PROTECT YOURSELF FROM AMERICA'S FLAWED PENSION PLANS BLIMPISH FEES AND FLIMSY LEGAL PROTECTION COST 15% OF THE U.S. WORK FORCE BILLIONS OF DOLLARS A YEAR IN LOST RETIREMENT SAVINGS.
By ANDREA ROCK

(MONEY Magazine) – When 36-year-old Deputy District Attorney Douglas Rose walked into the San Diego County board of supervisors meeting in early March, he felt confident that the board would vote to improve the county's $175 million retirement savings plan. After all, for 18 years the San Diego plan--a cousin to the 401(k), known as a 457--had offered just one investment option. That option was a variable annuity managed by $90 billion (assets) Hartford Life, an insurer that manages assets for 3,800 retirement savings plans nationwide. Rose and several colleagues had argued for five years that other money managers could offer the county's 15,000 eligible employees a choice of funds with better investment records than those in the Hartford annuity. One substantial drag on Hartford's returns: fees that siphon off as much as 2.45% of employees' assets each year.

The issue before the five-member board that morning was simple: whether to add mutual funds from $76.5 billion Baltimore-based T. Rowe Price to the plan's investment roster, alongside the Hartford annuity. The Price funds indeed had significantly better track records and much lower fees than the Hartford portfolios, and they had already been unanimously approved by a four-member committee appointed by the board to investigate inexpensive alternatives to Hartford Life. The vote seemed a no-brainer.

But as the supervisors took up the issue, Rose saw to his dismay that most of the board was rapidly backing away from its own committee's unequivocal recommendation. Clearly, Hartford Life's efforts to sway the board--which included hiring John Dadian, former chief of staff to San Diego's mayor, as a lobbyist on the 457 issue--had paid off. Rose wasn't the only one surprised by the board's sudden change of heart. Supervisor Pam Slater noted with some exasperation that the two fellow supervisors who had initiated the search for another plan provider were now championing Hartford Life. "I'll vote with the majority on this," she said reluctantly, "but in some ways I don't think it's the wisest thing to do." In the end, the board voted four to one to retain Hartford's hold on the plan's estimated $1.2 million in annual fees. "The Hartford won, and county employees lost," says a disappointed Rose. "As a result of the board's actions, everyone in the plan will probably have a less comfortable retirement."

The decision reached that night in San Diego highlights an issue of national importance: the inadequacy of the retirement savings plans covering some 20 million workers--15% of the U.S. labor force--employed in schools and universities, nonprofit hospitals, state and local government, and other not-for-profit enterprises. As Rose and his colleagues learned the hard way, they are often the losers in a U.S. pension system that operates two separate and unequal classes of retirement savings programs. On the one hand are private-sector plans, such as 401(k)s, which are governed by the Employee Retirement Income Security Act (ERISA). That 1974 law requires employers, investment advisers and plan administrators to put employees' interests first in managing retirement savings plans.

No such protection exists, however, for workers in the public and not-for-profit sector. Their retirement hopes ride on two plans that largely exist outside ERISA: 457 plans like San Diego's, which are specifically exempt from the 1974 law, and similar programs known as 403(b)s, which fall under ERISA only if the plan sponsors choose. (Because of the responsibilities and legal liabilities imposed by ERISA, only a minority of plan sponsors do so.)

The plans are often described as 401(k)s for government or nonprofit-sector employees. But as a three-month MONEY investigation found, many of them are grossly inferior to 401(k)s. In both 457s and 403(b)s, the crucial process of evaluating and choosing a money manager for employees' assets is routinely muddied by political lobbying, as in San Diego, or by cold cash from vendors eager to drum up business. While entirely legal for 457 and 403(b) plans not covered by ERISA, neither inducement would be tolerated in the 401(k) market. Not surprisingly, many of the 457 and 403(b) plans that emerge from this process are so riddled with unnecessary fees and mediocre investment options that it's virtually impossible for participants to accumulate savings comparable to those available through 401(k)s.

The highlights of our investigation:

No one is looking out for employees' savings. Exempt from the duties mandated by ERISA on corporate employers, 457 and most 403(b) plan sponsors and investment advisers have little incentive to make sure their workers get solid investment options, receive adequate information, comply with tax laws--or even participate at all. "Employees think the employer is looking out for them, and employers say it's not their job, and the vendors just want to take your money," says Peter Gold of Buck Consultants, a New York City benefits consulting firm. "No one is minding the store."

Employees are frequently relegated to subpar investment choices loaded with steep fees. Participants in 457 and 403(b) plans can be soaked for more than twice the annual expenses workers pay in 401(k)s. (Not that 401(k) fees are necessarily a bargain, as Money pointed out in its April issue this year; for a follow-up on that story, see Money Newsline Update on page 32.) If 457 and 403(b) plans charged the same fees as 401(k)s, workers in these plans would keep an extra $4.3 billion this year alone, according to estimates by the Windsor, Conn. benefits consulting firm Access Research.

Cash payments can influence which investment choices employees get. Many insurance companies, which manage most of the money in these plans, pay groups such as government workers' unions and teachers associations that endorse their investment products. For example, $34 billion Variable Annuity Life Insurance Co. (VALIC)--an insurer that controls $24.3 billion in 403(b) plan assets--makes payments totaling millions of dollars a year to more than 10 trade and professional groups that recommend the company's costly annuities. Although the organizations can spend this money as they please, VALIC contends that the payments reimburse these groups for the cost of marketing VALIC products to their members.

Participation rates are distressingly low. Only 6.4 million, or 32%, of workers eligible for 457 and 403(b) plans actually contribute, vs. 78% for 401(k)s. One reason is that employers rarely encourage them to. Only 30% of 403(b) sponsors and no state governments match a portion of what employees contribute, compared with 76% of 401(k) sponsors. According to Access Research, if 457 and 403(b) participants enrolled in their plans at the same rate as 401(k) workers, an additional 9.3 million Americans would be putting money into these retirement plans. If they were to save as much as today's average 457 and 403(b) participant does, Access figures, it would mean another $28 billion salted away each year.

Granted, workers covered by 403(b) and 457 plans may never participate in their savings plans as much as their typically better-paid corporate brethren. Similarly, 403(b)s and 457s might never completely close the gap in fees with the generally larger and more efficient 401(k) plans. What is clear, however, is that because of poor design, inadequate supervision and their historic domination by high-fee, low-return investment vehicles, 403(b) and 457 plans as a whole fall far short of the standard set by 401(k)s. The cost to nonprofit and state government workers in forgone savings and diminished retirement security runs in the tens of billions of dollars a year.

Like 401(k)s, 403(b) and 457 plans are named for the sections of the tax code that created them--in 1958 for 403(b)s and 1978 for 457s. Also like 401(k)s, they allow employees to set aside pretax dollars that grow tax deferred for retirement. The 403(b) plans, which cover an estimated 17 million teachers, hospital workers and employees of nonprofit organizations, typically allow employees to sock away up to $9,500 a year; 457 plans let some 3 million government workers stash away as much as $7,500 annually.

Beyond that, however, the plans differ sharply from 401(k)s. One major departure: While 401(k)s are typically run by money-management firms that offer employees a menu of mutual funds or institutional trusts, 457s and 403(b)s are run largely by insurers, who limit their investment options mostly to variable annuities. Variables are mutual-fund-like portfolios that contain a thin layer of insurance protection--and a fat layer of extra fees. Although mutual fund companies, including T. Rowe Price, $413.5 billion Fidelity Investments and $320 billion Vanguard, are trying to break into the market for these plans, insurers today hold 85% of the $370 billion invested in 403(b)s and 48% of the $60 billion in 457s.

In 401(k)s, by contrast, insurers control just 25% of the market. One reason is that ERISA requires 401(k) sponsors to safeguard employees' interests when selecting outside firms to manage the plan's investments--and those interests are rarely best served by variable annuities. "A major reason insurance companies still have the lion's share of the 457 and 403(b) markets is their marketing prowess," says Ronald Bush of Access Research.

Here are four of the main shortcomings of 457 and 403(b) plans, and our suggestions for reform:

HIGH FEES FOR MEDIOCRE PERFORMANCE

Insurers that sell variable annuities to 457 and 403(b) plans often claim that participants get to choose from a wide menu of portfolios managed by well-known mutual fund firms. Hartford Life's variable annuity, for example, includes funds managed by Fidelity, $45 billion Janus and $142.3 billion Putnam. What the insurers downplay, however, is that in addition to the funds' management fees--which average 1.4% on stock funds and 0.9% on bond funds--annuities nick you for an extra fee known as the mortality and expense charge, which averages 1.25%. (One significant exception: The variable annuities managed by TIAA-CREF, which dominates the 403(b) market at universities and research institutions, offer a variety of solid investing choices with razor-thin fees of 0.29% to 0.38%.) Result: Participants in a typical insurance company plan pay total expenses of as much as 3.5% annually, vs. as much as 2.25% for the typical plan that invests in mutual funds. For a look at how such extra fees can erode savings, see the chart on page 158.

Like many insurers in this market, Hartford Life justifies its higher cost by asserting that it offers personalized services to plan members. Hartford notes that it maintains a four-person San Diego office that advises employees at 150 or more group sessions a year and 3,000 one-on-one meetings. As an indication of the effectiveness of that counseling, Hartford notes that 51% of the San Diego County employees eligible to contribute to the 457 plan do so. While clearly higher than the participation rate of 457s overall, that figure only equals the average for local (as opposed to state) government employees nationwide, according to a survey by the National Association of Government Deferred Compensation Administrators, an association of 457 sponsors.

Moreover, several San Diego plan members MONEY spoke to claimed that other than being enrolled by a local sales representative, their only contact with Hartford Life has been by mail and telephone. Even the two "highly satisfied" participants Hartford itself referred us to appeared strangely uninformed about crucial aspects of their plan. As proof of Hartford Life's stellar performance, for example, San Diego County assessor Gregory Smith cited the 35.5% gain of the $272 million Hartford Capital Appreciation fund through the first half of this year, which was widely covered in the financial press. What Smith didn't realize is that public mutual funds are not usually the same portfolios you get in a variable annuity, even though they may have identical or confusingly similar names. Indeed, the Hartford Capital Appreciation fund available to Smith and others in San Diego's 457 plan is not the top-performing mutual fund. Rather, it is a separate $4 billion variable-annuity portfolio that gained 14.6% the first six months of this year, or nearly 22 percentage points less than the Hartford Capital mutual fund. That difference stems mostly from the fact that the annuity invests primarily in large-company stocks, while the mutual fund buys faster-growing small-company shares.

To be sure, participants in 457 and 403(b) plans also hurt themselves by having far too little of their retirement accounts overall invested for long-term growth. Some $232 billion, or 54%, of the money invested in 457 and 403(b) plans is stashed in so-called fixed accounts, essentially insurance companies' version of a bank certificate of deposit. In the case of the San Diego plan, at least $61 million, or 35%, of the plan's assets sit in Hartford Life fixed accounts. By contrast, only $162 billion, or 20%, of the $810 billion in 401(k) accounts rests in comparable investments.

Fixed accounts are a wonderful deal for insurers because they rake in as much as two percentage points in fees each year. But these accounts earned investors only 6% or so annually over the past five years. That's about the same as a five-year bank CD--but without the CDs' government guarantee. "The money in fixed accounts is considered part of an insurance company's general assets," says David Veeneman, a pension plan investment consultant based in Lincolnshire, Ill. "If the company gets into financial trouble, you're one of many creditors vying for whatever assets are left."

In the wake of well-publicized collapses like those of Mutual Benefit Life in 1991 and Confederation Life in 1994, virtually all 401(k) sponsors diversify so that no more than 15% of their fixed-income option is invested with any single insurer. An estimated 30% to 50% of 457 and 403(b) plans, however, still keep all their fixed accounts with one insurer.

FLEXING POLITICAL MUSCLE

The San Diego County battle provides a prime example of how in the absence of ERISA guidelines, politics can get mixed up with investment policy in 457s. Three of the four supervisors who voted to keep Hartford's monopoly contended that they were swayed by letters to the board from the county's two largest unions: the 1,500-member Deputy Sheriffs' Association (DSA) and the 10,000-strong Service Employees International Union. "Simply put, the performance by Hartford over the years has been outstanding," the DSA's letter says. "The addition of another provider will lead to confusion and possibly higher administrative costs and brings absolutely no benefit to our members whatsoever. We strongly urge the Board of Supervisors to keep Hartford as our sole provider."

The letter reads as if it was written by someone paid by Hartford. And it was, according to DSA president John Minardi, who told Money that John Dadian, the lobbyist Hartford had hired in June 1996, wrote the letter. "I read and signed it," Minardi said, adding that he believed it reflected the views of the union's board. Dadian declined to speak to MONEY.

But Ron Hudson, who sits on the DSA board, says that he authorized a letter saying only that Hartford Life was doing a satisfactory job, not one urging that the insurer's annuity remain the plan's sole investment. "I didn't see the letter before it went out," says Hudson, "and the members I've talked to do want more than one choice in their retirement plan." Union president Minardi also confirmed to MONEY that many members have told him they disagreed with the letter.

As for a similar letter from the Service Employees International Union to the county supervisors board, union executive director Mary Grillo told Money she can't remember whether it was she or Dadian who wrote it. "Dadian told me the Deputy Sheriffs' Association was supporting noncompetition and that he wanted to count on our support too," says Grillo. "The letter basically was a show of solidarity for the DSA."

When asked whether the letters actually reflected the views of Hartford's lobbyist rather than the unions' membership, a Hartford spokesman replied: "Both the Deputy Sheriffs' Association and the Service Employees International Union acted independently to endorse Hartford Life, as the DSA had done in 1993. In February, the 11-member executive board of the Deputy Sheriffs' Association voted unanimously to send a letter to the board of supervisors endorsing Hartford Life as the plan's sole provider based upon our excellent record with this account."

The unions weren't Dadian's only targets. The lobbyist got in touch with members of the county's board of supervisors as well as their staffs. Supervisor Ron Roberts joined Dadian and Hartford Life representatives for a round of golf and lunch at San Diego's exclusive Aviara golf course in August 1996, four months after Roberts formed a committee to consider adding alternatives to the insurer's annuity.

Roberts told MONEY that his outing did not influence his vote. Supervisor Dianne Jacob, the only other board member voting in favor of Hartford Life who agreed to be interviewed by Money, admitted that Dadian had argued the insurer's case with members of her staff but said he had no impact on her decision.

Bill Horn, the lone dissenting board member, however, contends Hartford Life's lobbying affected his fellow supervisors. "Listen, there was no logical reason for us not to have approved this," he says. "I think what happened is that my colleagues got pressured." Rick Roeder, a principal at Gabriel Roeder & Smith, the benefits consulting firm the county retained to help select a competing investment choice for employees, added: "I was certainly surprised that the county paid $20,000 for our work over eight months and then didn't follow the committee's recommendation. But I'm never shocked by what happens in politics."

Other benefits consultants confirmed that insurers increasingly rely on persistent lobbying to maintain market share against the encroachment of mutual funds. "Some companies are much more comfortable using a lobbyist to protect their product from competition rather than adapting their product to meet the demands of the participants," says George D. Webb, a consultant with benefits firm William M. Mercer who has 13 years' experience dealing with 457 plans. "Hartford Life prefers to be the exclusive provider, and they are very aggressive about that," he says. Indeed, Hartford is the sole investment firm in more than 80% of the 1,200 457 plans it manages.

ENDORSEMENTS WORTH MILLIONS

To promote their annuities, insurers often make payments to trade associations and professional groups that represent the employees whose retirement dollars they're trying to snare. Two years ago, for example, the National Association of Counties (Naco) signed a 10-year contract under which the association designated a $10.6 billion Nationwide Insurance subsidiary called Public Employees Benefit Services Corp. (Pebsco) as the "preferred" investment provider for the $4.3 billion retirement savings plan that covers 300,000 county employees across the country. After receiving that seal of approval, Pebsco paid the association $3.5 million this year, according to Naco director of public/private partnerships Tom Sweet.

For Pebsco, the arrangement is a sweet deal. "When I go to a county, I can say I've got a plan sponsored by Naco," says Pebsco vice president of national sales Eric Holmes. "And that may help my marketing effort."

The workers who followed their trade association's recommendation have less reason to be pleased. Although they get to choose from a menu of investments that includes portfolios from well-known fund companies like Massachusetts Financial Services, employees in some cases pay nearly a full percentage point more for these options than they would if they invested directly in the same firm's mutual funds. For someone investing $2,000 annually over 20 years, that extra tariff amounts to $13,353 lost in fees.

While deals like Pebsco's are common among sponsors of 403(b) and 457 plans, they're virtually unknown among 401(k)s. Explains Mary Rudie Barneby, president of a Denver trade association for 401(k), 457 and 403(b) plans: "ERISA rules essentially say you can't profit by directing a plan's money to one manager rather than another."

A SMORGASBORD OF BAD CHOICES

While most 457 plans steer workers to one or a small handful of investment firms, many 403(b) plans allow dozens of companies to pitch costly annuities or mutual funds to employees. The reason thousands of sponsors open the gates to so many firms is that certain 403(b) plans--ones for nonprofit and charitable organizations and those for private schools and hospitals--could become subject to ERISA if they limit employees' choices to fewer than three investment vendors. "Sponsors want to avoid that because ERISA imposes stringent rules for selecting and monitoring investment providers," says Howard Pianko, head of employee benefits at New York City law firm Epstein Becker & Green.

Even 403(b)s for public schools--which technically are exempt from ERISA anyway--often deluge employees with dozens of investment choices. To gain an edge, many insurance companies hire teachers and school administrators as part-time sales agents to hawk their products.

For example, since 1983 Elaine Houle, 58, principal of the 510-pupil Ann Visger Elementary School in River Rouge, Mich., has been peddling annuities in her school district for $5.9 billion Great American Life as well as mutual funds with a maximum 4.75% sales load for the $2.9 billion Fortis mutual fund group. Houle sees no conflict of interest between her role as principal and a saleswoman who gets a 9% first-year sales commission on annuities and as much as 0.5% for each dollar that goes into the funds. "I don't solicit anyone or put fliers in mailboxes because that might be misconstrued as cajoling someone into something they don't want because I'm their boss," says Houle. "My teachers come to me on their own."

School officials agree with Houle, says Philip Pollick, the district's director of finance. "She was doing this before she was put in a supervisory position, and I've never seen her solicit anyone," Pollick says.

HOW YOU CAN FIGHT BACK

The best way to protect the interests of the 20 million Americans who are eligible to join 403(b)s and 457s would be to subject both plans to ERISA. Unfortunately, no one in Washington, D.C. appears to be considering such a bold move. Legislation that became effective this year, however, does allow some employers who would normally offer 403(b)s to create 401(k)s instead. But so far only a handful of employers have done so. Few want to comply with ERISA regulations if they can avoid it.

While some employers and plan providers do a creditable job watching out for participants' interests, the safest strategy is to assume that only you can safeguard your retirement savings in a 457 or 403(b). Here are three steps you should take:

1. Compare the fees in your plan vs. those in 401(k)s. You can do that by checking the prospectus for the variable annuity or funds your plan offers and comparing the fees listed with those in our table on page 156. If your fees appear excessive, form an employee group to lobby your employer to investigate lower-cost options such as mutual funds from major no-load families.

2. Consider transferring money out of your 403(b) plan. If your employer won't improve your menu of investment options, you might be able to take advantage of a 1990 law that allows employees to move assets from their present 403(b) plan to a 403(b)(7) custodial account with another firm. Most large fund firms can handle such exchanges. Warning: Some plans forbid transfers, and others may make them difficult. For instance, the 403(b) plans of Montefiore and several other New York City hospitals contain clauses drafted with the help of an insurance brokerage subsidiary that manages the plans. Not surprisingly, the clauses prohibit employees from transferring money out.

3. Take advantage of 403(b) "catch-up" provisions. Since high fees dampen the growth of savings in many 403(b) plans, you should do all you can to bulk up the assets in your account. Employees with at least 15 years of service may be able to boost their 403(b) contributions by nearly a third, if they failed to sock away the maximum in earlier years. An estimated 73% of 403(b)s offer this catch-up provision, but in only 4% of those plans do more than 10% of the participants take advantage of it.

Ultimately, workers themselves will have to lead the fight to rid these plans of companies that charge confiscatory fees. "Employees will have to lobby vigorously for better choices," says benefits consultant Webb. "Their quality of life in retirement depends on it."