What is a 403(b) plan?
Under Internal Revenue Code 403(b), employees of 501(c)(3) non-profit institutions (colleges and universities, public schools, hospitals, etc.) can contribute money for retirement on a pretax basis through a payroll-reductions plan offered by their employer. In all cases 403(b) contributions are federal income tax deferred, and in most cases, state income tax deferred as well. Generally speaking, these contributions are payroll tax-deferred until withdrawal after retirement, or age 70 at the latest. In all cases, the standard 403(b) plan is voluntary and a supplement to the ORP plan or the Teacher's Retirement System.

What is the Texas Optional Retirement Program (ORP)?
Optional Retirement Program (ORP) is an employer matching contribution 403(b) plan available to faculty, administrators, and other eligible employees of most Texas colleges and universities who have been recruited through a national job search. Essentially, ORP is the ability to select a mutual fund company or an insurance annuity company as an alternative to the Teachers' Retirement System of Texas (TRS). Other states in the US have also adopted their versions of the Texas ORP plan.

What is the "match" that I will receive if I elect ORP?
If you elect the ORP retirement plan option within 90 days of your initial employment date, your employer will match 6% of your annual salary (divided by each paycheck) if you were hired after September 1st, 1995. For many ORP contributors, the State ORP match is still up to 8.5% of your annual salary if you were hired before September 1st, 1995. depending on your employer. As an employee, your part of the matching "deal" is a 6.65% annual contribution. If you elect TRS, the percentages are roughly the same.

What investment options are available in 403(b) or ORP plans?
You are allowed to invest your ORP/403(b) contributions into either mutual funds or variable annuities (a fixed annuity option is usually available within a variable annuity product). Mutual funds are a portfolio of stocks and/or bonds that are "managed" and marketed by regulated investment companies (such as Fidelity, Vanguard, T. Rowe Price, etc.).

Variable annuities are products marketed by insurance companies that offer a bundled package of mutual funds (called variable sub-accounts) and usually a fixed annuity. A fixed annuity is a portfolio of bonds from which the insurance company pays you a fixed interest rate (they skim about 2% of the gross total return) without the yield volatility usually associated with bond investing.

Are mutual funds or variable annuities best for your 403(b)/ORP investments?
No-load mutual funds are almost always the best choice for retirement plan assets. No-load mutual funds are superior in three ways:

1) they are 100% liquid within the ORP/403(b) plan;

2) they are free of costly commissions and insurance mortality fees; and

3) they generally "perform" better over time, all things being equal.

In fact, the big secret about variable and fixed annuities is that they are actually designed for after-tax investing, since insurance products already offer tax-deferral of any interest, dividends, or growth generated by the performance of the annuity. In essence, variable annuities are redundant in a tax-deferred retirement plan.

What does "load" mean?
A "load" (used by the investment industry) indicates that a commission is being paid to an insurance agent or a brokerage house salesperson. A 5% "front load," for example, means that if you invest $10,000.00, a $500.00 commission is paid up front. After the "load," you will then have only $9,500 that actually gets invested. In the case of insurance annuities, investors pay a 1% to 1.5% annual change and a "back-load" surrender charge if they cash out the annuity before a contracted period of time.

Are variable annuities "insured"?
Initially, yes. And only if the stock market goes down immediately after buying the annuity or if you die shortly thereafter. In the long term, the "insurance" feature if an annuity is usually worthless and an unnecessarily high expense.

One of the reasons a variable annuity is a poor choice for your ORP/403(b) plan is because you are forced to pay a 1% to 1.5% insurance/mortality charge on your entire ORP/403(b) account value every year. This mortality charge is supposed to pay for a "guarantee" that, only upon your death, your beneficiary will receive the higher of your original investment or your current account value. But rarely is your account value lower than your original contributions. In other words, the insurance annuity mortality benefit is only of value in the case of death and/or your investments do poorly.

Here is a concrete example: You invest a lump sum ORP/403(b) amount to a variable annuity. The market goes down 10% to $45,000 and then you die. Your beneficiary will receive $50,000 and you will have protected the 10% loss. However, over time, if your annuity is worth $55,000, you are unnecessarily paying roughly $500 a year every year for a meaningless "insurance policy" for what is now a $5,000 death benefit. And it gets more expensive every year as your account value increases. It is a very costly and unnecessary insurance policy.

How do insurance annuity surrender charges work?
The average insurance annuity contract is "loaded" with a 3% to 6% surrender penalty on each ORP/403(b) contribution for a period of at least 5 years to as long as 15 years. The surrender charge, along with the annual insurance mortality charge described above, is designed to "reimburse" the insurance company for the up front commissions paid to the annuity salesperson and to make sure the insurance company has your money long enough to make a profit. It is a forced "load" paid over time on the back end.

Moreover, although you are paying the insurance company the annual 1% to 1.5% insurance mortality fee, the surrender charge is still lurking for a minimum of 5 years on each contribution, even after you stop contributing to the annuity. In contrast, a no-load mutual fund has no insurance charges, no surrender penalties, and generally lower total annual expenses.

Are annuities the only 403(b)/ ORP product with surrender penalties?
Unfortunately, no. Most mutual fund companies are now selling what are called "back-load" mutual funds (called B share funds). Since B share mutual funds also carry hefty surrender penalties as well as higher annual management expenses, back-loaded mutual fund products are really no better than insurance annuities. As with insurance annuities, the use of "back-load' mutual funds are also too restrictive and expensive and strongly discouraged for use in an ORP/403(b) plan.

Please e-mail or telephone us for further information.

Rocky Boschert
Arrowhead Asset Management

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