New York's investigation into 403(b) plan costs and the sales tactics used by insurers is welcome action from regulators that will hopefully be accompanied by long-overdue reforms and
financial relief for vulnerable consumers.
The exploited consumers in this case are schoolteachers. Whereas corporate workers save for retirement in 401(k) plans, which afford them a relatively high degree of protection, many teachers don't enjoy such luxuries. They save in 403(b) plans, which are offered by public schools and tax-exempt organizations and most of which don't fall under the purview of federal retirement rules.
This dynamic exposes teachers — primarily those teaching kindergarten through 12th grade, according to experts — to shady sales practices and high fees, primarily from insurance companies, which offer the bulk of 403(b) products.
"It's ripe for abuse," said Tony Isola, who heads the 403(b) division at
Ritholtz Wealth Management, said of the 403(b) market for teachers.
It appears officials at the New York Department of Financial Services have taken note and opened an industry-wide investigation. The watchdog on Tuesday issued requests for information from insurers on their policies and procedures around 403(b) fees and how these retirement programs are being marketed to teachers, according to a source familiar with the probe, who cited concern around such practices as the regulator's impetus.
[More: Texas 403(b) law causes adviser concern over investor protection]
The source said insurers are required to furnish the requested information under Section 308 of New York insurance law. In other words, it's not a voluntary exercise.
Mr. Isola, who's based in New York, said the probe is significant because regulators have never taken an investigative action like this around 403(b) conduct.
"There's no one policing this market," said Kenneth Ford, president of
Warwick Valley Financial Advisors, who works with teachers and school district employees nationwide. "We need to shed some light on this."
The lack of policing has led many financial advisers and other experts to call the 403(b) market for K-12 schoolteachers the
Wild West of retirement plans.
The nation's 401(k) plans are beholden to the Employee Retirement Income Security Act of 1974, a federal law that sets minimum standards for plan governance and allows employees to bring class-action lawsuits to right alleged wrongdoing. Indeed, many participants have exercised that right within the past several years.
However, most 403(b) plans aren't subject to ERISA. Non-ERISA plans held 54% of the $900 billion in 403(b) plans as of 2015, according to the most recent statistics from the
Investment Company Institute. These participants don't have recourse to sue in a class-action setting.
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About 76% of assets in the 403(b) market are held in variable and fixed annuities, according to data from Aon Hewitt. Mutual funds hold the remainder. In comparison, fewer than 10% of 401(k) plans even offer an annuity to participants, according to the Plan Sponsor Council of America.
Some blame for the poor state of the schoolteacher 403(b) market resides with states and school districts themselves. The lack of a national legal standard for the retirement plans means states and school districts largely shirk any responsibility. As a result, many have an "open access" policy that allows any investment and annuity firm to offer their products to participants — which opens the door to dozens of providers, higher costs, an overload of investment choices and a lack of transparency.
Insurers seem to be using the system to their advantage, with brokers selling high-fee products — which also offer high commissions — when possible.
There aren't many readily available statistics on non-ERISA 403(b) plans, due to the fragmented nature of the market. However, a report published in 2010 by the
TIAA-CREF Institute shows fees tend to be significantly higher in "open access" states. For example, average asset-based fees in California and Texas (two open access states) were 2.11% and 1.71%, respectively; in Iowa and Arizona, two "controlled access" states that offer products based on competitive bids similar to a 401(k) environment, fees were respectively 0.87% and 0.80%.
Further, in Texas, roughly 80% of fixed annuities and 78% of variable annuities offered to teachers in a 403(b) had a surrender charge; 45% of investment options had either a front- or back-end commission. Neither Iowa nor Arizona had such charges, according to the report.
"There's no standard in this marketplace," Mr. Ford said. "Why do 403(b) vendors get to sell [these products freely] when in the 401(k) market there'd be lawsuit after lawsuit after lawsuit?"
Insurers also seem to be using misleading marketing practices in many circumstances. One frequent tactic, advisers said, is a salesperson posing as a district-appointed 403(b) representative.
"Teachers get good healthcare and pension benefits, so they make the assumption that if the district sent [the representative], it goes with their other package," Mr. Isola said. "I can't tell you how many teachers have told us that, and that's how they initially got into [the 403(b)]. That's obviously just a blatant lie."
Further, there's often no barrier to entry for brokers to come into a school setting, so some loiter around teachers' lounges and cafeterias waiting to make a sale, advisers said.
[More: Finra panel awards schoolteachers $2.38 million in fraud case]
All of this is to say, New York is doing the right thing by looking into this mess. Reforms are needed.
Some detractors make the argument that teachers already have good retirement benefits in the form of pensions — so why should we worry about their 403(b) plans? This may be true, but consider this — nearly half of all state and local teachers aren't
covered by Social Security, according to the National Association of State Retirement Administrators. That means they'll need strong supplemental savings plans like 403(b)s to help make up the difference.
The TIAA-CREF Institute found that teachers participating in a low-fee 403(b) plan in a controlled access state can generate an additional $4,000 annual annuity income in retirement, providing an additional 7% income replacement rate of the teacher's final year salary, relative to a teacher in a high-fee plan in an open access state. That difference could prove meaningful to many retired teachers.
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Teachers also often have to work decades to receive their maximum pension benefits. In New York state, for example, it's 30 years, Mr. Isola said. And the strength of the pension plan shouldn't dictate the level of rip-off consumers suffer in 403(b)s.
"If a person has a lot of money, then it's OK to rob his house?" Mr. Isola asked.
