Did new 403(b) regulations improve retirement plans in higher education?

It has been two years since the new regulations of 403(b)plans went into effect. As a result, on campuses across the country retirement plan committees were formed, consultants hired, and investment options examined. Have the new regulations had any effect? Are higher education retirement plans any better than they were before? The new regulations gave employers much more responsibility for the design and operation of their plans. Many plans are now subject to ERISA which assigns plan sponsors fiduciary duty in managing their plans “prudently.” This means closely monitoring the investment options offered in the plan, paying attention to costs, and participant education. How are employers doing? This article takes a brief look.

Cost

The new scrutiny of higher education retirement plans seems to have brought  about only a modest reduction in cost.  Some universities, for example Cal Tech, did this by adding the low cost mutual fund provider Vanguard. The reductions in costs are modest because the new provider manages only a tiny fraction of assets as it slowly accumulates new contributions. Other schools, for example Harvard University, eliminated the relatively high cost provider DWS from its menu of investment options. The existing balances were rolled over into other options. The impact is modest because the DWS’s was small to begin with.

Given that TIAA-CREF still dominates the higher education retirement market, any significant reduction in cost for higher education plans will have to be associated with changes at TIAA-CREF. TIAA-CREF’s share among the largest 30 retirement plans remains above 70 percent. The vast majority of those assets (around 74%) are in two vehicles: TIAA Traditional fixed annuity and CREF Stock variable annuity.  The expense ratios on CREF Stock and other variable annuities are the same as they were in 2005. The expense ratios on TIAA-CREF mutual funds, if anything, have gone up. For example, the hugely popular Large-Cap Value Fund retirement class had the expense ratio of 0.74 in 2010 compared with 0.48 in 2005.

The good news on the TIAA-CREF front is the introduction of the institutional class of shares on TIAA-CREF mutual funds in a number of higher education plans. The institutional share class has an expense ratio about 20 basis points lower than the retirement class. The TIAA-CREF institutional class index funds have expense ratios similar to those of Vanguard’s index funds – an industry leader in low-cost index funds. Unfortunately, the impact of the new class share is small for two reasons. First, most of the TIAA-CREF assets are still in its variable and fixed annuities, and the expenses on those have not changed. The second reason is that only the very largest of plans are able to offer the institutional class. Even among the largest plans, only some have the institutional share class. For example, the University of Pennsylvania, Georgetown, Carnegie Mellon,  Indiana University and Cal Tech each have about one billion in TIAA-CREF assets.  Perhaps as a result, they were able to negotiate the lower cost share class. As of the end of 2010, other large plans such as Cornell University and the University of Chicago still offered only the more expensive retirement class shares despite having as much in TIAA-CREF assets as the schools that now offer the institutional class. Hopefully, it is only a question of time until the fiduciaries of those plans successfully push for the lower cost options. How successful smaller plans will be in pushing for lower costs remains uncertain. It is similarly uncertain how successful employers will be in encouraging participants to consider shifting from the higher cost variable annuities to lower cost mutual funds. Still, the introduction of lower expenses on TIAA-CREF options is a significant step in the right direction.

Plan design

Despite the new attention to plan design, 403(b) plans remain far more complex than their 401(k) counterparts. Some observers hoped that the new regulations would force plans to streamline their design. This has not happened. The average number of investment options among the largest twelve 403(b) plans is over 160, and no plan has less than 30 investment options. This stands in sharp contrast to the typical number of investment options in the 401(k) world which is 14. Even IBM’s plan, which is the largest private sector defined contribution plan in the U.S. with 36 billion in assets and 200 thousand participants, has only 23 investment options.

There are a number of strikes against plans that offer a large number of options. First, breaking up assets into many options denies the plans the economies of scale associated with asset management. Consolidating assets would probably make more plans eligible for lower cost share class. Second, research shows that a large number of investment choices lowers participations as participants become overwhelmed. Certainly, participant education – a point emphasized in the new regulations – is much more difficult and probably ineffective when participants face hundreds of funds to choose from. Portfolio theory says people should be able to invest in various asset classes - it says nothing about the need to offer choice within each asset class. Therefore, offering five different large cap value funds seems superfluous. Finally, monitoring hundreds of investment choices must be costly for the plan sponsor. At a time where universities and colleges struggle with tight budgets, spending on investment monitoring seems wrongheaded.

As evidence of the need streamline higher education retirement plans, consider the plan of Financial Engines - a firm whose business is to advise plan sponsors and plan participants on defined contribution plans. Unlike faculty and staff at colleges and universities, the employees of Financial Engines are skilled investment professionals. Yet, their plan consists of only 17 index funds – each fund covering a major asset class. Other financial advisory firms have similarly simple plans. If anyone should be able to navigate hundreds of investment options it would be the financial professionals. That their own plan is so simple suggests that there is little value in offering hundreds of investment options. If financial experts can’t benefit from in a huge menu of investment options, it is doubtful that the faculty and staff at a university can.

Overall, the impact of the new regulations on the nature of higher education plans seems less than dramatic. Yet, there is evidence that universities are taking a look and making small changes in the right direction.

The 12 Largest 403(b) Plans in Higher Education

University (plan number)	Assets as of 12/31/10  (in billions)	Number of Participants (in thousands)	Assets per participant (in thousands)	Estimated number of investment options	Share of TIAA-CREF in Total Assets	Share of TIAA-Traditional and CREF Stock in Total Assets	Providers in addition to TIAA-CREF
Stanford University (001)	3.6	20	177	30	46	38	Prudential, Vanguard
Duke University (001)	2.9	28	104	385	35	25	DWS, Fidelity, VALIC, Vanguard
University of Pennsylvania (001)	2.9	20	144	97	70	53	Vanguard
Washington University (001)	2.7	20	132	97	81	60	Vanguard
California Institute Of Technology (002)	2.1	17	122	31	97	65	Vanguard and others
Emory University (001)	1.9	21	90	130	52	40	Fidelity, Vanguard
New York University (001)	1.8	12	145	88	78	58	TIAA-CREF, Vanguard
University Of Southern California (001)	1.6	22	73	350	65	47	Fidelity. Prudential, SunAmerica , Vanguard
University Of Chicago (001)	1.6	14	115	130	77	58	Vanguard
Boston University (002)	1.5	6	258	200	58	46	Fidelity, MetLife, Vanguard
Cornell University (001)	1.5	25	60	226	80	60	Fidelity, and others
Georgetown University (211)	1.1	5	237	250	70	55	Fidelity, Vanguard

The Gap Between the Cost of Actively and Passively Managed TIAA-CREF Funds Widens

During the last few years, the expense ratios of actively managed TIAA-CREF mutual funds have risen.  For example, the expense ratio of the TIAA-CREF Large Cap Value fund retirement class rose from 0.47 in 2003 to 0.77 in 2011. Similar increases occurred in other actively managed TIAA-CREF funds. This is despite the fact that the average expense ratio of stock mutual funds declined over the same time period. (see p.64 of 2011 Investment Company Fact Book). TIAA-CREF expense ratios are still lower than the average expense ratio across all stock mutual funds, but since most of TIAA-CREF mutual funds are held inside retirement plans, we should compare the TIAA-CREF expense ratios to expense ratios of mutual funds inside retirement plans. According to this ICI study, the average expense ratio inside retirement plans is only 0.71 – a bit lower than many of TIAA-CREF’s actively managed funds.

Interestingly, expense ratios on TIAA-CREF’s index funds have declined somewhat. The expense ratio on the retirement class of TIAA-CREF’s longest running index fund, the S&P 500 index fund, declined from 0.44 in 2003 to 0.34 in 2010. Index funds, especially S&P 500 index funds, have become a commodity which drives down expenses. TIAA-CREF index funds in the retirement class are still about three times as expensive as Vanguard’s or Fidelity’s index funds, so perhaps a mild decline in cost is to be expected.

The allocation of assets between actively and passively managed funds has always influenced the overall cost of a retirement plan. The widening gap between the costs of actively and passively managed funds magnifies the effect of allocation between actively and passively managed funds on the overall cost of the plan. Informing participants about the importance of costs on long-term performance seems more relevant than ever. In addition, plan sponsors could mitigate the rising costs of TIAA-CREF mutual funds by insisting on institutional share class , which some very large plans are beginning to offer. The institutional class has expense ratios of about 20 basis points lower than the retirement class.

Is TIAA Traditional a good deal? - The Payout Phase

The accumulation in any retirement investment is only as good as the income it buys. TIAA Traditional with the 3% guaranteed interest rate does not permit lump sum withdrawal of the accumulation – it has to be done over a period of nine years. According to a recent TIAA-CREF testimony about one third of retirees annuitize their accumulations, i.e. turn the accumulations into a stream of lifetime income. Is this income a good deal? Would one do better withdrawing the money and buying an annuity from another provider?

There are several difficulties in comparing TIAA’s annuity payments to alternatives. First, annuities come in thousands of varieties. This makes apples to apples comparisons difficult. TIAA Traditional in the annuity pay-out phase, like the accumulation phase, also has the capacity to pay additional amounts of interest, and the income payments you receive may fluctuate though never below the guaranteed amount. Historically, these fluctuations were almost always up but it has happened that payments went down. In the last 10-years or so payments were mostly flat. There is a guaranteed floor but it appears so conservative that the benefits have always been above this floor.

Another complication in comparing TIAA Traditional payments to alternatives is that TIAA payments depend on how long you have been accumulating money within TIAA. The longer you have been with TIAA, the higher the payment. The difference comes from a gradual payout of what TIAA calls “unneeded contingency reserves.” In one example, being with TIAA for 30 years lead to a 5% increase in the initial payment. Of course, there is no telling what difference this will make in the future.

Keeping in mind the difficulties in making valid comparisons, TIAA payments appear quite competitive – especially for women. A study from the year 2000 compares annuity payments from TIAA to a large number of insurers and finds TIAA payments slightly higher for men and quite dramatically higher (about 15%) for women. More recently I compared TIAA Traditional quotes to Berkshire Hathaway and MetLife’s fixed annuities. The TIAA payments purchased using recent vintages were a bit lower, but payments purchased using pre-1990 accumulations were more than 10% higher. However, TIAA payments can go up while fixed annuities from Berkshire or MetLife will not. Moreover, TIAA payments are unisex, i.e. men and women get the same payment. Other insurers pay women less than men because women are expected to live longer. This means that if there is any advantage of going with TIAA it is certainly higher for women than men.

A major issue with purchasing a fixed annuity is that inflation will eat the purchasing power of the payments. An ideal solution is inflation indexed annuities, but the market for these seems small and not very competitive. Given TIAA-CREF’s non-profit status, and that its TIAA Traditional annuities have potential for additional amounts, it is quite likely that TIAA would pass any gains associated with high inflation to its annuitants. Any other annuity issuer would pass these gains to its shareholders. TIAA annuities are certainly far from an inflation hedge, but I speculate that in this respect they beat other insurers.

 

Is TIAA Traditional a Good Deal? - The Accumulation Phase

TIAA Traditional is a guaranteed annuity that is best understood by considering its two phases: the accumulation phase and the payout phase.  In the accumulation phase, participants contribute money which grows at a guaranteed minimum rate of 3% for most contracts plus some additional amounts as declared by the company. The additional amounts are applied every year but different amounts are applied to different portions of the account. For example, additional 1% may be applied to money that was contributed in 2002 but only additional 0.5% to money that was contributed in 2010. Thus, different rates of interest are applied to different `vintages’ in each account.

The system of vintages makes calculating rates of return complicated. A few years ago TIAA began publishing ten-, five- and one-year rates of return. These are calculated consistent with the SEC’s guidelines for mutual funds as the annual growth of one dollar deposited ten, five- and one- years ago. This is helpful but it is not quite comparable to rates published for mutual funds. The problem is that the rates of return reflect the growth of only that particular vintage. For example, the ten-year return only reflects the growth of the money in the ten year old vintage. It does not apply to money contributed before the ten years or after. In the case of a mutual fund, the ten-year return applies to the entire balance as of ten years ago. Thus, a side by side comparison of TIAA Traditional returns and a comparable mutual fund is not possible.

I had a conspiracy theory. Because TIAA can assign different additional interest rates to different vintages, it has a great incentive to assign additional interest to the vintages that are `invisible’ in the ten- five- and one-year table of returns. For example, a four-year old vintage could be assigned very low additional interest, because the return on money deposited four years ago is not shown in the ten-, five- and one- year rates of return. Next year that vintage will be five-years old and so TIAA could assign high additional interest because it would be visible in the ten-, five- and one-year return table. TIAA is able to do this because they could pick and choose which vintage yields high interest.

The lack of data on historical interest rates for each vintage only fueled on my conspiratorial mind. It is impossible to find these historical rates on the TIAA-CREF website or anywhere on the internet. I requested the historical interest rate from TIAA-CREF as part of due diligence done on behalf of my institution’s retirement plan committee. A spreadsheet came back a few weeks later with all the historical rates, but it also had a message “Not for Further Distribution.” Why? I asked myself. This data should be on the internet. After all, there are 190 billion dollars invested in this product. Shouldn’t everyone have access to the historical interest rates? What are they trying to hide?

Alas, if they are hiding anything it is pretty good performance. I pitted TIAA Traditional against Vanguard Total Bond Index Fund (VBMFX) and Fidelity U.S. Bond Index Fund (FBIDX). The results are shown in the chart below. A participant putting away $100 a month starting in April 1990 would end up with almost identical amounts of money at the end of 2010 using any of the three investment options. The trajectory for TIAA Traditional is remarkably smooth compared to the two index funds. It appears that TIAA probably invests in the same types of investments that the bonds funds do, but TIAA smoothes out the fluctuations. In addition, TIAA does not seem to play any games with the additional interest rates. The “visible” ten- five- and one- year returns are no higher than the “invisible” eleven-, nine-, six-, or four-year horizons. I also compared the TIAA Traditional to Barclays Stable Income Market Index. This index begins only in July 1999. TIAA Traditional RA contracts slightly outperformed the index, while TIAA Traditional SRA contracts slightly underperformed.  

In summary, average returns on TIAA Traditional match those in the overall U.S. bond market, but TIAA does a fabulous job smoothing out short term fluctuations. It has returned well above its guaranteed 3% interest rate. Yes, past performance is no guarantee of future returns, but at least I can put my skepticism and conspiracy theories to rest.

Is TIAA Traditional a Good Deal?

Three months ago I was very skeptical of TIAA Traditional. A number of things made me nervous: the apparent arbitrariness with which crediting rates are set; the illiquidity of accumulations; the opaqueness of the vintage system; the lack of information on historical interest rates; and the entrenchment of individual contracts that makes moving TIAA-CREF assets to a different provider difficult.  I went on to investigate. The result of this investigation are the following two posts. They summarize two phases of the TIAA Traditional: the accumulation phase and the payout phase. The bottom line is that that TIAA Traditional is a pretty good deal: in the accumulation phase, the returns match returns on bond index funds; in the payout phase the payments appear competitive (particularly for women) and are probably better inflation hedge than annuities from other insurers. If you would like details with pictures, read the next two posts.

TIAA-CREF has 70% of the higher education market

TIAA-CREF continues to play its historically important role in providing retirement savings in higher education. The 2009 Form 5500 disclosure data on 40 largest private higher education defined contribution plans shows that the average share of TIAA-CREF in assets is nearly 70%. Within TIAA-CREF, the two oldest investment options, TIAA Traditional Annuity and CREF Stock variable annuity account for 47% and 30% of TIAA-CREF assets.  This means that TIAA Traditional Annuity accounts for nearly one third of all retirement assets in higher education, making it undoubtedly the single largest investment option. Even Federal Reserve Chairman Ben Bernanke, according to his financial disclosure statement, has most of his financial assets in TIAA-CREF - split about evenly between TIAA Traditional and CREF Stock.