In the words of the Internal RevenueService (IRS) on July 23, 2007, a mo-mentous event occurred in the world

of 403(b) plans with the issuance of thefirst comprehensive set of regulations in43 years. The final regulations under Sec-tion 403(b) of the Internal Revenue Codehave been released and take effect Janu-ary 1, 2009.

The 403(b) plan is only available tononprofits and governmental entities,and the large majority of the employersthat offer these plans are in education—

public schools, grades K-12, colleges anduniversities—and in the hospital market.The 403(b) plan is on the radar screen ofIRS and the legal community.

In some cases, employers, especiallypublic school districts, have considered403(b)s as supplemental to other plans of-fered (like defined benefit plans) and havechosen to provide access to any provider li-censed to sell a product. Morningstar callsthis the “hog wild” model. While there maybe some cursory criteria to be “approved”by the employers, it is typically an elemen-

New IRS regulations that pertain to 403(b) plans take effect in 2009. For the first time, employers will hold fiduciary responsibility forthese plans. Employers typically include higher education institutions, public school districts and nonprofit organizations. This articleoutlines the prudent process for these plan sponsors to select and monitor providers and investments, as well as an approach todevelop quality participant education.

Best Practices for 403(b) Plansby R ichard M. To dd and Wendy J . Dominguez©2008 International Foundation of Employee Benefit Plans

BestPracticesfor403(b)PlansBestPractice 34 January 2008 • www.ifebp.org • Benefits & Compensation Digest

tary analysis as compared to what a typicalretirement plan sponsor is legally requiredto conduct for Employee Retirement In-come Security Act (ERISA) plans such ascorporate 401(k) and pension plans.

Fred Reish, a pension attorney withReish Luftman Reicher and Cohen in LosAngeles, believes that the hands-off ap-proach with 403(b) plans is a big mistakefor employers.

“Exempt 403(b) plans and government457(b) and 403(b) plans are also subject tolegal requirements, just not ERISA’s,” Reish said. “Instead, they are subject tothe laws of the states in which the plansare established. Many state fiduciary lawsare based on principles similar to thoseunderlying ERISA—such as modern port-folio theory, the prudent man rule and theuse of generally accepted investmentprinciples—and a number of statestatutes use language identical to the pro-visions of ERISA.”

Plan sponsors should develop a pru-dent process to select vendors, monitorand evaluate these vendors and invest-ment products, and provide for qualityparticipant education.

The primary problem is that 403(b) in-vestment costs are extremely high as com-pared to the 401(k) market, where the plansponsor typically uses one provider for theplan. Morningstar estimates 403(b) inter-nal costs from 3.75% per year to 4.60% peryear. Although Morningstar’s estimatemay be high, fees in this market can attimes be almost egregious. In many cases,the employer/plan sponsor is seeminglyignorant and unaccountable about ven-dor costs. However, the employee/partic-ipant can often feel comfortable since theproduct was “approved.”

Another common problem is the steepsurrender charges that participants maybe forced to pay in the event that theychange their minds about a product orvendor. Surrender charges vary from ven-dor to vendor and are typically tied tocommissions that the salesperson re-ceives. If the participant was to leave thevendor relationship, these charges recoupthe large commissions paid for the ven-dor. The longer and higher the surrendercharge, the more the commission paid tothe salesperson. Surrender charges aretypically declining but can be as high as10% of the value of the account.

Some 403(b) providers argue that com-petition brings down prices. As a result,

they tend to promote multiple vendor en-vironments. The authors agree that com-petition is good, but only if the competi-tion occurs at the plan sponsor level. Inthe 403(b) market, competition is oftenonly at the participant level. In a multiplevendor environment, participants lose alleconomies of scale that come with a con-solidated plan level account. If 403(b) em-ployers actively negotiated on behalf ofparticipants (like 401(k) employers), par-ticipants would receive increased servicesand much lower costs. Participants couldeasily save 1% per year in fees by movingfrom a high-cost “retail” solution, mostcommon in the 403(b) market, to an insti-tutional solution. For a participant saving$5,000 per year for 25 years, a 1% fee sav-ings equals nearly $60,000—and that isjust for one participant.

Services to employees can potentiallybe improved in a single vendor environ-ment. Meetings with employees becomeless focused on which company is better(or has a better salesperson or has the bet-ter food at its meetings) and become more focused on educating employees onwhich investment vehicles will meet theirgoals. This change in focus is significant.Gone are the rumors and the water coolerconversations of who is the cheapest ven-dor, who has the best investment prod-ucts and who has the best information.Instead, an environment in which the em-ployee feels comfortable is established.Employees can feel confident they are get-ting great service and great pricing andcan focus on designing the right invest-ment portfolio and achieving retirementgoals.

What Can Plan Sponsors Do?

Defined contribution plan consultantscan be valuable for plan sponsors con-templating a change, possibly helpingthem save both time and money. Typi-cally, a plan sponsor’s retirement plan ex-perience relates to just his or her ownplan, while consultants see dozens ofplans and can assist plan sponsors in un-derstanding the marketplace and a plan’sopportunities.

Step One:Benchmark the Current Plan

Determining the costs of a plan is verydifficult to do (especially insurance-basedplatforms). Generally, 403(b) plans have

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anything but transparent fee schedules.There are multiple layers of fees that arealmost impossible to discern. Asking eachvendor to complete a fee disclosure work-sheet (designed by the requester ratherthan the vendor) is a good first step. Itshould detail every fee imaginable andask the fee question in several differentways in order to get a clear idea of whateach vendor is earning. This informationwill provide the baseline from which tomove forward.

Step Two: Build a “Perfect Plan”

What would a person rebuilding a planfrom the ground up want? Better invest-ment vehicles (i.e., mutual funds vs. annuities), better investment products(institutional names vs. retail), more employee education? More one-on-one employee education? Once desired char-acteristics are determined, building a request for proposal (RFP) to get them ismuch easier.

This is also a good point to determinewho from the employer should be involved in the RFP process. Many em-ployers are reluctant to have a large com-mittee with employee representatives.However, getting buy in from employees(especially leaders or very vocal employ-ees) on the process will eliminate battlesin the future.

Step Three: Design the RFP

Questions should address the follow-ing at a minimum:

• Customer service. Important areas toconsider include staff size, qualifica-tions, training and turnover, refer-ences and terminations, financial sta-bility, and dedication andcommitment to the industry amongothers.

• Recordkeeping. Important questionsinclude data editing and manipula-tion, payroll format requirements,control, backup and recovery proce-dures, system capacity, flexibility andstate of technological development,the ability to monitor regulatory limitsand other technical compliance facil-ities, vesting/tax calculation utilitiesfor benefits distributions, and partici-pant and plan level reporting features.

• Administration. Important areas toconsider are Internet and voice re-

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January 2008 • www.ifebp.org • Benefits & Compensation Digest 35

sponse capabilities, system operationhours, live operator availability, turn-around times and benchmark stan-dards on service items, data securityand assurance levels, participantstatement and form capabilities, and employee educational capabilities,among others.

• Participant communication. Impor-tant areas to determine include expe-rience in both new election periodsand ongoing communication, thetypical process used in commu-nication, the availability of bilingualmaterials, sample materials, andphilosophies and biases, among others.

• Investment options and investmentproducts. Areas of importance in-clude product availability and flexi-bility, customization capabilities,product performance evaluation,lifecycle fund availability, the abilityto utilize outside products and theoffering of investment advice. Mostsuccessful RFP processes identify afund lineup in the RFP and ask eachvendor to bid on that exact lineup.This way, plan sponsors can identifythe flexibility of an investment menuas well as complete an “apples-to-ap-ples” cost analysis.

• Plan compliance. Questions shouldaddress the capability of the providerto comply with the technical and reg-ulatory provisions of the plan docu-ment, IRS regulations and Depart-ment of Labor requirements.

• Service costs. Costs are usually allover the board and can be creatively

hidden by the vendor. Areas of ques-tion include recordkeeping and ad-ministration costs, product internalexpenses, trading costs, loads, 12(b)1fees, commissions and surrendercharges, custody and transactioncosts, employee communicationcosts, Internet, voice response, meet-ings, statement expense, guaranteedinvestment contract (GIC) spread,market value adjustments and re-strictions, cash handling and fees,distribution and processing fees,conversion fees, fees charged in theevent of changes to the plan, plus anyother asset fees or participantcharges. This is an area for potentialcreativity. Vendors can be asked tobid on the plans as if that vendor isone of five vendors, one of three ven-dors and a standalone vendor. Thiswill give plan sponsors an idea of theeconomies of scale that are trulyavailable with vendor consolidation.

• Identifying and understanding con-flicts of interest. Commissions, kick-backs, referral fees, fee sharing, par-ticipant product and service sales area few areas that create conflicts re-quiring full disclosure and under-standing. Additionally, GIC providersand others with proprietary productsmay be motivated to encourage par-ticipant allocation to those products.Provider relationships with trustees,employees and other vendors shouldbe duly noted as well.

Step Four:Evaluate the Responses

Some areas are important to someplan sponsors and unimportant to others.Issues that are absolute should be identi-fied and can be used for screening ven-dors. Other areas should be ranked orrated in importance.

Step Five:Select the Vendor(s)

While cost is an important variable, sois service. It is extremely important tocheck references, both of existing clientsand terminated clients. As many of thevendor’s clients as possible should also becontacted. (The best to talk to are theones not listed as references by the ven-dor.) It is important to be creative in de-veloping the outline for finalist presenta-tions. If education is a hot button, a mock

education session can be requested. Ifplan sponsor customer service is an issue,meeting the day-to-day client servicecontact is essential. Plan sponsors shouldtake control of the finalist presentationand make sure the direction and contentof the presentation will assist in selectinga vendor.

Case Study

The 26th largest U.S. school districttook a big step last year by consolidating55 vendors into a single provider.

“It became quite clear that our em-ployees didn’t know what fees they werepaying, and the district was concernedabout the complexity and prudence ofdealing with 55 vendors,” said Lorie Gillis,the district’s chief financial officer. Al-though participants were initially con-cerned about having “choice,” it is esti-mated that each participant will savebetween $10,000 and $100,000 with thenew vendor by the time each participantretires. While huge strides were made bythe district, not everyone was happy—namely, 54 vendors that were displaced.However, participants no longer have toplay the investment guessing game andtheir employer has acknowledged its re-sponsibility to employees.

Ongoing Plan SponsorResponsibilities

For the first time, IRS rules require403(b) plans to operate according to awritten plan document—similar to that ofan ERISA 401(k) plan. 403(b) plan spon-sors should follow the lead of their 410(k) cousins in developing a sequentialprocess to manage their plan in accor-dance with best fiduciary practices.

Menu Design

The 403(b) plan sponsor is responsiblefor menu design comprised of comple-mentary styles and strategies. Too manyoptions can confuse participants, espe-cially if there is option overlap. At timeswhen left to the vendor, their own biasescan produce an awkward or cookie-cuttermenu. A few considerations in menu de-sign for plan sponsors should include:

• Are other plans available to partici-pants? A solid defined benefit planshould allow participants to be moreaggressive.

36 January 2008 • www.ifebp.org • Benefits & Compensation Digest

While cost is an important variable, so is service.

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• What is the sophistication level andinvestment experience of the partici-pants? The inexperienced shouldhave fully diversified target date ormodel portfolios in their menu.

• Age levels should drive menu design.A large number of participants ap-proaching retirement would dictateconservative options (like stablevalue), conservative models of targetdate options and/or even an annuityincome option.

Most investment structures have atwo- or three-tier design. Tier One is cre-ated using either lifecycle funds or targetdate portfolios. These products can becustom built from the individual funds inTier Two (best-of-breed approach) or pur-chased as investment products. Tier Twois an investment lineup that typically cov-ers the different investment style boxes(i.e., large cap value, large cap growth,small cap value, etc.). Depending on thesophistication level of the employees, thetypical investment menu will include tento 15 different investment styles. TierThree, if utilized, would be a brokeragewindow where a participant could selectfrom any mutual fund or stock or bondthat is traded with the provider. Ulti-mately, each plan is different and shouldbe designed with an investment structureor modified structure to meet their needs.

Investment Policy Statement

The investment policy statement is aninvaluable strategic planning tool for in-telligent investment management. Theinvestment policy statement is a workingdocument, the contents of which willchange in accordance with any changesmade to asset allocation variables. Thedocument serves as a paper trail for fu-ture investment committee members.

The completed investment policystatement permits the translation of theestablished risk/reward characteristics forthe plan into written investment guide-lines, or “job descriptions,” and perfor-mance benchmarks for each managerand the total fund.

Investment Products

This refers to the specific managerevaluation process focused on selectinginvestment products, typically mutualfunds, and representing particular invest-ment styles within the menu. Fundsshould have characteristics that are in

line with the benchmark. The plan spon-sor should endeavor to select managersthat can outperform the appropriatebenchmark and peer group on a risk-ad-justed basis over time. Ownership, teamdepth, business focus, strategy, researchfocus, portfolio concentration, capacityand compensation are all elements tomanager selection.

Ongoing Monitoring

In meeting the duty to routinely moni-tor their plan, trustees discover and correct potential problems, and most importantly, a documented process isrecorded for future litigation use, if neces-sary. The best protection against litigationis a demonstrated, documented prudentprocess of plan governance.

• Monitoring investment products.Monitoring is not a simple regurgita-tion of performance vs. benchmarks,but rather an intense analysis to un-derstand “why” performance hap-pened, good or bad. This enablestrustees to make better forward-look-ing decisions about products andmanagers.

• Performance measurement reports.The client’s investment committeeshould meet quarterly and evaluatedetailed analysis on each investmentmanager as well as for the total port-folio.

• Plan governance. Plans should ad-here to effective plan governance,complying with the various regu-lations and responsibilities that dic-tate a plan’s ongoing operation aswell as fiduciary behavior. Organi-zations frequently manage risk bypurchasing insurance to guardagainst large losses. Yet, it is surpris-ing how few organizations effectivelymanage the risk associated with theirretirement plans. An obvious riskmanagement tool is consistent, on-going plan oversight. Trustees have afiduciary duty to monitor and pru-dently review the performance ofplan vendors and service providers.That means the plan sponsor mustact prudently with expertise in fulfill-ing the duty to monitor the plan’s in-vestments, the duty to monitor the plan’s costs and fees, and its serviceproviders. If a plan sponsor adopts aplan and does not monitor the planon a routine basis, the process stan-

dard of plan governance breaksdown.

Plan sponsors should design commu-nication programs to assist participantsto meet their goals and objectives. Parti-cipants should clearly understand theamount required to adequately fund theirretirement nest egg and should make in-formed asset allocation decisions.

Participant Education

Plan sponsors should consider educa-tional workshops that can be designed forretirement plan clients in which plan-specific data is customized for their plan.Workshops should be presented by expe-rienced, unbiased professionals who un-derstand how to successfully communi-cate complex subject matter and inspireparticipants to make necessary decisions.

• Individual counseling. Face-to-faceinteraction with participants is thecornerstone of a successful educa-tion program. While group presenta-tions, workshops and informationalmaterials are an efficient means ofeducating participants, most peoplelike to have personalized access toprofessionals. Some people don’t feelcomfortable discussing their per-sonal finances in a group environ-ment, and many are embarrassed todisclose their lack of knowledge andunderstanding of investments infront of their peers. For others, indi-vidual counseling with a knowledge-able professional simply providesgreater confidence and reassurance.

• Allocation. Investment allocationconsistent with time horizon and risktolerance and helping participantsallocate their assets more effectively

• Calculation. Helping participants ac-tually establish a realistic retirementincome goal, calculate funding re-quirements and identify revisions totheir investment allocation and/oramount of increased contributionsrequired to achieve success

• Participant education materials.Quarterly information regardingmodel portfolios and quarterly fundperformance summaries should beincluded in a participant educationprogram.

The time is ripe for employers to revisittheir 403(b) plans. Participants should ask

January 2008 • www.ifebp.org • Benefits & Compensation Digest 37

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employers about their due diligenceprocess, and employers should come togrips with their fiduciary responsibility.IRS has made gigantic changes regarding403(b) employer responsibilities. 401(k)plan sponsors have taken bold steps in ac-knowledging their fiduciary responsibili-ties and offer a sound path for their 403(b)counterparts. B&C

For information on ordering reprints ofthis article, call (888) 334-3327, option 4.

38 January 2008 • www.ifebp.org • Benefits & Compensation Digest

Richard M. Todd is a co-founder and managing principal ofInnovest Portfolio Solutions LLC of Denver. He has morethan 20 years of experience in investment consulting forpublic funds, corporate plans and Taft-Hartley funds. Toddhas a business degree from Western State College of Col-orado.[ [

Reproduced with permission from Benefits & Compensation Digest, Volume 45, No. 1 February 2008, pages 34-38, published bythe International Foundation of Employee Benefit Plans (www.ifebp.org), Brookfield, Wis. All rights reserved. Statements oropinions expressed in this article are those of the author and do not necessarily represent the views or positions of the Interna-tional Foundation, its officers, directors or staff. No further transmission or electronic distribution of this material is permitted.

Wendy J. Dominguez is a principal and co-founder of In-novest Portfolio Solutions LLC of Denver. She has more than15 years’ experience in the investment-consulting profes-sion. Dominguez has a master’s degree in business admin-istration from the University of Denver.[ [