A Tough Test for 403(b)s

EDITOR'S NOTE: This article was originally published in the November 2008 issue of Kiplinger's Retirement Report. To subscribe, click here.

Six weeks after classes started, Robert Lever, 57, a high-school business teacher, joined hundreds of placard-carrying educators at a board of education meeting of the Baltimore County Public Schools. The protesters wanted the board to reject a proposal to cut the number of investment providers in their 403(b) plans to one, down from ten.

"How can you put people with different expectations and desires into the same provider?" says Lever. The school board capitulated and was expected to approve five providers.

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Baltimore County was trying to comply with new IRS rules that require 403(b) sponsors to maintain more oversight of investment providers. As of January 1, teachers nationwide will see changes in their 403(b)s, a retirement-savings plan used by school systems and nonprofit organizations.

Like 401(k) plans, 403(b)s permit employees to set aside pretax money for retirement. But 401(k) sponsors must meet a fiduciary standard that obliges them to find low-cost investment options. School districts have taken a hands-off approach, often approving as many as 30 vendors -- many selling annuities with high fees. "The participant would ask for vendors, and the sponsors added them," says John Begley, executive vice-president with Fidelity Investments, a provider for many 403(b) plans.

The new rules require sponsors for the first time to draw up a formal document that details standards for eligibility and for how participants can take loans and make hardship withdrawals. Sponsors must also draw up agreements with vendors.

School districts are likely to vary in their response. In some, low-cost mutual funds could replace some annuity choices. In others, annuities could prevail. But new monitoring mandates will prompt many districts to reduce the number of vendors. "It is too difficult to manage multiple vendors in this new environment," says Dan Otter, a former teacher who operates the Web site 403bwise.com. "That's a good thing if the vendors that remain are low cost."

When Maryland's Montgomery County school district requested bids from investment providers, it ruled out mutual funds with sales charges and certain variable-rate annuities, says John Kevin, the district's investment officer. "A majority of the companies came up with better, lower-cost products," he says.

The district dropped from 14 vendors to nine in 2007, but the vendors offer about 3,000 investment options. Kevin says it's up to employees to research options. "We're not saying that because this vendor is here, it has good investment options," he says. "Teachers need to educate themselves."

If You Don't Like the Choices

Before September 24, 2007, teachers who didn't like the choices could transfer to providers outside the plan. You can still ask for a transfer, but the IRS rules severely restrict this escape hatch. The financial institution receiving your money must agree to share information with your employer. Outside providers may not want this headache.

Otter expects that teachers in many districts will demand low-cost options. But if that fails, you can forgo the 403(b) and contribute to an IRA instead. "In an IRA, you can put your money in almost anything," says Scott Dauenhauer, a certified financial planner in Laguna Hills, Cal.

However, the contribution limits for an IRA are much lower than they are for a 403(b). Individuals can contribute up to $5,000 to an IRA, plus a catch-up contribution of $1,000 for those 50 or older. With a 403(b), you can contribute $16,500 in 2009, plus a $5,500 catch-up contribution and an extra $3,000 for five years after 15 years of employment.

For many teachers, lower contribution limits may not be important. Their 403(b) plans often supplement defined-benefit plans. And many don't fully fund their 403(b) plans.

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