9 ideas to fix 403(b) retirement plans

August 2, 2023 2:52 PM

Retirement accounts for teachers, university staff, health care workers and other public and nonprofit employees known as 403(b) plans are ripe for change, according to a new report.

Millions of plan participants hold more than $1.1 trillion in the 401(k)-style accounts, with many falling outside the consumer protections of the Employee Retirement Income Security Act of 1974 governing most other employer-sponsored retirement holdings, according to a July 24 report from the U.S. Government Accountability Office, a watchdog agency for Congress. The report comes after the same agency and author, Director of Education, Workforce and Income Security Tranchau "Kris" Nguyen, reviewed 403(b) plans comprehensively last year.

Citing the confusion of ERISA vs. non-ERISA plans and a mishmash of agencies overseeing 403(b) accounts including state regulators, the Securities and Exchange Commission, the IRS, FINRA and the Labor Department's Employee Benefits Security Administration, Nguyen's latest report made updates to the latter agency's educational materials its central recommendation. However, the watchdog also examined a range of tactics that plan sponsors and states have taken to reduce fees and complexity. Those ideas are outlined in a slideshow below.

"Stakeholders and experts we interviewed identified multiple options that they said could potentially improve 403(b) participant outcomes," the report said. "These options aim to enhance fiduciary protection for some participants in non-ERISA plans, better inform participants about the fees and expenses they are paying, provide plan participants with a means to access investment options with lower fees and expenses or raise plan participation rates."

For financial advisors who work with teachers and other 403(b) participants, the agency's proposals struck a familiar chord. Disturbing anecdotes and enforcement cases have popped up frequently, especially after the SEC ramped up scrutiny and education efforts for teachers and military members in June 2019.

Members of the Financial Planning Association cited the importance of keeping up with all news, advocacy and networking relating to the plans through the website of the nonprofit called 403bwise, which has as its motto, "The K-12 403(b) is broken. Together we can fix it." Others pointed out that the problems have been long-standing.

"I'm glad this topic is getting attention as I've witnessed the weaknesses in consumer awareness and plan clarity with both clients and close family," said Edward Jastrem, the chief planning officer of Westwood, Massachusetts-based Heritage Financial Services. "I wrote about this in 2020 and think my comments then are still relevant now."

Jastrem's 2020 blog post pointed to an SEC page for public school employees explaining how 403(b) plans work, and he described a family friend who was stuck with a plan offering investment options that carried expense ratios of around 1%, with a service cost of $30 per year and insurance products charging a mortality and expense fee of 1.75%.

"Plan participants may have no idea what they're buying. It's possible a variable annuity contract within a 403(b) could appear like signing up to invest in mutual funds, though with little understanding of the actual fee structure," Jastrem wrote. "All of these charges reduce the value of the account and the return on investment. An investment with high costs must perform better than a low-cost investment in order to produce the same net returns for you. Even small differences in costs can result in large cumulative differences when compounded over time."

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To see nine potential policy suggestions compiled by the U.S. Government Accountability Office as part of its July report, "403(b) Retirement Plans: Department of Labor Should Update Educational Materials to Better Inform Plan Sponsors and Participants," scroll down the slideshow. For a look at the watchdog agency's analysis of 403(b) plans last year, click here.

Update DOL educational materials

Since the Labor Department oversees the majority of 403(b) plans that are covered by ERISA, the agency should revamp the educational sections of its website to ensure that sponsors and participants "have the information they need to make better management and investment decisions regarding their plans by providing materials comparable" to that of 401(k)s, according to the report.

"DOL provides guidance and educational materials that help 401(k) plan sponsors and participants make informed decisions. However, DOL does not provide the same level of detailed information regarding 403(b) plans as it does for 401(k) plans," the report said. "Updating DOL's educational materials with information relevant to 403(b) plans would help ERISA 403(b) plan sponsors and participants understand and evaluate fees and expenses in those plans and select a 403(b) investment option that meets their financial goals."

In its response, the Labor Department neither agreed nor disagreed with the finding.

"DOL stated that it would review its relevant publications to see if they should more specifically reference 403(b) plans," according to the report.

Consolidate product providers

Two states, Delaware and Connecticut, have drastically reduced the number of product sponsors whose vehicles are available to plan participants, according to the watchdog. Paradoxically to the idea that more choices can push down cost, each state reported much lower fees after the changes. In Connecticut, average investment fees tumbled by 120 basis points to 0.42 after its 2004 consolidation. In Delaware, the highest investment expenses on its menu for participants fell by 330 basis points to 0.87 after its 2016 consolidation, while the lowest ratio decreased by 7 to 0.05%.

Convert to ‘closed-access’ systems

Some states' laws have provisions giving "any willing vendor" access to the 403(b) plans in the jurisdictions, meaning that they have an "open-access" system, according to the report. While, in theory, that gives participants more options for their investment accounts, the system can create headaches. One sponsor that spoke to the watchdog agency last year said its 403(b) plan had amassed as many as 1,600 different potential choices for participants. The alternative is a "closed-access" system with limits on the number of vendors and products.

"Pooling assets together into a more limited number of investment products may allow the plan sponsor to obtain administrative cost efficiencies and economies of scale," according to the report. "In closed-access systems, the relationships between plan sponsors, participants, and vendors resemble those typical of 401(k) plans, according to two experts and one stakeholder we interviewed."

Implement fiduciary protections for plan participants

Accounts that aren't subject to ERISA hold an estimated 43% of all 403(b) assets, with some states adopting fiduciary or "best interest" standards and others requiring that the plans be merely "suitable" for clients. Some stakeholders expressed concern that plan sponsors, especially K-12 school districts, lack the resources and expertise to fulfill the fiduciary duty and manage the inevitable lawsuits. Others said tougher rules would drive significant changes.

"Attaching fiduciary responsibilities to plan sponsors or designees could improve participant outcomes by providing them access to investment options with better performance and reasonable fees, according to several stakeholders we interviewed," the report said. "They said that fiduciary duties would require sponsors or designees to take a more active role in screening out service providers or investment options that underperform or carry excessive fees."

Standardize fee and investment option disclosures

Industry experts suggested uniform, plain-language disclosures such as a basic text box similar to consumer credit card statements would enable participants to compare investment options and product sponsors more easily. Ideas to "promote transparency of fees at the plan and investment level" represented one of the most popular solutions among survey respondents, according to the report.

"Multiple stakeholders noted that requiring plan sponsors and service providers to provide standardized information on investment options' fees and returns to non-ERISA 403(b) plan participants would increase transparency," it said. "In particular, several stakeholders said that, in their view, some participants in non-ERISA 403(b) plans did not receive sufficient disclosures that would enable them to make informed investment decisions."

Include collective investment trusts

A collective investment trust, also known as a collective investment fund, uses the economies of scale of pooled accounts to slash participants' fees and build greater portfolio diversity. The trust accounts' expense ratios are 28 basis points lower than those of mutual funds for actively managed products and 3 basis points below the level for passive vehicles, according to a 2020 study by Morningstar cited in the report. Sponsors of 401(k) plans are already using the trusts widely. Some stakeholders pointed out that the trusts receive less regulatory scrutiny and operate with little transparency compared to traditional mutual funds, though.

"Specifically, 403(b) plans are generally only allowed to invest in annuities and regulated investment company stock (or mutual funds) held in custodial accounts," the report said. "In contrast, 401(k) plans can offer a wider range of investment products, such as collective

investment trusts (CIT) and real estate investment trusts. Recently, Congress enacted legislation that changed the [internal revenue code] in such a way to facilitate greater inclusion of CITs in 403(b) plans, but additional changes to federal securities laws — specifically, those that require certain 403(b) plan investments to be registered as securities — would still need to be amended for 403(b) plans to allow CITs in a manner consistent with the recently enacted legislation."

Increase outreach to plan sponsors

Smaller school districts that sponsor 403(b) plans and other government or nonprofit employers sometimes struggle to understand their investment options and fees, according to stakeholders and survey respondents. Many called for federal agencies to supply more information to sponsors and participants such as educational materials that are widely available about 401(k) plans but can be harder to find for 403(b)s.

"Several stakeholders told us that federal agencies are missing opportunities to provide additional outreach to plan sponsors, particularly smaller plan sponsors," the report said. "Such outreach could help plan sponsors better administer their 403(b) plans and understand the rules that govern those plans."

Enroll and escalate employees automatically

The automatic enrollment of employees into their workplace 401(k) plans, as well as preprogrammed escalation of a participant's contributions, are growing in retirement plans. Last year's Secure 2.0 Act made auto-enrollment a requirement for newly created 401(k)s and 403(b)s starting in 2025. Stakeholders told the watchdog agency that bringing auto-enrollment and escalation to all 403(b) plans would require some states to alter wage garnishment laws.

"A majority of respondents to our survey of 403(b) plan sponsors and service providers said that expanding the use of automatic enrollment and automatic escalation features in 403(b) plans could improve participant outcomes; several stakeholders we interviewed cited the value of automatic enrollment in particular," the report said. "Allowing these non-ERISA plans to use both automatic enrollment and automatic escalation were the two most frequently cited options to improve participant outcomes by our survey respondents."

Take cues from enforcement cases

The watchdog agency's researchers analyzed a total of 18 settlement orders involving 403(b) plans from the last seven years. At least 13 came with an agreement for plan sponsors and vendors to take actions that addressed participants' concerns in addition to paying monetary damages between $225,000 and $32 million, according to the report.

Those required shifts in procedures were: using a request for proposal process for competitive bidding among prospective service providers; employing independent consultants on fees and investment options in plans; reviewing investment menus to identify potential lower-cost choices; charging a flat fee for recordkeeping rather than an amount based on assets; and enforcing limits on cross-marketing and selling of other investment or insurance products.