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1999 » November

Running the Fund: Teachers' rocky transition to mutual fund investing

Mutual funds have become more prevalent in 403(b) plans. But most educators are still stuck with old-fashioned annuity products




» Making Sense


» Tough On Schools




The grade school and high school teachers in our nation’s public schools already endure long hours and low pay. Now many of them are also faced with the fact that the huge market gains experienced by many workers with 401(k) plans at private corporations have passed them (and their 403(b) plans) by. While the Tax Reform Act of 1986 intended to level the playing field for non-profit workers by putting the investment options available in 403(b) plans on a par with those available to workers with 401(k) plans, analysts and consultants agree that most teachers still get left out in the cold when it comes to having access to low-cost, equity investments because many districts refrain from offering 401(k) plans.




One reason is that teachers have historically relied upon their defined benefit plans at state teacher’s retirement systems for their retirement security, according to Ann Mahrdt, a senior consultant in Spectrem Group retirement services, a financial consulting firm based in San Francisco. In fact, Spectrem research shows that only two in five public school teachers even have 403(b) accounts. The plans were traditionally limited to insurance-based investments, such as fixed or variable annuities and, despite liberalization in 1986, insurance companies remain the primary 403(b) vendors. Defined contribution vendors are not necessarily scrambling for business in this market because: (1) it is hard to compete with face-to-face marketing; (2) such competition diffuses administration on the local, district and state level regarding the retirement plans, and because of (3) the indemnity agreement required by many public plans. According to Spectrem, more than 85% of all 403(b) money is invested in either fixed or variable annuities, referred to as tax sheltered annuities or TSAs, offered by insurance vendors.




This puts teachers in something of a bind. Fixed annuities pay a fixed rate of return for some specified future period of time and generally earn little more than a certificate of deposit. The return on a variable annuity depends on the performance of the underlying investments, often mutual fund accounts through the insurance company. Both come with an insurance component called a “wrapper” that typically costs about 1.25% of assets annually for a guaranteed death benefit up to the total amount of contributions and sometimes some minimum amount of investment growth. Additional annual fees are tacked on top of the cost of the insurance and average 2.11% of assets every year, according to Morningstar Inc. The final insult is the surrender fee, which can be as much as 6%-9% percent of assets if the annuity is surrendered in the first year and descending on a sliding scale thereafter for seven to 10 years. With many contracts, the surrender period begins anew each time the teacher makes a new contribution. Costs are not regulated and there is little oversight, since insurance regulators usually do not police the market and securities regulators do not get involved because the mutual funds are offered through insurance companies.








Making Sense




While it makes financial sense to make investments in cheaper no-load mutual funds that have been averaging generous gains throughout the decade, few teachers have done so. Even though direct investments by non-profit employees in mutual funds have more than doubled since 1992, still only 15% of all 403(b) money is invested in such accounts, according to the Spectrem study. The low figure demonstrates the difficulty teachers have had in getting direct access to no-load mutual funds due to lax administration and an unwillingness at the district level to take on more legal responsibility. Federal tax laws now allow non-profit organizations to start 401(k) plans for their employees. Very few public schools seem to have turned to 401(k) plans, however, most likely because 401(k) plans are subject to ERISA’s fiduciary duties. Only those 403(b) plans that provide employer contributions or are subject to employer control—where employers control which and how many vendors come into the plan—come under ERISA.




The bad news for teachers is that the hands-off approach results in an overflow of investment options and information that can quickly overwhelm participants. “The districts have offered choice, but no education,” says Mahrdt. She says that the typical 403(b) plan will offer 20 to 25 investment choices to participants.




Karen Hemingway, the contracts administrator at the Los Angeles Unified School District, says that her district is prohibited by state law from mandating the type or number of 403(b) vendors offered to schools within the district. “We have approximately 100 different 403(b) plans within the district,” she says, “including five or six mutual fund families such as Oppenheimer.” She says that the district is not permitted to make assessments or value judgements about the vendors seeking participants within the district. “We must offer the investment options of any company that is willing to come into the district and sign our standard agreement,” says Hemingway. The result is more than 1,000 investment options marketed to 1,100 districts statewide without objective advice or education from the plan sponsor.




One of these plans is sponsored by the California State Teacher’s Retirement System in conjunction with State Street Global Advisors in Boston. CalSTRS’ new 403(b) program currently has $50 million in assets. The CalSTRS 403(b) will offer up to 12 low-cost direct mutual fund options such as an S&P 500 index fund, a money-market, and an international fund with an average expense ratio of 75 basis points, covering both administration and investment management fees. CalSTRS cannot streamline the plan, however, as State Street is prohibited by state law from operating as both administrator and investment manager. Investment management for the plan must be contracted out to other companies. Each fund offered in the plan will be run by a different investment manager.




Randy Taylor, a vice president with State Street Global Advisors, says that it has been difficult historically for participants to get out of TSAs and into mutual funds for several reasons. “Insurance companies have dominated the market with TSAs for so many years and it’s difficult to move money out of those accounts,” he says referring in part to the surrender policies of most TSAs. Also, mutual fund companies cannot easily duplicate the way TSAs have been marketed in public schools, he adds. “Insurance companies have individual brokers and much of the marketing relies on face-to-face contact out of the school setting. We are trying to shift that paradigm by marketing over the phone, holding seminars and by using simple self-enrollment programs. We are also developing a Web site for CalSTRS.” While some teachers may prefer the hand-holding they get from their individual brokers when they buy an annuity, few realize the additional cost involved.








Tough On Schools




John Barth, a principal at Vanguard who heads its Retirement Services Group, adds that, because school districts are typically small and decentralized environments, it is administratively difficult and costly for a cost-conscious company like Vanguard to enter the market. “Districts generally do not conduct retirement education programs for their teachers and, therefore, both the districts and teachers may be relatively unaware of the importance of controlling costs,” he says. “In many cases, the education is provided by individual sales reps who may not have a completely objective outlook. At Vanguard, we primarily rely on prospects to self-select us,” Barth says. Vanguard is willing to market funds in school districts if there is a minimum of 15 teachers willing to sign up.




LA Unified considered making Vanguard another vendor, since many teachers requested Vanguard funds, but Hemingway says the deal was abandoned in an impasse over the hold harmless indemnity agreement required by the district. “We have our standard agreement,” she says, “and they wanted to impose theirs, which we cannot accept.” The hold harmless agreement is required by some districts to protect them from liabilities such as improper payroll deductions, willful fraud or suits based on a participant’s financial expectations, according to Doug Wills, an attorney for CalSTRS.




The problems enumerated here seem to be unique to the public schools. Taylor and Barth say that other non-profit groups, especially hospitals, colleges and universities, have made much bigger strides toward offering employees low- cost mutual fund investment options.




Teachers willing to take matters into their own hands can take steps to transfer money from 403(b) accounts into mutual funds, whether their plan offers the mutual fund family or not. They cannot invest new contributions, but can make what are called “frozen asset transfers” by which accumulated savings are transferred, sometimes at the cost of some surrender fees.






Robin Glenn











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Hi Joel,

The date of this publication is very old, in the investment world 1999 is archaic. Karen Hemingway has been long gone, thank God, from LAUSD for a while now. We have new blood, a new CFO and a new benefits administrator in the LAUSD system. I met both of them. The change of attitudes from the old thinking as quoted in the article and the new people are light years forward. But we will see what they will actually do.



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Knowing the great strides and changes that are in the works in LA I would never have posted this article if it referred only to the LAUSD. It does not. On a national basis the abusive/high cost 403(b) arrangement is alive and well notwithstanding the date of this article.


Peace and hope,


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