For anyone watching the emerging rules and regulations governing retirement plans in our country, the last year or two have provided plenty of action: new ERISA rules for 401(k)s, the Pension Protection Act of 2006, and new rules from the Financial Accounting Standards Board (FASB) and the Government Accounting Standards Board (GASB). Now 403(b)s join the wave of change sweeping the retirement world, with the IRS issuing the first new regulations for these plans in more than 40 years. While the changes facing the 403(b) landscape may seem remote to those who do not use these kinds of plans, they are actually quite instructive. The new regulations are similar to the rules that apply to 401(k)s and are expected to mirror dynamics from across the industry—transparency, fee disclosure, and the growing need for fiduciary scrutiny, to name a few. In this sense, changes to 403(b)s are indicative of larger pressures facing the retirement environment in the United States.
Although 403(b)s are not as widely recognized as 401(k)s, we all know someone who has such a plan. Created to serve employees of certain tax-exempt organizations, 403(b)s have become a standard investment vehicle for teachers, museum curators, healthcare professionals, and others who work for certain nonprofit organizations. Today, employees of nonprofits have about $680 billion invested in 403(b) plans.1 Yet the plans have received little regulatory oversight since they were first created, and many have become unwieldy and inefficient; "403(b)" and "fiduciary" have rarely occurred in the same sentence because employers have not been concerned about fiduciary responsibility for 403(b)s. This is no longer the case with the new regulations.
403(b) plans: Where we've been
At the start, fixed and variable annuities were the only investment products available in 403(b) plans. Plan management was handled primarily by the companies offering the products and, in many cases, employers' compliance responsibilities were confined to ensuring contribution limits. Often 403(b)s have not even had a written plan document. Without clear guidelines to follow, many employers responded to vendor suggestions or employee requests for products and ended up offering more and more options. As time went on, many plans became loaded with myriad investment products (frequently annuities) from numerous vendors.
In the 1970s, 403(b)s were opened to mutual fund investments, but to a certain extent the die was cast. Today annuities are still the predominant investment option, and the choice of available annuity products is often overwhelming to plan participants. Many 403(b)s have operated almost as if they were in a retail environment, instead of as an employer-sponsored plan.
403(b) plans: Where we're going
On Jan. 1, 2009, the new IRS regulations will go into effect. The rules are far-reaching and will bring significant changes to 403(b) plans, creating new fiduciary responsibilities for employers and very likely a new level of competitiveness to the market and a much better product for plan participants.
Foremost among the new rules is that 403(b)s must have a written plan document and must be operated according to the plan's written terms, similar to 401(k) plans. This means that employers for the first time will be required to review and describe all the investment options available under their 403(b) plans. In many cases, this will be a daunting task.
A substantial number of employers likely will opt to bring in a single organization to handle recordkeeping and administrative services. It also is likely that once employers are required to take stock of and list all available vendors and investments, they will significantly limit the options they make available in their plans in the future. For companies that have provided products to 403(b) plans over the years, this could signal a change in business. With the regulatory guidelines for 403(b)s being structured more like 401(k)s, nonprofit employers may well start looking for fee structures similar to those found in the private sector.
The 403(b) difference
Both 401(k) and 403(b) plans allow workers to set aside pretax money that grows tax-deferred until it is withdrawn at retirement. In some cases, employers offer matching or other contributions for their 403(b) plans.
And just as mutual fund investments in 401(k) plans have been under scrutiny for hidden fees that erode plan participants' retirement savings, the fees charged for investment products in many 403(b) plans will likely become a hot issue as employers begin looking at their plans more closely.
But in the case of 403(b)s, the hidden fees tend to be even higher because of outdated rules, the confusing fee structures of many annuity investments, and a legacy system of investment options that has not kept up with the market.
Besides the higher fees, the variable annuities that often dominate 403(b) plans also typically carry with them additional charges, such as high surrender charges if the money is withdrawn within a certain number of years and annual contract charges. The result of the higher overall costs of the average annuity-type investments compared to the average mutual funds is lower investment returns, translating to fewer retirement dollars.
For instance, assuming contributions of $250 a month over 35 years with an annualized rate of return of 8%, the average variable annuity would grow to only $334,787 after 35 years, while the average managed mutual fund would grow to $441,774 and the average index fund would grow to $534,231—differences of $106,987 and $199,444, respectively.2
The new regulations impose due diligence and compliance criteria that require employers to assume a greater fiduciary role. As a result, employers must act in the best interest of plan participants, which means not only keeping track of but also weighing the costs of various investment options.
Like private-sector employers that offer 401(k) plans, it is in the best interest of employers offering 403(b) plans to create an investment policy statement with guidelines for selecting, monitoring, and evaluating plan investment options, as well as forming an investment committee that meets regularly to review investment performance, plan expenses, and employee education, and keeps well-documented minutes of each meeting.
The new 403(b) regulations will provide employers with an incentive and structure for selecting best-of-class investment options and potentially enhancing their plans' performance significantly.
A boost in participation
The ability to invest in products with clear and competitive fee structures and understandable performance is likely to boost participation in 403(b) plans. It also is likely that enrollment will be boosted just by reducing the number of options. Some 403(b) plans have had hundreds of investment choices. Most were annuity-type products and the average participant has been ill-equipped to make informed, discerning choices. Not wanting to make the wrong decision, some participants opted out just because of the sheer volume of options.
Now, with the incentive to move to a single, unified platform for all 403(b) investments, employers will be better able to develop a communication strategy for employees, helping to educate them about appropriate investment allocation strategies for their various life stages.
The new IRS regulations also require universal availability for employees, ensuring that nonprofit employers make retirement savings opportunities available to most workers. Currently, employees whose schedules are irregular, such as substitute teachers and visiting professors, could be excluded because they sometimes work fewer than 20 hours a week. The new regulations require coverage for these employees once they work 1,000 hours in a year.
Besides being universally available, the new regulations require that the 403(b) plan be effectively available. That means that if an employee is eligible to participate in the plan but has not been effectively notified that he or she may participate, the IRS will not consider it available. The new regulations require an employer to provide an annual meaningful notice to all eligible employees of their rights to participate in a 403(b) plan.
What comes next
Because 403(b) plans have been largely unscrutinized for many years—and some have evolved into highly complicated investment platforms—the transition is not going to be easy for a number of employers.
For some, the first challenge may be to get their arms around the investment options currently offered in their plans. With multiple investment providers offering numerous products, as well as accounting and recordkeeping services delivered by multiple firms, it could initially be difficult for some to track down their plan's holdings.
There also will be strategic choices to be made. If, for instance, employers choose to reduce their options or change them entirely, they may have to weigh the costs of surrender charges for terminating contracts that typically run for terms of five to seven years.
What is certain is that employers will be looking hard at their 403(b) plans in the next year, as they have only until the end of 2008 to prepare for the new rules. The stepped-up fiduciary responsibilities for employers increase their liabilities, and the IRS has signaled that it will be ramping up its audits of 403(b) plans.
Similar to recent reform in 401(k) plans, the new IRS regulations governing 403(b) plans will likely continue the trend among plan sponsors to seek unbiased, outside expertise in managing their companies’ retirement plans. Increasingly and particularly in the face of so many regulatory and accounting changes many companies now look to firms with extensive benefits expertise to perform audits of their investment plans and advise them on a wide range of investment options.
As retirement plans become more and more focused on compliance, there is a growing trend toward a single platform for plan administration. For employers offering 403(b) plans, this would mean a dramatic shift from the multiple-vendor model that most currently employ. Employees could benefit from an easy transfer among all investment options, at-a-glance information on their total 403(b) position, consolidated participant statements, and a Web site for all 403(b) money. In other words, tomorrow's 403(b) plan may look a lot like today's 401(k) plan!
The need to create a comprehensive written plan document opens the door to a fresh perspective on 403(b)s, and nonprofit employers have the opportunity to take advantage of the shift to greater fee transparency and open investment architecture. They and their employees deserve the best that the market has to offer as they prepare for their hard-earned retirements.
GINNY BOGGS is a senior compliance consultant with the Dallas office of Milliman. As head of the Compliance Consulting group within the Southern Employee Benefits practice, she provides clients with technical and practical guidance on a wide range of retirement plan issues. Ginny has more than 25 years of experience working within the qualified plans area. Her experience encompasses plan design and installation, government reporting and disclosure, plan terminations, mergers and acquisitions, IRS and DOL audits, and nondiscrimination testing. Ginny is a frequent speaker and writer on topics affecting 401(k), 403(b), and 457(b) plans.
SUZANNE D. SMITH is an employee benefits consultant with the Albany office of Milliman. She is an attorney and is licensed to practice law in New York and Missouri. Suzanne has more than nine years of experience working with qualified and nonqualified retirement plans. Her areas of expertise are plan design, plan drafting, and plan compliance.