Will Your 403(b) or 457 Plan Close the Gap in Your Retirement Plan?
Your Pension Is Not Enough
At the end of a satisfying career, you deserve to enjoy an enriching retirement. But you need to start planning now.
Professionals recommend that you replace 90% to 100% of your pre-retirement income in order to enjoy a comfortable retirement lifestyle. You may think that you won’t need that much. However, as you age, health care expenses tend to rise, and the high cost of retiree medical care is taking an
increasing bite out of retirement income (see “Health Care Costs Are a Major Retirement Expense”).
CalSTRS estimates that the average career teacher’s pension replaces just 60% to 65% of final pay.* For CalPERS school members, for example, a teacher’s aide retiring at age 55 with 25 years of service will receive about 50% of his or her annual compensation under the CalPERS formula.** If your defined benefit pension will replace less than two-thirds of your paycheck, where will the rest come from?
One strategy is to supplement your CalSTRS or CalPERS defined benefit pension with voluntary savings in a
403(b) or 457 plan. However, the type of 403(b) or 457 product you choose, along with the performance of its investments over time, will impact the amount of funds you will have available to you upon retirement.
Making the Choice
If you are currently investing in a 403(b) plan, do you know what type of product you purchased? Or if you are a new investor, what type of product will be best for you?
There are three basic investment product options in a 403(b) or 457 plan:
A fixed annuity is a financial contract with an insurance company. It offers a fixed rate of return guaranteed by the issuer over a specified time and your principal investment or contributions are guaranteed by the issuer. Since the guarantee comes from the issuer, it’s important to choose a company that’s highly rated by the major rating agencies, such as Moody’s or Standard & Poor’s. Fixed annuities may seem attractive because of their guarantee, but they generally pay low interest rates that may not keep up with inflation over time.
The insurer may charge fees and make money on the spread, and how they derive income from the spread can vary as to how it is disclosed. The spread is the difference between what the insurer makes by investing your money and what you are paid by the annuity company. For example, if the issuer is able to invest your money at 5% and pays you 3%, they earn 2% each year on the money you’ve invested.
Fixed annuities often have surrender fees that penalize the investor for withdrawing funds and/or transferring to a different 403(b) company. These fees may apply even if you’ve been invested in the fixed annuity for 10 years or longer. There are additional fees that may be included in a fixed annuity for optional features such as a guaranteed lifetime income rider or a loan option.
A variable annuity is also a financial contract with an insurance company. Unlike a fixed annuity, there is not a guaranteed rate of return while you
are accumulating money in the annuity. With a variable annuity, you choose from a range of investment options, called subaccounts, and the value of your annuity fluctuates depending on the performance of the subaccounts you select. These subaccounts are generally a selection of mutual funds that are made available by the insurer.
Variable annuities generally come with a couple of layers of fees. First, there are the fees that are incurred by the underlying mutual fund investments. You pay these indirectly, since they are passed through the mutual fund to the insurer.
The second layer of fees is associated with the insurance company offering the variable annuity. For example, a variable annuity may include a
death benefit, for which you pay a mortality and expense (M&E) fee. This feature provides that, in the event you die while working and the market is down, your beneficiary will receive no less than your contributions less any withdrawals. Typically, the mortality and expense fee is 1.25% a year, according to the Securities and Exchange Commission. Like fixed annuities, many variable annuities also charge surrender fees if you decide to surrender the contract before a certain period. These fees may apply for 10 years or longer, so be sure to determine whether the variable annuity charges surrender fees and, if so, for how long.
Some 403(b) variable annuity companies offer a living benefits rider which guarantees that at retirement if you take an annuity you won’t outlive your annuity. As with a fixed annuity, every additional feature of a variable annuity adds on fees that will erode your return. As a result, when purchasing an annuity (or any investment, including mutual funds), you should be careful to weigh whether the protection or features you are purchasing are worth the fees you will have to pay to receive them.
403(b)(7) Mutual Fund Custodial Accounts
One nice feature of a 403(b)(7) plan is that you can invest directly in mutual funds without incurring the fees and expenses inherent in a variable annuity that is offered by an insurance company.
Mutual funds pool money from investors to purchase shares in a particular asset class. Funds may invest exclusively in one asset class, such as exclusively stocks or bonds. Or they may invest in more than one asset class, such as asset allocation and targeted-maturity funds, which may include a mix of stocks, bonds and/or cash equivalents.
The mutual fund investment company includes fees to manage the investments, often referred to as the expense ratio. This can range from .05% to 2.0% and includes the cost of hiring fund managers and administrative costs of the mutual fund. You may also be paying 12b-1 fees, which are used to promote the fund (yes, you could be paying for TV commercials!).
It is very important to consider the fees when you purchase a mutual fund, because annual fees will reduce your return. For example, if your fund earns 6% one year, and the annual fee is 1.25%, then you’ve actually earned just 4.75%.***
Finally, when investing in a mutual fund you may be paying a “load” or a commission to a salesperson. Have you heard of front-end and back-end loads? These refer to when a fee is charged – when you buy (front end) or when you sell (back end). A good 403(b) vendor will offer some or all no-load mutual funds, which do not charge loads or sales fees.
* Source: http://www.calstrs.com/eNewslettersCalSTRS
** Source: www.calpersresponds.com/downloads/
*** Fees and return are for illustration only and do not
represent the costs or performance of any specific fund.
Important Information About Annuities:
- Although one of the selling points of fixed and variable annuities is tax-deferral, it is important to understand that you receive no additional tax benefits by putting annuities into your 403(b) plan which is already tax-deferred.
- If you purchased your annuity from a local representative, you may be paying commissions or fees to this insurance
representative, on top of the annuity fees and the fees that are charged by the underlying investments. Ask that all fees and commissions be disclosed to you in writing before purchasing any investment. If you are already investing, contact your vendor to identify all the fees you are being charged or that you might incur should you want to withdraw and transfer your funds to another investment.
When you are eligible to retire, you can decide whether to take a lump sum withdrawal of your 403(b) and 457 savings or, at that time, purchase an annuity with an insurance company.
If you purchase an annuity with an insurance company at retirement you will be paying an annuity rate.
Why pay this rate during your investing years when fees erode your nest egg?
Important Information About Mutual Funds:
- All mutual funds have explicit
fees – those that are revealed in
the prospectus, such as 12b-1
marketing fees and annual fees.
They also have implicit fees.
These include the costs to the
fund to trade the securities within
the fund. All these fees will affect
- All mutual funds have risks.
Investing in a mutual fund through
your 403(b) or 457 plan does not
guarantee a profit or protect
against loss in a declining market.
- Ask for information in writing
about the fees and expenses in
It is important that you decide
what type of investment is best for
you and that you are not “sold” a
product by a representative who
has a financial incentive to tout one
product over another. One way to
start is to educate yourself about
the different types of 403(b)
products and understand the
different fees included in these
products. CTAinvest.org can help.
Be an educated buyer! You can find
a wealth of information and tips
at the CTA Financial Education
Web site, CTAinvest.org.