How to choose a 403(b) vendor

If you have a 403(b) plan with your employer, or you plan to sign on for one, one of the most important decisions you have to make is choosing a 403(b) vendor.

Basically, that’s the investment option you’ll be choosing for your plan. Next to the amount of money that you decide to contribute to the plan, choosing a vendor is your single most important decision.

How to choose a 403(b) provider

You certainly want to choose the best 403(b) providers, but exactly who they are isn’t always obvious. And you should never choose a provider just because it was recommended by your boss or a coworker.

Let’s take a look at the different vendor options that your 403(b) likely offers.

403(b) Overview

A 403(b) is a 401(k) equivalent plan, primarily for government workers, nonprofit employees, but especially teachers. While it’s set up with basically the same features and benefits as a 401(k), 403(b) plans do have significant differences.

Among the similarities, the 403(b) has the same contribution limits as the 401(k). Each enables you to make tax-deductible contributions up to $18,000 per year out of your salary, or as much as $24,000 if you’ are age 50 or older. Both also allow for employer matching contributions, though not all employers offer this benefit.

Both plans also allow you to take loans against the plan. If loans are permitted by the employer, and they aren’t in every situation, you can borrow up to 50% of your vested balance in the plan, up to $50,000. Loan terms generally run no more than five years. And loans need to be fully repaid if you terminate your employment.

Withdrawals are permitted from the plan beginning at age 59 ½. Distributions from the plan are taxable at ordinary income tax rates. But if you take withdrawals prior to turning 59 ½, you may also have to pay a 10% early withdrawal penalty.

Like the 401(k), the 403(b) also requires that you begin taking required minimum distributions, or RMDs beginning no later than age 70 ½.

The Best 403(b) Providers

Probably where the 401(k) in the 403(b) differ the most is with investment options within each plan.

In theory at least, investment options in the two plans are also the same. However, those options are offered at the discretion of your employer. In that regard, the employer can choose the plan provider (or trustee).

Those providers can be any of the following:

  • An insurance company – which is usually handled through an annuity, or
  • An investment company, which could be a mutual fund family, a managed investment account, or even a diversified investment broker, enabling you to have nearly unlimited investment options.

Investment options are more typical with 401(k) plans, while insurance providers are more common with the 403(b). This is done in part because the type of employers who sponsor 403(b) plans tend to prefer lower risk plan providers for their employees.

The best 403(b) plans are more likely to offer investment providers, but many plans offer only insurance options.

Insurance 403(b) Providers

Insurance providers are very common among 403(b) plans, but unfortunately they’re not the best choice.  Here’s the cliff notes version in why insurance companies are not the best option.

  • Insurance 403(b)s can be up to 3x more expensive
  • Investment choices in an insurance 403(b) are limited, and you may only have 20 (sub-par) options. An investment 403(b) can have up to 2,000 fund choices for you to consider.
  • An insurance 403(b) is an annuity. This is an insurance contract which has a long lock-in period (up to 12 years) where you can’t transfer your 403(b) to another vendor without paying a penalty. It’s my belief that you should be able to move to another vendor if yours stinks, without paying them for that privilege. Don’t you agree?

Insurance companies usually manage 403(b) plans by using annuities. An annuity is an investment contract between you and the insurance company. In it, you agree to invest your money in the plan, and the insurance company agrees to provide you with a specific income at the end of the contract term.

This sounds like the perfect arrangement for a retirement plan, at least on the surface. But there are a few reasons why annuities are actually not the best vehicles for retirement money.

Limited investment income.

Many annuities have income caps. For example, they may limit the income in the contract to say 8% per year, even though the underlying market is providing a 12% return. That means that you will lose 4% investment return in that year.

Surrender charges.

Very few annuity investors are familiar with this concept. Since an annuity is a contract, the insurance company wants to lock you into it for a very long time. To enable that to happen, they impose a surrender charge. If you terminate the contract early, you can be penalized a fee of 8% to 10%. The insurance company may impose that fee, or a declining balance of the fee, for up to 12 years. That would make it difficult for you to exit the contract, should you decide that you want to go in a different direction.

A lack of investment options.

Within annuities, insurance companies invest in their own proprietary mutual funds. While an investment brokerage might offer you the choice of several thousand different funds, the insurance company may have only 20. Worse, insurance company funds are generally not publicly traded. That means that you will not be able to check values and performance the way you can with independent funds.

The Biggest Drawback of Insurance Providers: High Investment Fees

This rates a discussion all by itself. Insurance annuity fees run on average, about three times what investment providers charge. You can easily pay 3% per year or more, which will reduce your net investment income. What’s worse, you may not even know about some of the fees. They can be carefully hidden within the complicated text of the annuity contract.

To illustrate the point, let’s say that you have an insurance company and an investment company, and both are expected to provide an 8% annual return on your investment. Let’s also say that the insurance company charges a 3% annual fee on average, and the investment company charges just 1%. The result will be net return on investment of just 5% for the insurance company, but 7% for the investment company.

As just a simplified example, if you were to invest $10,000 with an investment provider at 7%, for 20 years, you’d have nearly $38,700.

But if you invest the same $10,000 with an insurance company at 5%, for 20 years, you’d only have a little bit more than $26,500.

That means that the investment provider will give you $12,200 more over 20 years than the insurance provider, just as a result of having lower average annual investment fees.

If insurance providers are the only investment options available in your plan, you will have no choice but to work with them. But if they do offer other investment options, you need to seriously consider taking advantage of them.

Investment 403(b) Providers

Without a doubt, investment providers are almost always the best 403(b) providers. That’s because they generally provide you with many more investment choices, and charge much lower fees.

Investment providers come in three basic types:

  1. Managed investment accounts,
  2. Mutual fund families, and
  3. Self-directed investment brokerage accounts.

Managed investment accounts are usually held by large, full-service investment brokerage firms. This can include Edward Jones, Raymond James, USAA or Wells Fargo Advisors. For a fee, ranging between 1.0% and 1.5% of your account balance per year, the firm will handle all of the investment management of your account. This is a good option for people who want higher returns, but don’t have either the expertise or the desire to manage their own investments.

Mutual fund families are investment companies that can offer anywhere from a dozen to several hundred mutual funds or exchange traded funds (ETFs). You can choose funds that invest in the general stock market, or various market sectors, such as specific industries or foreign countries. They usually offer bond funds as well.

Fees for mutual fund families are variable. Mutual funds often come with what are known as “loads”, which are fees that are charged for either buying the fund, selling it, or even both. For example, the fund might charge a 3% upfront load to buy into the fund. Or it may charge 2% to buy the fund, and 1% to sell it. Obviously, no-load fund families are the best.

Mutual fund families are excellent if you want to spread your investment capital around, but don’t want to get involved in the mechanics of managing each allocation. Examples of mutual fund families include Vanguard, Fidelity Investments, and American Funds

Self-directed investment brokerage accounts offer the widest variety of investments. This can also include mutual funds and ETF’s, but also individual stocks, bonds, options, and real estate investment trusts (REITS).

Generally speaking, self-directed investment brokerage firms usually have the lowest fee structure. They may have an annual account fee of between $50 and $100, and charge very small commissions on trades. The lowest investment brokers charge as little as $4.95 per trade. Unless you’re an active trader, the cost of investing will be minimal.

Examples of large investment brokerages include Fidelity, E*TRADE and Charles Schwab. These brokers are the best option for people who like to do their own investing, and need only minimal assistance from the broker.

What to do if You’re Not Happy With Your Current 403(b) Provider

This is more likely to be the case if your plan offers primarily (or only) insurance providers. But it may also be possible that you will have a choice of more than one insurance company.

If you have the flexibility, the following insurance companies are best avoided:

  • American United Life
  • AXA (yuck, avoid this company like the plague – they are the most expensive and predatory in their practices)
  • Great American Insurance Group
  • Horace Mann
  • Jackson National Life insurance
  • Lincoln Financial Group (not to be confused with Lincoln Investment Planning)
  • MetLife
  • Nationwide
  • New York Life
  • VALIC
  • VOYA/Reliastar (previously known as ING)

It’s not that they’re bad insurance companies, but rather that their investment fees are on the higher end of the spectrum.

The best 403(b) plans will offer you different investment options. If they do offer an option to go with an investment provider, you should move at least some of your money into that option. Moving all of it is likely to be the better choice.

The best 403(b) providers offer a flexible investment-based 403(b). These providers include:

  • Aspire (I tend to use them the most when available)
  • Fidelity
  • Lincoln Investment Planning
  • TIAA
  • T. Rowe Price, and
  • FTJ Fund Choice

If you’re already locked into an insurance annuity contract, then just target your new plan contributions to an investment provider.

Roth 403(b) Options – If Your Employer Offers It

Roth plan variations are becoming steadily more popular. In addition to the Roth IRA, employers are increasingly offering a Roth 401(k) option. But there is also a Roth 403(b) as well.

Roth plans in general work somewhat in reverse of traditional retirement plans. For example, while contributions to traditional IRAs, 401(k)s and 403(b) plans are usually tax-deductible, contributions into a Roth are not.

Investment earnings on a Roth are tax-deferred, just as they are for traditional plans. And you’re generally unable to withdraw funds from a Roth until you are 59 ½. If you take them sooner, you’ll be subject to a 10% early withdrawal penalty.

An employer can also offer matching contributions on a Roth plan. However, those contributions will go into your traditional plan, since they do not represent nondeductible contributions.

But the big difference between the Roth and traditional plans is that while distributions from the other plans become taxable as ordinary income upon withdrawal, distributions for a Roth plan are tax-free. That is, if taken after you reach 59 ½, and have been invested in the plan for at least five years.

Roth plans have become incredibly popular, and that’s why a lot of employers are offering them, alongside of traditional retirement plans. That includes employers who offer traditional 403(b) plans.

If your employer offers the Roth option, contribution limits to the plan are the same as they are to a traditional 403(b) – $18,000 or $24,000. It’s an excellent way to build up a large reserve of future tax-free retirement income.

Now if the Roth 403(b) investment options are limited to insurance providers only, then this may not be a viable workaround to the limited investment problem.

But you’ll still have one more option…

Traditional or Roth IRAs to the Rescue

If you’re not satisfied with the investment options in your 403(b) plan, you should consider opening up either a traditional or a Roth IRA. This will give you the benefit of choosing the investment trustee. And with that investment trustee, you’ll also have the possibility of paying much lower investment fees, for many more investment options..

You can consider either an investment brokerage company, managed investment accounts, or mutual fund families. You can also choose to go with a robo advisor, like Wealthfront or Betterment.

An IRA allows you to contribute up to $5,500 per year, or $6,500 per year if you are 50 or older. That’s a lot less than what you can put into a 403(b), but it will give you the option to diversify at least some of your annual retirement contribution into a better investment arrangement.

One thing to be concerned about with IRAs is the possibility of income limits. Since you’re participating in an employer-sponsored retirement plan through the 403(b), there is an income limit on traditional IRAs.

For example, if you’re married filing joint, and your income exceeds $119,000, you can still make an IRA contribution, but it won’t be tax-deductible.

With Roth IRAs, you can still make a contribution, despite the fact that you are covered by an employer plan. However, the Roth IRA has an absolute income limit. If you exceed it, you will not be eligible to make a Roth IRA contribution at all.

For 2017, that income limit is $196,000 if you’re married, filing jointly, and $133,000 if you’re single.

But if you’re within the income limits for either a traditional or a Roth IRA, then one of the two accounts can be an excellent alternative to a 403(b) plan with limited or poor investment options.

It can also help to increase the amount of money that you’re saving for retirement. For example, you can contribute $18,000 to your 403(b) plan, and an additional $5,500 to a traditional or Roth IRA. That’s $23,500 being invested for your retirement, which might even enable you to retire early!

So if you’re not happy with the investment options in your 403(b) plan, contact the plan administrator, and find out exactly what your options are. If that doesn’t work, start your own IRA. That’ll solve at least part of the problem.

How to Choose the Right Financial Advisor to Manage Your 403b

Finding the right company to manage your 403b is just the beginning.  Now you have to find a qualified financial advisor to assist in choosing the right investments.  First step is to contact some reps and do some research. Ask them the following questions:

  • What is your educational background?
  • How long have you been advising teachers on their investments?
  • Will you point me in the right direction if a 403(b) is not a good option for me?
  • How will you invest my money? Are there are restrictions on investments I can use?
  • Can you provide me a list of all the fees that I will pay with this account?
  • How do I contact you, and how long will it take you to respond if I leave you a message?

The most important question:

If I decide to leave this 403(b) and go to another vendor, what fees do I pay and how will you help me with the process?

To get an extensive list of questions to ask, use this resource from our friends at http://www.403bwise.com/

I’ve found a few reps and companies I like, what’s next?

The next step is to meet with these reps – and make sure to meet with more than one.

(It’s important to note at this point to not just use the rep your fellow teachers are using. They might be using them based on another teacher’s recommendation, and this may not have been properly researched. Many clients have told me they did not know the difference between reps and companies and were going on what their colleagues told them. Sadly, no one was informed of the differences and everyone was using a product that potentially cost them thousands in lost investments returns.)

Look these reps in the eye and get a good feel for them. It’s important to note that this person will be investing thousands of dollars of your money, so take as much time as you need to make this decision.

Ask them to put together an investment portfolio for how they would invest your money. Ask them to use the cheapest and most diversified funds available on their platform and outline how much this would cost. MAKE THEM WORK FOR YOUR BUSINESS!

Final Steps

When you have gone through this and have various proposals, they should look similar. The reason for this is that you are choosing from companies that use the same open platform for choosing investments, and may have the same fees. When looking at the proposals, choose those that have the cheapest investments costs and invest not only in the US, but around the world in various size companies.

When you’ve eliminated those that don’t meet this criteria, it’s about choosing the person you are most comfortable with. Choose a rep who you can have a conversation with and actually asks you questions.

If you’re still not sure, shoot me an email and I’ll give you my two cents.

Happy Shopping!