Barbara O'Neill: When to Say No to a 403(b) Plan
August 15, 2023
By Barbara O'Neill, CFP®, AFC®
Thanks to visible and effective advocacy by 403bwise and teachers across the country, as well as various media reports, flaws of 403(b) plans are becoming widely known. As 403bwise notes on its website, “The K-12 403(b) is broken. Together we can fix it.” Some major flaws of 403(b)s are high fees that erode investment earnings, a narrow range of costly investment choices (often high expense annuities and mutual funds with high expense ratios), and the fact than many plans lack oversight by the Employee Retirement Income Security Act of 1974 (ERISA), a federal law that sets standards to protect participants in retirement savings plans. Many plans also have a confusing array of dozens of vendors to select from.
The many disadvantages of 403(b) plans beg the question: “Are K-12 school employees and other non-profit sector employees better off without them?” In some cases, the answer is yes if investment options are limited to high-cost fixed or variable annuities with multiple layers of fees (e.g., administrative fee, advisor fee, custodial fee, mortality charge, surrender charge). This, then, begs another question: “So where else can plan participants save for retirement where they have a wider selection of investments to choose from, including low-expense index funds and exchange-traded funds (ETFs)?”
This post explores the high-fee landscape of 403(b) plans, including long-term financial damage caused by poor 403(b) investment choices. It also discusses advantages of 403(b) plans, which can often be replicated elsewhere, and “dealbreaker” features of 403(b)s when it is time to consider walking away. The post then describes five 403(b) plan alternatives (traditional and Roth IRAs, a simplified employee pension (SEP) for workers with self-employment income, taxable accounts, and health savings accounts or HSAs). It also includes research about the “drag” on 403(b) plan earnings caused by high-expense investments, as well as three “need to know” facts and six take-away action steps.
The 403(b) Plan Landscape
A study of 403(b) plans by the human resource consulting firm Aon Hewitt estimated than plan participants collectively paid nearly $10 billion in excessive fees. $10 billion! Their research summary stated:
“Today’s 403(b) plans are showing their age with outdated plan designs imposed by regulations that predate their for-profit employer 401(k) plan peers by roughly 20 years. Most notably, their existing multi-provider recordkeeper platforms, outsized investment menus, and inability to utilize more institutionally focused investment vehicles have created an environment that impairs retirement outcomes for participants.”
The report also noted that 403(b) plan investment options are limited, often just to fixed or variable annuities. Hence the alternative name for 403(b)s is “tax-sheltered annuity” or TSA, because annuities were the only product allowed in 403(b) plans when they first began in 1958. Mutual fund investments were subsequently allowed in 1974. At the time of the Aon Hewitt study, in 2016, 43% of 403(b) assets were held in fixed annuities, 33% in variable annuities, and 24% in mutual funds. The average fees charged by these three investments were 1.15%, 2.25%, and 0.97%, respectively. By contrast, the average expense ratio on an equity ETF today is 0.16% and the average expense ratio on stock mutual funds in 2022 was 0.44%.
The chart, below, from the U.S. Government Accountability Office (GAO) illustrates the corrosive long-term effects of high-cost investments, such as those found in many 403(b) plans, using a hypothetical $100,000 starting deposit. Note, during a 20-year period, the 21.5% reduction in value and over $45,000 difference in investment accumulation between a 0.25% fee and a 1.5% fee. Since teachers typically work more than 20 years to receive a pension, the spread between high- and low-expense investments would likely be greater. One teacher posted “I made a mistake in my 20s that cost me thousands.” Sadly, this is the case for many.
Source U.S. GAO (p. 41)
Advantages of 403(b) Plans
Despite the high fee and vendor “baggage” that many 403(b) plans have, they do have three key advantages:
- High Contribution Limit- Participants can deposit up to $22,500 in 2023 and up to $30,000 if they are age 50+. Maximum contributions are indexed annually for inflation.
- Catch-Up Benefit- Participants working for an employer for 15+ years can contribute an extra $3,000 a year on top of the IRS limit up to a $15,000 lifetime maximum.
- Tax Advantages- Deposits to traditional 403(b)s made with before-tax dollars are excluded from taxable income and qualified withdrawals from Roth 403(b) accounts, made with after-tax income, are tax-free.
Workers saying “no” to a bad 403(b) plan will want to retain as many of these benefits as possible elsewhere.
When to Walk Away
“Red flag” indicators of when it may be “403bwise” to pass up a 403(b) plan (or get out of a bad 403(b) plan) and invest for retirement elsewhere include the following:
- All vendor choices in your employer plan are rated Red (as in stop or avoid) by 403bwise.
- Your school district vendor list has a 403bwise grade of F (i.e., only “red” rated vendors are available)
- So-called “financial advisors” who visit your school are actually salespeople making commissions
- Vendor investment choices include only annuities without any mutual funds available
There is also a strong case to be made for forgoing a 403(b) if you have multiple alternative options (e.g., an IRA, HSA, and SEP). Bottom line: invest as much as you can somewhere for retirement.
403(b) Plan Alternatives
Traditional IRA
Both types of individual retirement accounts (IRAs), traditional and Roth, require earned income (e.g., a salary). The maximum deposit to either type (or both combined) in 2023 is $6,500 and $7,500 if age 50+.
Contributions to traditional (a.k.a., regular) IRAs may or may not be tax-deductible. For workers who do not have access to an employer-sponsored retirement plan, contributions are fully tax-deductible. However, 403(b) participants have employer plan access (and often a pension as well), so income limits apply.
With retirement plan availability, a tax deduction for traditional IRA deposits depends on modified adjusted gross income (MAGI). Above a MAGI of $83,000 (single tax filers) and $136,000 (married filing jointly), there is no tax deduction, but non-deductible deposits are allowed. Earnings on deposits accumulate tax-deferred until withdrawal. Withdrawals are taxed as ordinary income and are mandatory at age 73 (if born between 1951 to 1959) or 75 (if born in 1960 or later). IRA participants select their own investments.
Roth IRA
Roth IRAs have the same annual contribution limits as traditional IRAs and, like traditional IRAs, workers must select their own investment products (e.g., mutual funds). Roth IRA contributions are made with after-tax dollars (money that has already been taxed) and withdrawals are tax-free if certain requirements are met. Specifically, an investor must reach age 59½ and an account be open for at least five years
Contributions are restricted for high earners. In 2023, singles with a MAGI above $153,000 and couples filing jointly with a MAGI over $228,000 are ineligible to fund Roth IRAs. You can convert a traditional IRA to a Roth IRA, regardless of income, with taxes on the converted amount due for that tax year.
Workers can fund either type of IRA (or both combined, up to the annual limit) for a non-working spouse if the couple files a joint tax return and the working spouse has enough earned income to cover the deposit. This is a great way to save more money since the IRA limit is $16,000 less than that for a 403(b) plan in 2023. Another type of IRA is a rollover IRA for workers who cash out of a former employer’s 403(b) plan.
Simplified Employee Pension (SEP)
SEPs provide an opportunity for 403(b) plan participants who “moonlight” as entrepreneurs to save additional tax-deferred income for retirement. The maximum that can be saved by solopreneurs is 25% of the net earnings from self-employment, not including contributions for themselves, up to $66,000 in 2023. Like IRAs, SEPs must be opened and funded by the tax filing deadline for the tax year that deposits are made (i.e., on or around April 15 of the following year). Like traditional IRAs, required minimum distribution (RMD) withdrawals must begin at age 73 or 75 and investors are free to select a wide array of investments.
Taxable Accounts
Taxable accounts are assets that are not held in a tax-deferred retirement savings plan. Instead, they generate income that is taxed annually. Investors receive a 1099-INT form (statement for interest income) or 1099-DIV form (statement for stock dividends and mutual fund dividends and capital gains distributions) annually. These forms indicate how much income was earned. Taxable accounts often include individual stocks, mutual funds (especially index funds and other low-turnover stock funds), exchange-traded funds, municipal bonds, Series I bonds, and certificates of deposit. Qualified dividends and long-term capital gains are taxed at a 0%, 15%, or 20% tax rate. Short-term capital gains and earnings on I bonds are taxed as ordinary income.
Health Savings Account (HSA)
HSAs were described in a previous post. HSA money gets deposited tax-free, grows tax-free, and comes out tax-free, if used for health care expenses. As long as funds are spent on qualified medical expenses, all contributions, capital gains, and withdrawals remain untaxed. There is also retirement savings potential. Of course, nobody knows their future health status and whether an HSA will be needed for medical expenses. If you are lucky (no accidents), have good health habits, and incur modest medical bills, HSAs can be saved instead of spent. The penalty for not using HSA funds for qualified medical expenses is waived in later life and, after age 65, HSA savings can be used without penalty for non-medical purposes.
Research Results
TIAA-CREF Institute examined whether controlling vendor access to public K-12 school supplemental 403(b) plans improved teacher outcomes by controlling the number of providers (vendors), products, investment options, and fees that teachers pay. The study compared “open access management” (i.e., allowing any willing provider) to “controlled access management” (i.e., limiting the number of providers).
The study found that teachers in open access states face significantly higher asset-based fees and variability in fees relative to teachers in controlled access states. They also have a higher likelihood of paying front- or back-end loads and being subject to surrender charges (i.e., a fee to sell/withdraw money from an annuity). Assuming 4% systematic withdrawals, teachers in a controlled access state retiring at 65 will generate about $65,000 more in real retirement income and have about $80,000 more in real retirement assets left at age 85.
Three (More) Things
- Most representatives of 403(b) vendors who sell accounts at schools are not legally bound to put the interests of their clients first (i.e., a fiduciary standard).
- The best 403(b) investments have expense ratios less than 1%. Lower is better. Otherwise, consider other options. A useful tool to evaluate 403(b) investments is 403bcompare, a free resource run by the California state teachers pension plan CalSTRS.
- Over 35 years, with a $250 monthly contribution and 6% return, the accumulated value in a variable annuity with 3% in fees is $185,391 vs. $343,474 from an average index fund with 0.07% in fees.
Six Smart Strategies
No. 1: Dig Deep — Read 403(b) plan sales literature carefully. Expenses are often buried in the fine print and “invisible” in tables and charts.
No. 2: Divide and Conquer — Consider partial retirement savings in a less than stellar 403(b) plan (C or D grade from 403bwise) for ease of payroll deduction and generous contribution limit. Then save more elsewhere if you want to “max out.” Example: $8,500 in 403(b), $6,500 in IRA, $2,500 in SEP, and $5,000 in a taxable account.
No. 3: Lobby Your Employer — Organize fellow employees to address poor 403(b) options together and reach out to school administrators to lobby for low-expense vendors and investment choices.
No. 4: Do Not Do Nothing — Do not use a bad 403(b) as an excuse not to save for retirement. Save something, somewhere. Pick the lowest expense option available in the 403(b) and/or select alternative retirement plans described above.
No. 5: Practice Tax Diversification — Select a combination of tax-deferred, tax-free, and taxable investments that are taxed in different ways to reduce your tax bite in later life.
No. 6: Get Help When Needed — Consider hiring a fee-only financial planner on an as-needed basis to evaluate your 403(b) plan and suggest alternative investments as appropriate.
In Summary
Many 403(b) plans have serious flaws, but all hope is not lost. Alternative retirement savings plans provide many of the same advantages of 403(b)s including tax-deferral of savings and automated deposit features.
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.