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Barbara O'Neill: Where to Stash the Cash

February 14, 2023

By Barbara O'Neill, CFP®, AFC®

A 403(b) plan, like an individual retirement account (IRA), is not an investment product, per se. Rather, it is a tax-deferred “umbrella” under which plan participants select specific investments. The two different investments allowed in 403(b) accounts are insurance company annuity contracts and mutual funds. The 2023 contribution limit for 403(b)s is $22,500 for workers under age 50 and $30,000 for those age 50+.

When 403(b) plans began in 1958, annuities were the only investment option allowed and 403(b)s were called tax-sheltered annuities or TSAs. In 1974, 403(b) plans were permitted to invest in mutual funds. Annuities are still the primary (or only) investment available through many 403(b) vendors. 403(b)s do not permit other investments found in 401(k)s and IRAs, such as stocks and exchange-traded funds.

This post describes the two types of 403(b) investments (annuities and mutual funds), including their general characteristics, specific types, fees and expenses, and selection criteria. Research results, three “need to know” facts, and six take-away action steps conclude this discussion.

Investment Option #1: Annuities

Annuities are a contract between an annuitant and a life insurance company. Within 403(b) plans, annuitants make deposits over time (i.e., while working) in exchange for payments from the insurer in retirement. There are three main types of annuities: fixed, equity-indexed, and variable.

Fixed Annuities

Fixed annuities are similar to bank certificates of deposit, only tax-deferred. They guarantee a specific minimum rate of interest for a specified time period (e.g., 3 to 10 years), after which the issuer adjusts the interest rate based on market conditions. The fixed return is paid on annuity deposits no matter how financial markets are doing. Fixed annuities appeal to conservative investors seeking a guaranteed rate of return. However, because their return is constant, there is no potential for market-based growth to hedge inflation.

Equity-Indexed Annuities

An equity-indexed annuity is a type of fixed annuity that ties a portion of its return to a stock market index; e.g., Standard & Poor’s (S&P) 500. A variety of methods are used to do this and contracts must be reviewed carefully. Many equity-indexed annuities cap the potential return investors can earn, regardless of how the market performs. An annuity’s “participation rate” determines how much of an index’s increased value is applied to an annuitant’s account (e.g., 50% participation rate = 50% of the gains associated with an index).

Variable Annuities

Variable annuities are like mutual funds, only tax-deferred. Variable annuity owners select underlying mutual funds, called subaccounts, and their annuity’s performance is based upon that selection. Future payouts from variable annuities are determined by the rate of return on subaccount investments and annuity expenses. The value of these subaccounts is called their accumulated unit value (AUV).  

Annuity Fees and Expenses

A common complaint about annuities in general, including those held in 403(b) plans, is their complexity and high fees, which lead to lower-than-market average returns. Two especially pesky annuity fees are surrender charges and mortality (a.k.a., mortality and expense or M&E) charges. 

Surrender charges take effect when investors cancel a contract early (e.g., before seven years) and typically decrease over time. They can range from 5% to 25% of the amount withdrawn and are a costly deterrent to moving 403(b) accounts to a less expensive investment (e.g., index mutual funds).

M&E charges provide a guarantee, which investors pay for, of a return of premiums so annuitants don’t get back less than the amount of money they invested. This death benefit is often highly touted as a selling point for variable annuities, where there is a possibility of losing money during market downturns.

Annuity investors should carefully review annuity expense ratios which can run as high as 2% or 3% of invested assets.  This means that, on a $100,000 account, the life insurance company would deduct $2,000 or $3,000 a year in fees. Over time, high fees can result in tens of thousands of dollars of lost wealth.

Annuity Selection Factors

Key criteria to consider when selecting an annuity are surrender and mortality charges and overall expense ratio (i.e., expenses as a percentage of money invested). The lower the percentage charged, the better. The financial stability of the annuity-issuing insurance company is also important. 403(b) participants should look for an issuer that is highly rated by at least two insurance company rating firms such as A.M. Best, Fitch, and Standard and Poor’s.

Investment Option #2: Mutual Funds

Mutual funds are a diversified portfolio of securities such as stocks, bonds, and cash equivalent securities. They are collectively owned by many investors, whose investment deposits are pooled together, and managed by a professional investment company. There are approximately 7,500 mutual funds in existence.

Characteristics

Mutual funds are a financial “intermediary.” By law, they are required to pass-through (to investors) a pro-rated share of the income that they earn each year. Mutual funds do not pay taxes on their transactions, but their shareholders do. Of course, within a tax-deferred 403(b) account, taxes on mutual fund distributions are typically postponed until later life. Mutual fund investors make money from interest, dividends, and capital gains distributed by mutual funds and by selling mutual fund shares for more than their cost basis. 

Pros and Cons

A big advantage of mutual funds, in addition to professional management, is a reduced risk of loss due to diversification. Most mutual funds hold 100+ securities in their portfolio. Mutual fund expense ratios vary widely, but there are some (i.e., index funds) that charge rock-bottom percentages around 0.2%.

A big disadvantage of mutual funds is that there is no guaranteed return. Instead, mutual funds generally follow market performance (up or down), often resulting in losses during market downturns.

Index Funds

Many 403(b) participants select index funds that contain all, or a statistically representative sample of, the stocks or bonds in a benchmark market index used as an indicator of market trends. Some examples of indexes are the Standard and Poor’s 500 (S&P 500), which tracks the performance of U.S. large company stocks, and the Wilshire 5000, which tracks the market value of almost all actively traded U.S. stocks.

One reason investors select index funds is performance. Most actively managed funds are outperformed by indexes in a typical year. Index funds maintain a significant cost advantage because they are very efficiently run. Some have expense ratios less than 0.2%, compared to 1.5% for average actively managed stock funds.  

Target-Date Funds

Another popular 403(b) choice is target-date funds, which hold a mix of stocks, bonds, and/or cash assets and gradually become more conservative (read: a smaller percentage of stock in the fund portfolio) and income-oriented as the “target date” (e.g., 2060) approaches and, once it is reached, going forward. For example, a target-date fund might start out with 80% of its portfolio invested in stocks and gradually shift to 40% over the course of three decades without the need for any action on an investor’s part.

Target-date funds are frequently selected as a “set it and forget it” approach to investing for retirement. They are built on the long-standing assumption that investors should have less stock and more fixed-income securities in their portfolio as they get closer to retirement. Investors generally choose a fund target-date fund close to their planned retirement date or a date beyond that if they want to invest more aggressively. The target dates in target-date funds are generally provided in five- or ten-year intervals (e.g., 2025, 2030, etc.). 

Mutual Fund Fees and Expenses

Like annuities, a key cost indicator is a mutual fund’s expense ratio. The lower the percentage, the better. Some mutual funds also charge sales charges (a.k.a., loads) upon the purchase of shares (front-end load) or the sale of shares within a specified time period following purchase (back-end load). Another pesky sales charge that some mutual funds charge is a 12b-1 (distribution) fee of 0.25% to 1% of asset value. No-load funds are sold without any sales charges.

Mutual Fund Selection Factors

There are three key selection criteria for 403(b) mutual funds: fund objective (most retirement plan investors want long-term growth), fees and expenses (mutual funds with low expense ratios and without front- and back-end loads), and historical performance (funds with sustained above-average returns). Mutual funds to avoid are those with poor performance relative to market indexes, 12b-1 fees, and narrow portfolios that provide poor diversification (e.g., sector funds).

Research Results

A study by the TIAA-CREF Institute examined how controlling vendor access to K-12 public school 403(b) plans improved retirement outcomes by controlling the number of vendors, investment products, and fees paid by plan participants. They found that “controlled access” plans, with a relatively small number of vendors and investment products, had relatively low overall fees vs. “open access” plans that allow “any willing provider” (vendor). The difference in fees translated into $60,000 to $100,000 of additional wealth.

Three (More) Things

  1. Annuity and mutual fund expenses matter! High fees diminish investment performance, which translates to tens (even hundreds) of thousands of dollars of “lost” wealth and decreased monthly income.
  2. Index funds have low turnover (i.e., how often a fund buys and sells securities), which reduces transaction costs and capital gains taxes.  
  3. When annuities are the only option in a 403(b), plan participants should look for low-expense, A-rated vendors and/or select alternative retirement savings vehicles such as a Roth IRA.

Six Smart Strategies

No. 1: Be Fee Conscious — Never select a 403(b) investment (annuity or mutual fund) without checking its expense ratio. This information can be found in a prospectus or in the “fees and expenses” section of a vendor’s website.

No. 2: Diversify Investments — Consider owning a variety of asset classes (e.g., stocks, bonds) and diversify investments within each (e.g., large and small company stocks) because no one has a “crystal ball” with respect to market performance.  

No. 3: Consider Index Funds — Check out index mutual funds, especially for “efficient” segments of the stock market where detailed information about stocks is readily available. An example is U.S. large company stock funds.

No. 4: Consider International Investments — Consider index funds that track the performance of foreign securities for diversification within or outside of a 403(b). An example is the MSCI EAFE index that tracks securities issued in 21 developed countries.

No. 5: Balance Your Portfolio — Consider purchasing securities that are not offered within your 403(b) plan in taxable and/or tax-free accounts (e.g., a Roth IRA) for tax diversification as well as investment diversification.

No. 6: Beware of Fake Promises — Be wary of 403(b) vendors who promise that their investment products have “no fees.” Just because a separate fee is not charged does not mean that it is not embedded in the cost of an investment.

In Summary

403(b) plans can be invested in two types of investments: annuities and mutual funds. Before selecting a vendor and investments, take the time to learn about plan options and ask questions, if needed.

 

This post provides general personal finance information and does not address all the variables that apply to an individual’s unique situation. It should not be construed as legal or financial advice. If professional assistance is required, the services of a competent professional should be sought.

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Dr. O'Neill is the owner/CEO of Money Talk: Financial Planning Seminars and Publications where she writes, speaks, and reviews content about personal finance. She is a Distinguished Professor Emeritus at Rutgers University and a long-time 403(b) plan participant.