, is that the administration of 403(b) plans is different from district to district so there is no one-size-fits-all recommendation. There are some good 403(b) plans available, but generally the 403(b) accounts I’ve seen have two primary problems:

1. Exceptionally high costs. In some cases, management fees for the underlying investment funds are multiple times what equivalent investments outside of these accounts charge. And those are just the ongoing fees. These accounts also can include significant upfront commissions and contingent deferred sales charges (when using annuities within the 403(b)) that reduce the amount invested on the way in and possibly the way out. Legislation that requires transparency for 401k plan fees does not apply to the same extent to 403(b) accounts. The insurance companies that dominate product sales in the 403(b) space continually deploy their lobbying force to keep them from facing reform and clarity.

2. Sales practices not in the participant’s best interest (even though they are authorized by teachers unions in some cases). A good rule of thumb for evaluating whether an investment is a bad one is whether the person selling it will receive credit for the transaction in a sales contest.

For example, consider the compensation section of the prospectus for the National Education Association Valuebuilder, a 403(b) structured as a variable annuity. In addition to ordinary commissions and noncash compensation, broker-dealers selling this product can be compensated with trail commissions or persistency payments, preferred status fees that pay “to obtain preferred treatment” in the broker-dealers’ marketing programs, one-time bonus payments for participation in sales promotions, periodic bonus payments based on average 403(b) contract value for the year, reimbursement for attending sale conferences and for offering sales seminars or “similar prospecting activities.”

Nowhere in that agreement is there compensation for providing service or advice, getting to know a client’s goals or risk tolerance.

YOUR OPTIONS

If you no longer work for the employer that offered the 403(b) because you moved to another district or retired, you are eligible to roll over the account to an IRA at a different provider with potentially much lower costs, transparency, and even access to financial planning and advice. But mind the deferred sales charges for exiting some 403(b) accounts. These withdrawal charges can last up to eight years in some contracts.

For people still saving for retirement, funding other accounts first should be considered.

Many local teachers are part of the state Teachers Retirement System, which offers access to investments managed by the Washington State Investment Board. In many cases, this should be the preferred tax-deferred retirement savings vehicle. The Total Allocation Portfolio or a target-retirement date fund both offer globally diversified, low cost investment choices. A drawback, however, is that you can’t change your contribution rate unless you change school districts.

If your spouse has access to an employer retirement plan, you might want to consider funding it fully, especially if there is any matching contribution not currently being received. After that, a Roth IRA could make a wise complement to other accounts if you are eligible to contribute to a Roth.

You may even prefer to invest in a nonretirement account without tax-deferral before utilizing a 403(b). Having some money that is available for goals prior to retirement without penalty for early withdrawal can be useful. It’s also helpful to have some assets that are subject to capital gains taxes at lower rates than the ordinary income taxes that apply to retirement accounts.

If you have money in a 403(b) and limited options for moving it or investing elsewhere, rally your co-workers to demand less expensive investment choices, better service and more transparency.

Gary Brooks is a certified financial planner and the president of Brooks, Hughes & Jones, a registered investment adviser in Gig Harbor. Reach him at bhjadvisors.com.

This story was originally published April 3, 2016 at 9:56 AM with the headline "403(b) accounts can have troubling conditions."