This is the latest part of a series by Ryan Frailich discussing financial planning for teachers. For more from Ryan, you can sign up for his monthly newsletter here.
I distinctly remember the first time I met the representatives from the 403(b) company at one school I worked for. They started and ended every interaction with a big hug, always brought a dish of candy, and made sure to say my name repeatedly. What I didn’t realize at the time was that all of this was simply putting me at ease so that I wouldn’t ask the hard questions I should’ve. Don’t be like me.
Ask the right questions before you decide to start investing money in an account that might not be the best for you.
As I’ve written about before, many pensions are under-funded and are likely not the right savings vehicle for teachers starting out today, unless they are reasonably sure that they’ll be teaching in the same state for their whole career. The next option teachers tend to turn to is the 403(b). A 403(b) is like a 401(k) and has the same annual contribution limits, $18,000/year for those 50 and under. The difference is that a 403(b) is used for public school employees and certain non-profit employees. Great! This must mean there are more protections and oversight, right? You would think and hope so, but, alas, you would be wrong.
The Problem with (Many) 403(b)’s
Ron Lieber and Tara Bernard at the NY Times have extensively covered problems with 403(b)’s, and I encourage you to take the time to read their full-length reporting (see here, here, here, and here). To distill their excellent work into a paragraph, 403b’s are often sold using aggressive sales tactics and minimal transparency. Investment options are often limited to high-cost annuities, and have restrictions, such as surrender fees and other charges, to get your own money out. A friend of mine put it like this: Two options: invest $100 and have $99.75 goes into your account. Or invest $100 and have $96.50 go into your account, with the rest going to the person who sold it to you for the work of having sold it to you. With annuities, you’re often paying 8-10x the cost but getting no better, and often times, worse returns. When mutual fund options are available, they are often at dramatically higher costs than other mutual funds that have historically earned similar investment returns. The “advisors” coming into schools are often incentivized by behind-the-scenes bonus and reward structures to sell the highest cost products, regardless of if that investment is right for you, the teacher. And the plan documents are so overwhelming that even if you try to decipher the costs, you’re going to struggle to sift through documents that sometimes reach over a hundred pages.
What My 403(b) Cost Me
I’ve experienced this first-hand. The accounts I set up were annuities with a fixed rate of return at 2%. While everyone’s risk and reward profile is different, a 2% fixed annuity is almost certainly not appropriate for a 24-year-old with a 40-year investment timeline. If I wanted to get to a savings of a million dollars, I’d have needed to be investing $16,555 per year to get there at 2%, and that’s before factoring in the associated fees. Given that I was making $48,000 per year, saving $16,555 wouldn’t be feasible. I left money in those accounts for 5 years after leaving that job (yayyyy inertia), during a period in which the S&P 500 returned an average of 12% annually. In real dollar terms, that difference between the overall market returns and what I got in my fixed annuity cost me about $7,700 over 5 years. Not only that, but once I left that job and wanted to take my money with me, I couldn’t get my money out without paying surrender fees. As is often said, annuities are often designed to be sold, not bought.
What to Do Differently
If you’re paying into a state pension, that will always be the first place dollars go, since that’s automatic in most districts. If you’re not paying into a pension, and if your employer offers any sort of matching contributions to a 403(b), I recommend taking advantage of that. If they offer a 100% match up to 3%, then take that match because you’re literally getting a dollar for every dollar you put in. Even with all the problems I laid out above, that’s still the best investment you can make. If your employer doesn’t offer any sort of matching funds in the 403(b), I recommend skipping the 403 (b) altogether and looking to a ROTH IRA.
These are accounts that have many advantages over the 403(b):
- They’re not tied to your employer.
- They are often dramatically lower in cost. You can open a ROTH IRA at Vanguard, Betterment, Schwab or other companies with as little as $1,000, and pay a fraction of what you’re paying in costs using a 403(b).
- A ROTH IRA means you pay taxes now, but the money grows tax-free until retirement. If you also have a pension or a traditional 403(b), this means you’ll have some money pre-tax and some money post-tax. This is helpful because no one can say where tax rates will be in 30-40 years, so you’ve got some in both buckets, which provides some flexibility.
- While you should be using a ROTH IRA for retirement savings, it’s much more flexible than other savings vehicles. Matt Becker over at Mom&Dad Money has a great explainer on all the ways you could use a ROTH IRA. This contrasts with 403(b)’s, which often come with a lot of restrictions, limitations, and fees to get your own money.
There is an income limit for ROTH IRA’s but since that limit in 2017 is $133,000 for a single person and $190,000 for a couple, it’s safe for me to say most teachers fall under that limit.
Beyond the 403(b) and ROTH IRA
If you’ve met the employer match and maxed out your IRA, where you go next is highly dependent on your situation. A 457 plan is an option in most states, and allows higher contribution amounts than an IRA, while also keeping costs fairly low. If you’re eligible for a Health Savings Account (rules here), that can be a great way to get more tax-advantaged investment dollars, and they could be used either for healthcare or if you have funds leftover at age 65, you can withdraw them penalty-free for any purpose. You can also look to regular taxable investment accounts. While those accounts don’t have tax advantages, they do have the advantage of being flexible and accessible, unlike some of the other options. Every person and family has unique circumstances, so the right account for you may be different than your neighbor, in-law, or college roommate. Do your homework before rushing into an investment of any kind.
If you get a feeling that the representatives you’ve met with aren’t giving it to you straight, continue asking questions. Know what they’re charging. Know what restrictions are placed on your accounts. Know what it’ll cost you if you want to get your money out. If you don’t fully understand an investment, keep asking questions until you do. Don’t be like me. I let a couple mini-hershey bars and a hug convince me to sign off on something that I never should have. And I don’t even like hershey bars.
(c) Ryan Frailich
Ryan Frailich is the founder of Deliberate Finances, a registered investment adviser in the state of Louisiana. Information presented is for educational purposes only and should not be relied on for investment or other financial decisions. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein.