The Next Evolution in 403(b) Plans: Investments

While 403(b) plans have made great strides, lifting restrictions on the types of investments the plans can offer and considering more diverse investment types could further improve participant retirement outcomes.

403(b) plans got their start as tax-sheltered annuities and it wasn’t until passage of the Employee Retirement Income Security Act (ERISA) in 1974 that custodial accounts—i.e., mutual funds—were added as a permissible investment. As such, the majority of 403(b) plans have had limited investment options for participants.

But a study from BrightScope and the Investment Company Institute (ICI) reveals 403(b) investment menus have evolved. The study looked at ERISA-governed 403(b) plans with 100 or more participants. For clarity, 403(b) plans are still allowed a safe harbor from ERISA requirements as long as the plan sponsor has limited involvement with the plan—something that is harder to do since the IRS passed 403(b) plan regulations in 2007.

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The “BrightScope/ICI Defined Contribution Plan Profile: A Close Look at ERISA 403(b) Plans, 2016” report says the average large ERISA 403(b) plan offered 25 core investment options in 2016—of those, about 11 were equity funds, three were bond funds and nine were target-date funds (TDFs). Nearly all plans offered domestic equity, international equity and domestic bond funds. Eighty percent of large ERISA 403(b) plans offered a suite of TDFs and 82% offered fixed annuities.

Mutual funds were the most common investment vehicle in large ERISA 403(b) plans, with 57% of plan assets in 2016. Variable annuities held 21% of assets and fixed annuities held 21%.

Prior to the IRS finalizing its regulations, some 403(b) plans held hundreds of investment options, mostly because plan participants were able to buy individual annuity contracts on their own from any provider they chose.

“There has been an evolution going on as ERISA 403(b) plan sponsors now have to file Form 5500s,” says Sarah Holden, ICI senior director of retirement and investor research, based in Washington, D.C. “They have been consolidating investment options but still keeping availability of prior options—perhaps in a brokerage window. But inferring from the small amount of assets [in legacy options], new participants get core options, not legacy options. Plan sponsors want to keep the number of options manageable.”

Wendy Daniels, vice president of strategy and not-for-profit, Workplace Solutions for Transamerica in Harrison, New York, notes that 403(b) plan sponsors are looking to consolidate providers and streamline investment choices among their plans for many reasons. “These actions help ease the ongoing monitoring of investments and create a single online experience, a unified participant education program and ultimately allow for lower fees through economies of scale,” she says.

The BrightScope measure of large ERISA 403(b) total plan costs has decreased since 2009, according to snapshots of 403(b) plan fees. In 2016, the average total plan cost was 0.77% of assets, down from 0.82% in 2009. The average participant was in a lower-cost plan, with a total plan cost of 0.58% of assets in 2016, down from 0.68% in 2009, while the average dollar was invested in a plan with a total plan cost of 0.48% in 2016, down from 0.59% in 2009. BrightScope’s measure of total plan cost includes administrative, advice and other fees from Form 5500 filings, as well as asset-based investment management fees.

Mutual fund expenses in ERISA 403(b) plans tend to be lower in larger plans and have trended down over time. For example, in 2016, the average asset-weighted expense ratio for domestic equity mutual funds, including both actively managed and index funds, was 0.71% for ERISA 403(b) plans with less than $1 million in plan assets, compared with 0.39% for plans with more than $1 billion in plan assets.

Tom Coughlin, senior director of investment consulting at Buck Consultants in Pittsburgh, says open architecture mutual fund-based platforms are being used by more 403(b) plans. “Once [a plan] moves to a mutual fund-based platform, fees come down substantially,” he says. “And recordkeepers realize they need to be more flexible and offer share classes with lower expense ratios.”

Coughlin suggests that as participants save more, it will help to further lower costs, because as plan assets grow, plan sponsors can go to recordkeepers to negotiate lower costs.

Daniels notes that even in non-ERISA 403(b) plans, investment lineups have generally benefited from the improvements seen in ERISA plans, such as the addition of TDFs, a refined fund menu for easier participant selection and managed account services. “With the plan sponsor and its financial adviser, Transamerica uses an ERISA-based approach to construction of investment menus for non-ERISA plans to help assure they have a strong, defensible process in place to support their decisions, even though they may not technically be required to do so.”

“403(b) plan sponsors are building an investment lineup while thinking of their responsibilities to offer a range of options with reasonable fees. They are also recognizing the needs of various demographics and appetites for risk,” Holden says.

The Next Evolution

With all this progress made on 403(b) investment choices, there is still room for improvement.

Many plans still have legacy annuities and plan sponsors cannot get rid of individual contracts as those are controlled by participants, Coughlin notes. “It’s hard to get them to move [their assets]. We’ve been trying to help plan sponsors educate employees about the benefits of closing out older contracts. The more assets that are aggregated, the better pricing,” he says.

The move to get individual annuities out of 403(b) plans may seem contradictory to the present push to get annuities into 401(k) plans, but the issue is cost. “The real issue becomes that many of these products are excessively expensive over what is appropriate. What needs to happen, and unfortunately we see little movement, they need to be using no-load products that serve the purpose of the employees, not the company that is the recordkeeper or the product sponsor. While conceptually having annuities inside of retirement accounts makes sense, especially at the end of their working careers, the expense ratios and even quality of the underlying investments should be examined closely,” explains Mike Scarborough, president and CEO of Oak Wealth Partners in Lexington Park, Maryland.

Even those advocating for annuities in 401(k) plans note that it won’t happen until the right product and pricing is in place.

Scarborough also points to the constriction in the investment options permissible in 403(b) plans, which he says makes it “harder to cover the investment spectrum as well as you would ideally want to see.” He suggests exchange-traded funds (ETFs) and real estate investment trusts (REITs) should be at least part of the core lineup of investment options in both 403(b)s and 401(k)s. “If these options are not included in these plans, we tend to have a higher volatility component than might normally be acceptable,” he says.

403(b) plans can’t use a traditional stable value fund since they are not mutual funds, Coughlin points out. “A capital preservation fund in most of our 403(b)s is an insurance product or annuity type product with a crediting rate,” he says.

Providers, for now, are innovating around this constriction. Daniels notes that in March, Transamerica introduced the Transamerica Capital Preservation Option, a new stable value solution developed specifically for 403(b) retirement plans.”

The largest efforts to expand permissible investments in 403(b) plans regard collective investment trusts (CITs). In a Viewpoint article, “Improving investment outcomes for 403(b) plan participants,” BlackRock says, “CITs are highly regulated and have the potential to provide many benefits to plan sponsors and their plan participants saving for retirement. CITs can offer pricing flexibility, can be used to customize investment options, can provide access to a broader range of asset classes and investment strategies and can experience lower portfolio turnover, which can result in lower transaction costs. BlackRock believes that all 403(b) plans should be permitted to invest in CITs.” The firm is urging Congress to pass legislation that would allow that to happen.

Considerations for Investment Menu Design

Until constrictions are removed to allow 403(b) plans to further evolve their investment menus, plan sponsors can use what is available and what are considered best practices when creating the right lineup for plan participants.

“Plan sponsors used to think they had to offer everything to cover themselves, but we’ve always advocated for reducing the number of funds to make it more manageable. Participants look at fund performance, not underlying strategies. We think 12 to 15 is a good number of funds to have in the lineup, with TDFs and index funds in each asset class and a core group of actively managed funds,” Coughlin says.

“Ultimately, a 403(b) plan’s investment committee is charged with selecting and monitoring the right menu of investments that give their participants the flexibility of choice. Investment committees may consider investments that adjust risk and holdings as the participant nears retirement, such as TDFs or an investment advice solution. These investments can be beneficial for participants who need assistance in the management of their investment allocations throughout their accumulation period,” Daniels says.

She adds that plan sponsors are also incorporating a core fund lineup consisting of both domestic and international fixed income and equity funds for participants who manage their own investments.

Daniels also suggests that there continues to be an increasing desire for investment choices that have sustainable business practices and positive impact. “Providing these types of investment choices can help participants know they are invested in companies that align with their environmental, social and governance [ESG] values,” she says.

Scarborough says 403(b) plan sponsors need to be cognizant of the expense ratios of the underlying funds in their investment offerings, and he suggests plan sponsors not be tied to one specific fund company. “We find that, oftentimes, if there is just one fund family that is used, the expense ratios tend to be higher across the full spectrum of investments,” he says.

“When we talk to our clients, it’s about implementing best practices, such as having an IPS [investment policy statement] and documenting meeting minutes,” Coughlin says. “If they face a lawsuit, it is good to have a record of discussions they’ve had and decisions they made to benefit participants.”

Daniels echoes this suggestion. “Due to concerns about fiduciary responsibility, it is increasingly vital that retirement plan committees stay up to date on the latest industry trends and best practices, including establishing and monitoring a written investment policy statement if they haven’t already done so. Regarding investment fees, if lower-cost investments are available but not offered, plan sponsors should document the reasons,” she says.