Course 203: 403(b) Plans
Handling the Shortcomings
In this course
1 Introduction
2 403(b)s versus 401(k)s
3 Handling the Shortcomings
4 Alternatives to the 403(b) Plan

Do those shortcomings make 403(b) plans worthless? Not necessarily. But if your company offers a 403(b) plan, consider the following.

Investigate the Options
As with any investment plan, you should learn what you can about your plan options. 403(b) plan participants often find a lot of annuities and very few mutual funds on their list of options. That's because annuities were the only choices the law allowed until the early 1970s. As a result, insurance companies selling annuities established a stranglehold on the 403(b) market.

Here's how an annuity works. A variable annuity ties its returns to the performance of a mutual fund, while a fixed annuity delivers fixed returns. With either, you sign a contract to make regular contributions for a period of time, and the annuity will provide regular payouts when it comes due. The annuity also carries insurance so that you or your beneficiaries won't receive less than what you contributed.

That guarantee might seem compelling, but it hardly makes annuities no-brainers. In fact, most 403(b) participants would be better served by mutual funds.

Funds benefit more than annuities do from the main advantage of 403(b) plans: Gains aren't taxed until participants start drawing money from the plan. Even outside 403(b) plans, annuities avoid taxes. There's no extra benefit in keeping them in a tax-deferred account. What's more, mutual funds often offer higher returns than annuities do. You'll find out why inPortfolio 401, which focuses exclusively on these investments.

Check the Fees
There's a simple reason why funds often perform better than annuities: They cost less.

For example,an annuitymay charge twice as much in percentage terms as the underlying fund. Over long time periods, these higher expenses have a dramatic effect on returns.

Let's assume you contribute $5,000 a year to an annuity that charges 1.77% annually. Let's also assume that its average annual return will be 12%. After 30 years, you'll have $947,018.87.

That's not chump change, to be sure. But if you instead put the same amount each year directly into the underlying mutual fund--which charges, say, 0.66%--via a tax-deferred account, you will walk away with $1,182,720.99. By choosing the variable annuity, you will have paid $235,000 extra for guarantee that you'll get your $150,000 contribution back.

Try to Make Your Plan Better
A little cajoling from a determined group of employees can make a weak 403(b) plan much better.

When you approach your company's higher-ups, have a list of mutual funds you'd like to see included in your plan in hand. In particular, look for funds with low annual expenses, good performance, and experienced management teams. You should also pick funds that invest in different parts of the market so that you can build a diversified portfolio. Those who are Morningstar.com Premium Members can get some ideas from our list of Fund Analyst Picks. (Nonmembers can sign up for a free trial to our Premium Service.)

Next: Alternatives to the 403(b) Plan >>


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