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Surrender fees haunt legacy 403(b) plans

Jul 23, 2014 @ 12:01 am

By Darla Mercado

403(b) plans, surrender fees, mutual funds,
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It's been five years since regulations from the IRS heaped greater responsibility on 403(b) plan sponsors, leading to heightened awareness of plan features and fees, but advisers say moving employers to lower-cost options remains difficult and expensive.

Historically, the 403(b) market has been thought of as the Wild West of retirement savings plans, different from the 401(k) market of corporate employers because not all 403(b) plans are subject to the Employee Retirement Income Security Act of 1974. Plan sponsors in the 403(b) space are primarily hospitals, nonprofit organizations, colleges and school districts. Insurance companies are among the largest service providers in that arena, and group annuities have been the primary savings tool of choice.

"It was common for employers to offer an array of group annuity vendors in their 403(b) plans. Whatever the participant wanted, [the employer] would allow the vendor to come in and offer the product,” said Jeffrey Levy, managing partner at Cammack LaRhette. “It was thought by the plan sponsor, 'the more funds the merrier.'” He has seen 403(b) plan sponsors with dozens of vendors available to their workers — the record so far is 47.

But those days gradually have been coming to an end since the double whammy of the Pension Protection Act of 2006 and a set of final rules from the Internal Revenue Service on 403(b)s that became effective in 2009. The latter development required plan sponsors to come up with written plan documentation that covers the features of all 403(b) plans, including those that are non-ERISA arrangements.

“There has been a convergence between 401(k) and 403(b) out of the PPA and the 403(b) regulation,” said Ed Moslander, senior managing director and head of institutional client services at TIAA-CREF. The end result: Independent auditing requirements and strenuous reporting mechanisms apply to 403(b) plans.

There's also an impact on the structure of these 403(b) plans: a movement to mutual fund products from group variable annuities, a greater focus on fees and a move toward consolidating the number of vendors available in a given plan. “That's instigated by the penetration of advisers who have played an important role in educating 403(b) plan sponsors about fiduciary responsibilities, investment policy statements, investment menus and monitoring,” Mr. Moslander said.

Plan-level fees have crept downward for 403(b)s when accounting for record keeping, investment management and custodial fees. The average cost of an ERISA-compliant 403(b) plan was 0.658% in 2010, dropping to 0.641% in 2012, the most recent data available, according to BrightScope. Those expenses do not include costs that affect individuals differently: loan processing fees, surrender charges and brokerage window access fees.

Enter some of the woes that continue to affect advisers who, in an attempt to step away from legacy group annuities written prior to the 2009 403(b) regulation, are trying to shift 403(b) plans to a structure that's either mutual fund based or that combines mutual funds and annuities.

For instance, Peter Weitz, senior vice president of investments at Fusion Analytics Investment Partners, says he has come across legacy 403(b) annuity contracts with surrender periods as long as 11 years with surrender charges as high as 8%.

Further, individual participants in a given 403(b) plan generally have their own individual contract with an insurer, so opting to change vendors in a given plan isn't simply as easy as talking to a plan sponsor and having him or her unilaterally make that call. Rather, advisers need to get each individual employee to make the switch out of the legacy contract and into something more reflective of today's marketplace: fewer providers and lower expenses.

“If Participant A has been there for more than 10 years, I can transfer them without penalty because they're out of the surrender period,” said Mr. Weitz.

“The other employees, the longer they work for that employer, a portion of their dollars will come out of surrender every year,” he added. “But say you don't work for the company anymore and you want to roll over into an IRA: You're still subject to the surrender charge.”

The restrictions of these legacy group annuity contracts makes 403(b) assets especially sticky.

“If you're a plan sponsor with these legacy contracts, frequently they'll throw their hands up in the air and the participant is left alone,” said Mr. Levy. Participant inertia also takes over, and advisers will find that it's only the most engaged participants who will make the move.

Mr. Moslander noted that generally, plan sponsors kick off a re-enrollment into the plan when they cut down the number of providers available, giving workers the opportunity to choose from the options available in the consolidated 403(b).

Though mutual fund choices may be similar from one provider to another, many legacy annuity contracts tend to stay where they are. “It wouldn't be uncommon for 50% to 60% of the assets to move over when they come from the individual contract method,” said Jon Shuman, vice president and head of markets and investment partner development at MassMutual. The insurer doesn't offer 403(b) group variable annuities, but does offer mutual funds.

Indeed, if the worker has to choose between eating a 7.5% surrender charge or moving to the new investment lineup, then it might be better to hold off. There are also other scenarios where it makes sense to stay.

“There's the grandfathering of certain 403(b) contracts, where it may not make sense to consolidate,” noted Mac Gardner, an adviser with Raymond James & Associates Inc. For instance, participants with 403(b) account balances prior to 1987 can wait until age 75 (or April 1 of the calendar year immediately after the calendar year in which they retire, if later) to begin taking distributions.

It can help to send participant communications to illustrate the underlying expenses of the old product versus the new one and to educate them on their options, Mr. Levy added.

On the product development side, insurers who participate in the 403(b) space have changed their group annuity products going forward. TIAA-CREF, for instance, provides a suite of annuity products that range from high-yielding with the least amount of liquidity to low-yielding with more liquidity.

“A 7.5% surrender charge is more reflective of legacy contracts,” Mr. Moslander said. “What you see more of now are equity washes or a one-, three- or five-year period of time that it takes to get the money out, which enables companies to manage disintermediation risk.”

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