What Are the Disadvantages of a 403(b) Plan?

A 403(b) plan is a retirement savings option available to employees of public schools, certain non-profit organizations, and religious institutions. These tax-advantaged accounts are designed to help these workers save for their later years, functioning in a way that is often compared to the more widely known 401(k) plan. While they can be an effective tool for building retirement wealth, they have potential downsides that can affect financial outcomes.

High Fees and Associated Costs

A drawback of many 403(b) plans is the presence of high fees that can erode investment returns over time. These costs come in several forms, including administrative and recordkeeping fees charged by the provider for managing the account. Participants also face investment-specific fees, such as the expense ratios of mutual funds. In some plans, these combined fees can exceed 2% annually, compared to lower-cost alternatives that may charge less than 0.50%.

The impact of these costs is compounded by the types of products found within 403(b) plans. Insurance-based investments, particularly annuities, are common and bring with them unique charges. For instance, variable annuities frequently include Mortality and Expense (M&E) fees, which compensate the insurance company for the risks it assumes under the contract. These M&E fees can add another 1% or more to the total annual cost.

Furthermore, many annuity contracts feature surrender charges. These are penalties an investor must pay if they withdraw money from the annuity before a specified period, which can last for several years. The charge is a percentage of the amount withdrawn and declines over time, but it can be a barrier for participants who need to access their funds or move their money to a lower-cost investment.

The long-term effect of these layered fees can be substantial. Consider an account with a $100,000 balance earning an average of 7% annually. If the plan has total fees of 2%, the net return is 5%, and the balance grows to approximately $265,000 over 20 years. In a lower-cost plan with 0.50% in fees, the net return is 6.5%, and the balance would grow to over $352,000.

Limited Investment Options

Many 403(b) participants face a restricted menu of investment choices, which can hinder their ability to build a diversified and effective retirement portfolio. Historically, these plans were dominated by annuity products, and annuities remain a prevalent option in many plans, especially in the K-12 public school market. This narrow focus contrasts with typical 401(k) plans, which provide a broader array of investment vehicles, including a wide selection of low-cost mutual funds and exchange-traded funds (ETFs).

The reliance on annuities presents several disadvantages beyond their cost. Annuities are complex insurance contracts that can be difficult for the average investor to understand. Their primary feature is to provide a guaranteed stream of income in retirement, a benefit that can be redundant within a tax-deferred retirement account that already offers tax-sheltered growth.

Fixed annuities offer a guaranteed interest rate, but these rates are often modest and may not keep pace with inflation over the long term. Variable annuities offer the potential for higher returns by investing in a portfolio of sub-accounts, similar to mutual funds, but they introduce market risk along with their higher fee structures. The restrictive nature of these products can make it challenging for participants to tailor their investments to their risk tolerance and financial goals.

Lack of ERISA Protections

A disadvantage in many 403(b) plans is their exemption from the Employee Retirement Income Security Act of 1974 (ERISA). ERISA is a federal law that establishes minimum standards for most private industry retirement plans. These standards require plans to provide participants with information about features and funding, and they impose a fiduciary duty on those responsible for managing plan assets.

Many 403(b) plans, particularly in the public school sector, are classified as “non-ERISA” plans. This status arises when the employer’s involvement is limited to facilitating payroll deductions to various vendors, without making employer contributions. The consequence of this classification is that the employer does not have a legal fiduciary responsibility to act in the best interests of the plan participants.

This absence of fiduciary oversight means the employer is not obligated to vet the investment options for prudence or to ensure that the fees charged by vendors are reasonable. It is a reason why plans with high-cost, underperforming investments can persist for years. The burden falls entirely on individual employees to navigate the options and identify the most suitable choices.

Navigating Plan Complexities

Participants in 403(b) plans face operational hurdles that can create confusion and lead to suboptimal financial decisions. A common issue, especially within school districts, is the multi-vendor system. Instead of a single, curated lineup of investments, the employer may present employees with a long list of approved insurance companies and mutual fund providers. This arrangement provides choice but often comes with little to no guidance from the employer on how to evaluate the different vendors.

This lack of guidance forces employees to sort through providers offering a wide range of products with varying fee structures and investment quality. The result can be “analysis paralysis” or a decision based on aggressive sales tactics rather than sound financial reasoning. An employee might choose a high-cost annuity product from a persuasive sales agent when a lower-cost mutual fund option was available from a different vendor.

Another area of complexity involves the rules for catch-up contributions. Like other retirement plans, 403(b)s offer a standard catch-up contribution for participants age 50 and over. They also feature a provision that allows participants aged 60 through 63 to make an even larger catch-up contribution. Additionally, a “15-year rule” allows employees with 15 or more years of service with the same employer to contribute an additional amount, up to $3,000 per year, with a lifetime maximum of $15,000.