Nuances of 403(b) Plan Investment Menus

The creation of the modern 401(k) is a complicated story, but the emergence of today’s tax-qualified 403(b) plan is an even more intricate tale.

It’s not the only corner of the retirement planning market impacted by misunderstandings and half-truths, but managing 403(b) plan investment menus effectively requires some serious know-how.

As noted by a recent Investment Company Institute (ICI) and Brightscope report, “A Close Look at ERISA 403(b) Plans,” it was not until 2007 that a comprehensive revision of regulations effectively began to transform 403(b) plans “from primarily employee-controlled, individual-focused tax-deferred accounts to more formally developed plans, clarifying and expanding plan sponsors’ responsibilities.”

According to ICI/Brightscope, the 2007 regulations—which were handed down by the Internal Revenue Service (IRS) and were generally effective starting January 2009—required all tax-qualified 403(b) plans to have a written plan document for the first time. The regulations also propelled fundamental change in the approach to the 403(b) plan investment menu—especially within 403(b) plans established under the Employee Retirement Income Security Act (ERISA).

Historically bound to purchasing individual annuity contracts, today ERISA 403(b) plans can still be set up as individual annuity contracts through an insurance company, but there are other forms the plans can take under the reformed IRS regulations. The ICI/Brightscope report points to two other common approaches: 403(b) plans created as custodial accounts, which can invest in mutual funds, and 403(b) plans arranged as “retirement income accounts,” set up for church employees, which can invest in annuities or mutual funds.

It’s a new paradigm 403(b) plan sponsors are still coming to terms with, according to Ray McGrath, an investment consultant at Cammack Retirement Group with significant experience creating and maintaining 403(b) plan investment menus. He tells PLANSPONSOR it’s not all that rare to find a plan sponsor who believes 403(b) plans are still limited to annuity investments, “but this wasn’t even the case before the 2007 regulations.”

“It’s true that up until 2007 403(b) plans were invested primarily in annuities,” McGrath explains, “but even in my old position 10 years ago I was solely responsible for helping to distribute mutual funds within 403(b) plans. Plan sponsors weren’t categorically prohibited, in other words, from using mutual funds prior to 2007. What is true is that more plans are focusing today on leveraging mutual funds as the primary investment within 403(b) plans.”

NEXT: Fees, Funds and Fiduciary 

Just as much as the 2007 rule changes, the ongoing industry-wide focus on fees, reporting transparency and fiduciary liability are all driving the move towards wider use of mutual funds in 403(b)s, McGrath explains (see “Advisory Committee Suggests Additional Guidance for 403(b)s”). Also driving the change is the fact that annuity contracts can be hard to value, especially when the provider has discontinued a given product that is held by a participant in a 403(b) account. This makes compiling the required disclosures under ERISA quite challenging.

“For all these reasons, moving forward we expect even more use of mutual funds and other assets beyond strictly annuities in the 403(b) plan environment,” McGrath explains. “Larger 403(b) plans have long been investing in mutual funds—it was the less than $50 million market that really felt itself pinned into using annuities. This is changing as well.”

McGrath says the main reason 403(b) plan sponsors are increasingly attracted to mutual funds is that they can bring lower costs and more promising growth potential, “and it can be so much more transparent to use a lineup of mutual funds than a group of individual annuity contracts.” One major benefit of the 2007 rule changes, he adds, is that mutual fund providers have grown much more interested in targeting the 403(b) plan market, bringing down minimum investment hurdles for zero-revenue sharing classes of mutual funds, for example.

In earlier days, looking across any given 403(b) plan, there were likely multiple annuity providers with a payroll slot at any given plan, so they all were receiving some flows from the participants.

“That led to at least some participants investing in a wide variety of annuity products,” McGrath explains. “This is not as common any more given the big fiduciary focus, but at the time, plan sponsors weren’t as worried about monitoring all the different providers touching their plan and offering investment products. The fiduciary liability wasn’t front and center like it is today—so plans simply weren’t as concerned about having a lot of providers and huge reporting complexity.”

Now with increased regulations inside and outside 403(b) plans, the sponsors are waking up to their fiduciary liability. This is leading many to try to freeze flows to legacy annuity providers and to designate just one or two providers moving forward.

“There are just so many challenges that emerge when the plan has too many annuity options,” McGrath continues. “For example, just think about the task of tracking loans across multiple annuity products or service providers. It’s going to be really tough to get it all right. It’s hard enough to keep track of loans on a streamlined and well-run 401(k) plan, but the task is so much harder and fraught with liability when you look across a really complex 403(b) plan with many different vendors.”

NEXT: Freezing legacy annuity flows 

It’s not just on the annuity side where 403(b) plan sponsors could afford to do some streamlining.

The ICI/Brightscope report found that, as of 2012, the average ERISA 403(b) plan offered 23 core investment options—of those, about 10 were equity funds, three were bond funds, and seven were target-date funds (TDFs). “Nearly all plans offered at least one equity fund and bond fund, about 70% of plans offered a suite of TDFs, and 84% offered fixed annuities,” the report notes. If all investments in ERISA 403(b) plans are counted, no matter how small, ERISA 403(b) plans have an average of 41 investment options.

“It’s hard to give general advice to these plans, because their situations can vary pretty dramatically,” McGrath says. “But there are some consolidation services out there and it’s an area where skilled advisers can help. For a fee you can try to build out an overlay that covers all the different providers to try to give consolidated reporting that eases the effort of valuing and updating information pertaining to 403(b) participant accounts.”

Even this doesn’t work as easily as the plan sponsor probably would like, he feels, “because just trying to pull all that data automatically from all these disparate provider systems is really difficult. There is a lot of nuance. It’s just not easy. In theory it seems very attractive to do this, but putting it into practice is not as easy as it might seem.”

What is especially challenging about mapping legacy 403(b) annuity assets into a new lineup of mutual funds is that participants invested in these legacy assets often have full discretion over their money.

“The main problem we see is that a lot of the legacy annuity products held by 403(b) plan participants are structured as individual contracts—with the plan sponsor acting more as a conduit to connect the insurance company with the participant,” McGrath notes. “This prevents the plan sponsor from actually being able to replace and convert an annuity fund. While the dollars are invested through the 403(b) plan, the key difference is that the sponsor doesn’t have the ultimate control over the relationship. It’s typically between the insurance company and the individual to decide whether legacy assets will move.”

NEXT: The path forward

“This is a challenge—because even if the plan sponsor wants to replace the legacy annuity option and convert the assets, many times the decision remains with the individual,” McGrath continues. “All the plan sponsor can do in many cases is to freeze future flows to an underperforming investment option. They don’t have the discretion to go in and remap assets that have previously been invested.”

A recommendation in the face of these challenges, McGrath says, is to have 403(b) plan sponsors take charge of streamlining their 403(b) plans moving forward.

“They may have complex legacy holdings that are going to remain a challenge, but at the very least they should try to refine things looking forward and select one or two annuity providers,” he concludes. “Even better is selecting a streamlined menu of mutual fund investments. We are seeing this frequently right now: a 403(b) plan client will opt to freeze all of the old options and create a new mutual fund lineup.”

Unfortunately, this won't solve the issue of hard-to-value legacy assets. Instead, plan sponsors will have to manually encourage plan participants to individually map their legacy assets into the new mutual fund lineup, perhaps through a targeted communications campaign.

“The sponsor can freeze all the legacy flows and push new flows into a best-in-class mutual fund lineup, most likely pushing people towards target-date funds,” he says. “The added benefit here is that the mutual fund investments are most often controlled by an investment committee, which retains discretion over plan assets and which has a lot more leeway to replace underperforming funds.”