- The Texas A&M University System is considering making changes in the criteria it uses to keep funds on its approved list for their defined contribution retirement plan. It would essentially eliminate all mutual funds except Fidelity funds and leave in its place a collection of variable annuities. Their single objection to the other mutual fund companies— American Funds and Pioneer Funds— is their front-end sales charge. I think many people can successfully invest by themselves and that Fidelity should be an option, but for those people that want a financial advisor they shouldn’t be stuck with the higher fees of a variable annuity.
What responsibility does the governing board, which decides these issues, have to ensure that all types of investment vehicles exist for the benefit of its constituents?
—D.F., Bryan, TX
- Let’s start with a positive observation: in much of the country there is little or not oversight on what investment products are sold to 403(b) plan participants. As a consequence, many— perhaps most— teachers and employees of non-profit institutions have relatively expensive investments in their plans. The long-term cost in terms of retirement income will be substantial. So accepting responsibility for oversight is a positive step.
One thing you might do is suggest to the members of the governing board that they become familiar with a class action suit against First Union Bank. Employees of an acquired bank are suing their employer because their investments were moved from a low cost provider with a good track record to funds owned and managed by First Union. The suit maintains that the employees have been damaged. I think this is a bell weather lawsuit, one that should get the attention of all employers vis-à-vis their fiduciary responsibility for the overall cost and management of qualified plans.
In addition, federal regulators have said that they would pay attention to the use of variable annuities in qualified plans, arguing— as I have for years— that the additional costs of variable annuities are unnecessary and redundant.
Finally, let’s compare the load mutual fund with a typical variable annuity. The American Funds group in Los Angeles only sells “A” shares— the original front end loaded funds— with commissions that average 5.33 percent. The commission is reduced for investors who make large investments or commit to make a large investment over a period of time. The average expense ratio of the fund family is 0.74 percent. The typical variable annuity has no front-end load commission but carries a very high expense ratio of about 2.1 percent. Worse, if you decide to change variable annuity providers, you face an early redemption penalty that can be significantly higher than the front-end load American Funds charges. Buy the variable annuity and you face 2.1 percent expenses forever. Buy the load fund and you recover the front-end load in four years. After that, the net expenses of the mutual fund are lower and the variable annuity becomes more expensive. Long term, the variable annuity is very expensive.
Let me give you an example. Suppose the American and a variable annuity firm both earned pre-expense returns of 10 percent a year and that you invested $10,000 in each. Where would you be at the end of 10 years? Even after taking the up front commission hit of $533, the remaining $9,467 will grow to $22,950 in the American fund while the variable annuity fund, which starts with the full $10,000, will grow to $21,370. That’s a ten-year difference of $1,580.
Over a longer period, such as a working lifetime, the difference will be even more substantial. A person who invested $2,000 a year, in monthly payments, for 30 years would accumulate $242,900 in the variable annuity but $304,980 in the front-end load fund. The difference is greater than the $60,000 the worker actually invested over the 30 years. That difference is one of the reasons you don’t find a lot of enthusiasm for the average variable annuity in this column.
If the board considers the total cost of investment for any period of time over 4 or 5 years a low expense ratio front-end load fund is less expensive than the average variable annuity product.
Beyond that, it would also be possible for the board to negotiate with the fund company for a lower front-end commission based on total sales volume.
This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
(c) Scott Burns, 2020