Invading annuities' turf: the huge and powerful mutual-fund industry is increasingly moving into an annuity stronghold--the 403(b) market.

Annuity writers dominate the more than half-trillion-dollar 403(b) tax-sheltered annuity market, but mutual fund providers, including some insurers, are beginning to give them a serious run for the money.

For some 45 years, annuity writers virtually owned the market. In recent years, however, the market's participants--teachers, health-care workers and employees in the scientific, charitable and religious sectors--have begun to demand access to mutual fund programs with lower fees and more investment options that are similar to what corporate employees have through their 401(k) plans. Mutual fund providers have chipped away at market share for more than a decade, but now appear poised to take chunks.

"You'll see a decline in participation in 403(b) variable annuities, particularly those with high fees, and an increase in those funded with mutual funds," said Dan Otter, an operator and co-founder of 403bwise, an online organization (www:403bwise.com) advocating more choices in the 403(b) marketplace. "When the stock markets were raging, expenses didn't seem to matter that much, but the past three years have been brutal, and now expense ratios are looking pretty high. And more and more young teachers are Web savvy and are willing to invest the time to research investments."

In 2000, some 82% of 403(b) money was invested in annuities and 18% in mutual funds, according to a study that year by the Spectrem Group. Fixed annuities accounted for 47% and variable annuities for 35%. Over the past three years, the proportion in fixed annuities probably increased due to declines in equity valuations and to transfers and reallocations toward fixed/stable-value products, said Spectrem Director Gerald O'Connor. "Overall, mutual fund companies have been gaining share in the 403(b) market, and we feel that this has continued over the past few years," he said.

The Beginning

Congress created so-called "tax-sheltered annuities" in 1958 under Section 403(b) of the Internal Revenue Code. They were the only funding vehicle allowed trader 403(b) for 16 years. As part of the Employee Retirement Income Security Act of 1974, Congress added Section 403(b)7, which authorized custodial accounts that invest in mutual funds, but the 403(b) market had developed in such a way that mutual-fund providers saw little reason to believe they could compete. That is now beginning to change, said Otter, and the Economic Growth and Tax Relief Reconciliation Act of 2001 has also made it easier for mutual funds to get into the business.

Agents are the primary reason annuity writers developed and gained control of the 403(b) market. Agents secured permission to sell to employees of jurisdictions covered by the plans--primarily in the kindergarten through 12th-grade school districts--and then marketed accounts to individuals and provided service to them. The schools and colleges under the 403(b) law are free of fiduciary responsibility, and they generally agree only to set up payroll deductions for contributions. Plan providers and their agents handle all other administration.

Moving to a Single Vendor

As a result, some school districts offer scores of vendors. "If one vendor could sign up 20 teachers, the district would put it onto their list," said Michael Beczkowski, an associate consultant with Baltimore-based Bolton Partners Investment Consulting Group Inc. "Now we're starting to see some jurisdictions paying a lot more attention, and there is more interest in going to a single vendor, as corporations typically do with 401(k) plans. By leveraging economies of scale, the jurisdiction is able to get much better programs. In the employee-benefit world, it's the difference between retail and institutional."

Getting the Word Out

While the 403(b) industry considers its contract holders conservative in nature, Otter makes the case that they just haven't been informed. "I was teaching elementary school in California, and all I heard about from friends was 401(k) plans," he said. "And what did teachers have? A tax-sheltered annuity. My principal said he could set me up with an adviser."

Otter said he did not act on the offer because he suspected something was "fishy." Four years later, he learned from another friend that most 403(b) plans in California were simply not as good as other retirement-plan investments. He checked that out for himself, and he and fellow teacher John Moore eventually formed 403bwise for the purpose of providing news, education and advocacy, and to post what they call a "403(h) bill of rights." Within six weeks of launching the site, many major news organizations had interviewed the pair. Now, three years later, Otter says the Web site has gone from avocation to a side business. His main job is adjunct professor at American University in Washington, D.C.

Otter said his main criticisms of variable annuities inside 403(b) plans are surrender charges and annualized fees in excess of 2% of assets. Surrender charges in many 403(b) variable annuities are on a seven-year declining scale starting at 7%, and every new contribution restarts the seven-year period, even if the contract has been in place for many years, he said. TIAA-CREF, the premier provider in terms of assets, is one of few exceptions; it offers low fees and has no surrender charges. "Companies will argue they are putting an agent into the field, and they should be compensated, but jurisdictions should do their due diligence," Otter said. The problem is that the jurisdictions focus on their defined-benefit plans and leave the defined-contribution plans to the vendors, he added.

Beczkowski said many jurisdictions don't have any policies and procedures for letting in vendors. Many also lack review-and-evaluation processes, and sometimes the permission to sell in the jurisdiction is "very politically connected," he said. Those are some of the reasons there aren't more moves to a single vendor. "It takes a lot of courage by school district officials to hire an expert to put out requests for proposals," added Otter.

Meanwhile, the financial feasibility of low-cost mutual-fund providers vying for business in this environment, especially in the K-12 level, is low. "If a district has 50 vendors, the only way to get noticed is to have agents, and that would destroy the low-cost model," said Otter. "Also, many school districts require vendors to sign 'hold-harmless' agreements that make vendors potentially responsible for events over which they have no control."

Moving In

According to O'Connor, mutual-fund providers first became active in 403(b) markets in the mid 1980s and have steadily added about 1% annually to their market share. Using their widely known brand names, easy accessibility to net asset values of their funds in daily newspapers, and their extensive administrative capabilities, they focused on the large end of the market--the health-care companies and the higher-education segments, he said. At that end, employers have traditionally taken more interest in choosing and managing plans, much as corporations do with 401(k) plans. TIAA-CREF is a major player in higher education without using an individual-solicitation model, O'Connor said.

These larger institutions were predisposed to giving plan participants choice, and once the mutual funds moved in, the fund companies' normal marketing attracted assets. In the past three to five years, the big mutual-fired companies started to move into K-12 school districts, O'Connor said.

Mutual-fund companies also may have taken advantage of Internal Revenue Service Revenue Ruling 90-24, that was made in 1990. The ruling states that transfers among 403(b) plans--and also to 403(b)7 plans--are not taxable events. Larry Sokolow, president of The Gabor Agency, a work-site marketing firm in Tallahassee, Fla., said his firm has used 90-24 transfers for years. "It's basically because people want to get into something with different investment choices," he said. "They may feel unhappy with their old carrier under an old pricing structure, or they may be unhappy with the service. Money is moved around quite often. As long as you're doing it for the betterment of your client--and not for the wrong reasons--then people don't stand still with investments anymore."

Even insurance companies have entered the arena with mutual funds. Some may do so to attract 90-24 transfers, but many may he taking advantage of their relationships with jurisdictions built up through many years in the tax-sheltered annuity marketplace. According to Beczkowski, insurers now offering 403(b)7 mutual funds include Security Benefit Life Insurance Co., TIAA-CREF and Equitable Life Assurance Society of the U.S. New York Life Investment Management, a subsidiary of New York Life Insurance Co., also lists the product on its Web site. The Gabor Agency works with the investment arm of Safeco Life Insurance Co.

"It says to me they see the writing on the wall," Otter said of insurers bringing mutual-fund products to the 403(b) world. "People are demanding access to these products."

New Programs

Safeco Life & Investments, Redmond, Wash., in June introduced 403(b)7 custodial accounts--along with a 457 mutual-fund program--to complement its 403(b) program, which as of July had $7.5 billion of assets under management. The new programs provide access to 50 mutual funds from eight different fund families.

In late September, Safeco Corp. announced it intends to sell its life and investments company and focus on its property/casualty business. (See "Taking the Next Step," page 47.)

Deanne Huff, stopped short of calling the new programs part of an evolution. "What's happening is that our market is interested in and curious about investments other than fixed and variable annuities," said Huff, assistant vice president, retirement services. "They particularly want something with a bit more risk, more diversification, or more options. They want a little more control over the things in which they invest."

Fees, however, were not an overriding factor in Safeco's decision to add 403(b) mutual funds, Huff said. Safeco distributes through a broad spectrum of independent agencies, and its wholesaling team has been training many of them about the new programs. Huff said Safeco already has payroll slots approved in many jurisdictions, so producers will not need to create new ones. The new programs should help give advisers opportunity to meet with clients more often, she said, adding that there is a lot of excitement and interest among producers. Company spokesman Le Roi Brashears said the mutual-fund program reaches people who typically did not have exposure to mutual funds in taxable accounts.

Safeco's programs stand out because most other 403(b)7 providers, including mutual-fund companies, only offer proprietary funds. Safeco claimed in a press release it is among the first in the nation to provide access to several fund families. The 457 program also provides access to ShareBuilder, an online, self-directed brokerage account that allows investors to buy fractional shares of stocks and exchange-traded funds on a recurring basis through payroll deductions.

Sokolow said the new programs are a "natural expansion" of Safeco's variable-annuity offerings. "Costwise, there's not a great deal of difference," he said. "And there are still features in variable annuities you would consider worthwhile. But the interest is in the side of the ledger where the investment opportunities are."

Three Are Enough

Otter said he would like to see each jurisdiction allow no more than three vendors to conduct business. One would offer a full-service variable annuity with guaranteed benefits, one a no-load annuity, and the other a fee-based plan using no-load mutual funds. "Do-it-yourselfers should have an option," he said. Some people will always want to use an agent or planner, but those willing to take more responsibility for their investments are likely to get more value from their 403(b) plans because fund selections and costs are the only things investors can control, he said.

Beczkowski said commissions on load mutual funds are usually in the 4% to 6% range, while full-service annuity writers range from 8% to 9%. Mutual funds also can charge annualized 12b-1 fees, which help pay for distribution.

Great-West Life Group, through subsidiary BenefitsCorp Inc., has taken a no-load approach to the 403(b) and 457 markets with its launch in January 2002 of EducatorsMoney, an online retirement planning service designed for educators. Once selected by an educational institution, it provides employees with 21 core mutual funds and access to 8,500 no-load funds through a self-directed brokerage account option. It provides account information, management, investment information, and investment advice from Advised Assets Group, a subsidiary of Great-West. Help is available through a call center staffed by noncommissioned, salaried service representatives.

EducatorsMoney is a replacement for Great-West's 403(b) annuity program, said Barbara Healy, vice president of BenefitsCorp. The program's administrative fee is only 0.15%, compared with mortality-and-expense fees averaging 1.25% or more in variable annuities, and it does not impose surrender charges. Great-West is a leader ha providing 403(b)7 and 457 plans to large jurisdictions that are accustomed to an "unbundled environment," Healy said, meaning that each often picks separate providers for recordkeeping, investment options and investment advice. This unbundling results in high value to the individual participant, she said.

BenefitsCorp can vary its pricing based on the size of the jurisdiction and whether it already has assets or is a start-up plan, said Healy. Pricing can be tricky in 403(b) plans because each individual must decide whether to roll over money, but 457 plans are typically the asset of the employer and can be rolled over at one time. Plans eligible under 457(b) allow employees to defer income taxation on retirement savings into future years.

The 457 retirement plans became more attractive after the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001, according to Healy. Employees now may invest in both 403(b) and 457(b) plans, effectively doubling the amount of retirement money they can set aside, she said.

Great-West is even beginning to have success with local school districts. Since they have fiduciary responsibility with 457 plans, some are willing to make use of a single vendor and leave their existing 403(b) plans in place, Healy said. "It's probably about time that school districts take responsibility for voluntary, retirement programs," she said. "Teachers have been paying high fees. "This new competition will probably force annuity writers to come up with a lower-fee model, she added.

Safeco is also marketing a 457 plan. In addition to offering mutual funds, the 457 program offers ShareBuilder, an online, self-directed brokerage account (www.sharebuilder.com) that allows investors to buy fractional shares of more than 3,500 company stocks and more than 70 exchange-traded funds on a recurring basis through regular contributions to their retirement accounts. The state of Florida is Safeco's first 457 plan customer to use the ShareBuilder service, according to Sokolow. The Gabor Agency also handles retirement plans with 10 state universities and 28 community colleges. The state was previously offering variable annuities inside the 457 plan, Sokolow said.

Spectrem has not conducted a study since 2000, but O'Connor said the bear market may have slowed the advance by mutual funds into the 403(b) markets. That is because most mutual-fund companies do not offer a stable-value product, which pays higher rates than money-market funds. But even if the bear market has slowed down mutual-fund momentum, O'Connor said he believes that market share continues to grow, at least as measured by the number of accounts.

The 403(b) Market

The chart illustrates the
distribution of investments in the
403(b) market as of Dec. 31,
2002. Percent changes are
since 1999.

Assets: $548 billion
Participants: 6.3 million
Plans: 34,000

Variable Annuities   36%   +1%
Fixed Annuities      43%   -5%
Mutual Funds         21%   +4%

Of the $548 billion in assets represented
above, $272 billion is invested through
college and university plans; $138 billion is
invested through public K-12 plans; $90
billion is invested through hospital plans; $28
billion is invested through private K-12 plans;
and $20 billion is invested through other
nonprofit plans.

Source: 403bwise, Spectrem Group

Note: Table made from pie chart.