The following is guide designed to help your clients better understand and manage their 403(b) retirement plan, whether they are a new or experienced investor.
When you chose to invest through your employer’s 403(b) retirement plan, how you invested was entirely up to you. That could have been good or bad—good if you had a wide range of choices to help you invest in a way that suited your style and needs, but bad if you were new to investing or didn’t have time to research the options available in your plan.
What is a 403(b)?
Certain employees of tax-exempt organizations are eligible to participate. Participants include, but are not limited to, doctors, professors, nurses, teachers, ministers and administrators.
Like a 401(k), employees must work through their employer to setup and participate in their plan. Although the options can vary, employees execute a salary reduction agreement to make pre-tax contributions.
These contributions are then sent to custodians chosen by the employer such as Fidelity Investments. Contributions grow tax-deferred until the time of retirement, when withdrawals are taxed as ordinary income.
The History of the 403(b)
403(b) plans predate 401(k)’s by over 20 years. In 1958, Congress passed the law that gave the IRS a green light to create tax-deferred savings accounts for employees at select non-profit organizations. (In comparison, 401(k) plans would not be launched until the early 1980s.) Three years after the 1958 law, eligibility for 403(b) plans was extended to workers in public schools and colleges.
403(b) annuities were the primary savings and investment vehicles in the early years of the 403(b) plan. Even before section 403(b) entered the Internal Revenue Code, annuities were used commonly by certain workers as a tax shelter to defer income, and likewise, their tax liability.
In fact, the impetus for the law creating 403(b) plans was to cap how much income workers could stash out of the IRS’s reach in tax-deferred annuity accounts. 403(b)’s weren’t meant to help people save for retirement; they were meant to help the government capture tax revenue they had not been collecting.
The legacy of annuities as the primary 403(b) investment vehicle persists even today–you still see 403b plans referred to as “tax-sheltered annuities” or “TSAs”, leftover language from the earliest marketing efforts.
The Wild West Years
By 2013, 403(b) assets were split almost evenly between mutual funds and annuities, according to 403(b) filings in BrightScope’s defined contribution plan database.
Though 403(b) plans shared many similarities with their 401(k) brethren, the marketplace was much different for 403(b) providers and participants. For many years, it seemed like the Wild West–any 403(b) plan provider could send their sales reps into a school or a hospital, with minimal oversight from the school district or healthcare system.
Greedy salespeople sold inflexible and high cost annuities with little explanation to participants as to what they were buying or what fees they would pay.
Regulations Rock the 403(b) World
Much like the plan documents required of 401(k) sponsors, these written rules would define eligibility requirements, contribution limits, investment selection and more for 403(b) plan participants.
The regulations transformed the 403(b) market to a structure that more closely resembled 401(k) plans. The new rules also would shrink the number of plan providers competing for 403(b) assets. There were fewer sharks in the water and not as many commission-hungry sales representatives chasing down doctors, nurses and teachers for their 403(b) contributions.
The 403(b) market became more efficient with these changes, but participants also saw fewer investment options directly on the plan side. However, many large plans opened brokerage windows for participants, giving them access to as many as 3,500 mutual funds to choose from.
Of course, so many choices have its advantages and disadvantages. A wide range of investment choices is great, but with all these choices how do participants decide?
Why Invest in Your 403(b) Retirement Plan?
The short answer is, you should invest because you can. Investing offers you a tremendous opportunity to put money you save to work for your future retirement needs. Think of it like getting a little extra money in your paycheck without having to work additional hours. Instead, your money works for you behind the scenes while you continue to work, allowing you to reap the rewards later.
The long answer is, you should invest because you must. That’s because money you earn today is worth more in the present than in the future because of inflation. This is a concept called the time value of money.
You can see a real-life example of this idea in the prices of many basic goods you purchase—for instance, a gallon of milk costs more today than it did 30 or 40 years ago and will likely cost more 30 or 40 years from now.
Inflation, as it is known, erodes the purchasing power of the money you save today so it won’t buy as much in the future. But you can counter the effects of inflation by seeking to grow your savings over time by investing it.
One Easy Way to Grow Wealth
Compounding is a simple concept—it involves putting the money you earn on your investments, whether it’s from price appreciation, income from dividends or interest you receive, back to work in the market. As you add earnings on top of earnings over time, the growth potential of your account multiplies.
Start Early to Make the Most of Time
Your Path to a More Secure Financial Future
In general, you can tap your 403(b) for income starting at age 59½. Withdrawals before age 59½ are likely to be subject to penalties—that’s how the IRS directs that your 403(b) should be used to plan for retirement. All 403(b) money (contributions and earnings) will be taxed at your current personal income tax rate upon withdrawal.
The Major Benefits of Your 403(b) Plan
- Contribution limits are very favorable for you, they come from your pre-tax earnings up to annual limits and are automatically deducted from your paycheck.
- Tax-deferred growth helps you keep and reinvest more of the money you earn on your investments.
- Several investment options from professional investment managers using pooled investment vehicles such as mutual funds.
Favorable Contribution Limits for 2018
Your employer may also offer matching contributions on top of what you contribute from your pay. The annual limit for combined contributions—your elective deferrals plus employer matches—is $55,000.
If you couldn’t contribute much to your 403(b) in prior years, your plan may offer you an additional catch-up opportunity. It’s called the 15-year rule, because it applies to workers with at least 15 years of service. If the average of your prior year contributions were less than $5,000 per year, you may be eligible to contribute an additional $3,000 per year to your 403(b), up to a maximum of $15,000.
Tax Benefits Available in Your 403(b)
Saving and investing through a 403(b) retirement plan account helps you manage your tax liability in two important ways. First, you contribute to your 403(b) account with pre-tax income.
When the IRS does take their share of your earned income each year, they are taxing a smaller amount—your gross pay minus your 403(b) contribution. As a result, you end up paying less taxes on your current income.
The second way your 403(b) account helps you is through tax-deferred growth. When you receive gains and income from the investments in your 403(b), you won’t pay taxes on them right away. So more of the money you earn can be compounded to grow for the future. In a taxable investment account, this money would be taxed as ordinary income or capital gains.
You’ll notice we didn’t say anything about your 403(b) account being tax free, because it’s not. You will pay taxes on qualified withdrawals you make after age 59½ at your ordinary income tax rate. If you take money out of your 403(b) before age 59½, you may also pay a 10% early withdrawal penalty on top of ordinary income taxes.
Access to Mutual Funds
The idea behind a mutual fund is “strength in numbers” — you could invest on your own and buy several different stocks for your portfolio, but it would cost you a lot of money to do so. By pooling your assets together with investors who share the same goals, you can hire a professional money manager who makes buy and sell decisions on behalf of the fund.
- Growth equity funds invest in stocks of fast-growing companies.
- Value equity funds invest in stocks that the fund manager thinks are underpriced relative to their potential for growth.
- Equity income funds invest in stocks of established companies that pay dividends to shareholders.
- Large-cap funds invest in stocks of the largest companies in the U.S.
- Small and mid-cap funds investing in smaller companies that have potential for explosive growth.
- International funds invest in stocks of companies outside of the U.S.
- Global funds invest in stocks from all countries, including the U.S.
- Emerging market equity funds invest in stocks of companies located in developing countries and economies.
- Sector funds invest in stocks of companies in specific industries.
- Bond funds invest in debt securities issued by companies.
- High yield funds invest in bonds of companies offering higher interest rates.
- Money market funds invest in short-term bonds offering low interest rates and relatively stable values.
- Asset Allocation funds offer the convenience of one-stop-shopping for investors looking for an easy solution for diversifying their investments.
However, having more choices also makes your investment decisions more complicated. Understanding the benefits of the different investment options available to you can help make this decision simpler for you.
There are too many plan variations to include in one guide. Below are the most common investment choices available using our preferred vendor Fidelity Investments.
Lifecycle Investment Options
Certain funds also target investors by their risk profile. Target risk funds invest along a spectrum from conservative to aggressive, changing their allocation to suit specific investor risk profiles. For example, an investor may have a long-time horizon for retirement but not much tolerance for an aggressive investment strategy. This investor may prefer a target risk fund that invests in a way that suits a more conservative risk profile.
Core Investment Options: Passive vs. Active Funds:
While this “hands off” management style is simple to implement, returns of passive funds also don’t vary from the index. If the index or the broader market goes down, so does the value of the passive index fund.
An actively managed fund will try to beat the returns of an index or the broad market, and the portfolio manager can pick investments they believe will outperform (within the parameters of fund’s investment strategy) without being tied to a market index.
Your 403(b) may also offer a wider range of investments than what’s available in the standard menu of mutual funds and annuity options. In 403(b) plans through Fidelity, this option is called BrokerageLink®.
BrokerageLink® opens a window to a wider universe of investment options, including thousands of mutual funds and individual stocks and bonds. BrokerageLink® may be a good option if you’re an experienced investor and want to put your savings to work in options not currently available in your 403(b) plan lineup. You may also want to consider BrokerageLink® if you prefer your 403(b) account managed by an independent investment advisor.
The financial world has many ways to talk about risk—alpha, beta, Sharpe ratio and so on—but at the end of the day, how much do you, or frankly most financial professionals, really understand about these terms? The answer is: not much.
No one really understands risk, so investors don’t talk about it and the consequences are significant. Only one in four clients say their financial advisor has talked about how much their investments may decline if the market crashes, per an investor survey by FinMason, a financial technology firm.
People think about risk and reward trade-offs nearly every day, most often outside of the context of the investment markets.
Consider these choices:
- “Should I buy life insurance?” You weigh the risk of paying too much premium for a life policy, versus the reward of knowing your beneficiaries get some degree of financial protection.
- “What should my car insurance deductible be?” You may reward yourself with lower premiums by choosing a higher deductible, but you risk paying more out of pocket if you have an accident.
- “Should I go to the gym or stay on my couch?” You risk the poor health consequences of a sedentary lifestyle for the reward of easy entertainment.
We think all the sophisticated ways to measure and discuss investment risk make the discussion more complicated. It needs to be kept simple. The one risk measurement you should care about the most (whether you realize it or not) is maximum drawdown risk—how much can you potentially lose in a catastrophic market downturn?
THESE TYPES OF DECLINES ARE WHAT YOU WANT TO AVOID:
This chart is for illustrative purposes only and must not be relied upon to make investment decisions.
Second, maximum drawdown can’t be changed, obscured, hidden or beautified by other performance statistics. With any peak-to-trough drop in investment value, what you see is what you get. There’s no hiding or smoothing over the consequences of a significant loss.
Investing is a marathon, not a sprint. It’s easy to get caught up in the latest hot stock, but the investors who survive and prosper are those who can manage their investment risk.
You should never invest in a product without first asking yourself “How much am I willing to lose?”
The Key Steps to Take Today to Supercharge Your 403(b) Account!
Your Investor Profile
Your profile will be your guide as you set goals, pick investments and make changes along the way to retirement, and possibly even beyond that. You can start to write this story by asking these important questions:
1. How much will you need for retirement?
There’s a temptation to pick an arbitrary number as your ultimate investment goal—say, $1 million. But an arbitrary number with no thought behind it is not a goal worth achieving.
So where do you begin establishing a goal? You can start by looking at your current income and lifestyle. It is generally assumed you can maintain your current lifestyle in retirement on 80% of your current annual income. This is a good place to start, but you should adjust it based on what you want your retirement to be.
For instance, if you plan to travel during retirement or want to provide financial support to family members, you should use a higher percentage of your current annual income, even as much as 100%.
Also, if you’re just starting your career, you can assume your income is going to increase as you gain experience. Instead of using your current annual income to estimate your expected retirement income, you can go to a salary estimator web site to see the average salary for your profession or industry. You should also assume this salary will increase over time along with growth in the overall economy.
Once you estimate your annual retirement income needs, you can multiply this amount by the number of years you plan to spend in retirement. This can be tricky to estimate too. But you can use current life expectancy statistics and add a few years in the event you live a longer than average life. To be on the safe side, you should estimate to spend 30 years in retirement.
2. How much do you need to save with each paycheck?
Your savings rates or contributions are also personal decisions and will depend on your household budget. You should try to save something on a regular basis, and routine payroll deductions through your 403b can help you establish a good savings habit. Once you get started, you can increase your contributions over time.
You can also use any matching contributions from your employer as a guideline. Matching your 403b contributions is basically free money offered by your employer, so you should make the most of this benefit.
Usually, an employer will match up to a specific percentage of your contributions. For example, if your employer matches up to 6% of your contributions, you should at least contribute 6% from your paycheck to get all this free money.
Your employer may only match a portion of your contributions; for instance, 50 cents of every dollar you contribute. You should still contribute enough from your own salary to maximize this matching contribution.
Also keep in mind these matching contributions may come to you gradually, after you complete so many years of service. This is called vesting and it’s designed to encourage you to stay with your employer to claim this “free money” as yours.
3. How much risk are you willing to tolerate your investments?
The rate of return you make on your investments will depend on how much risk you’re willing to take. Period!
Most investment guides will ask you to pick a target rate of return on your investments. We disagree with this approach because the key to “sticking with” any investment is being able to tolerate the eventual decline in account values.
You should decide what is the maximum amount of loss you are willing to tolerate. From there you can work backwards to then find the best mix of investments to match your tolerance for risk.
If you’re just starting out and have many years until retirement, you may be able to tolerate more risk and therefore are able to utilize more aggressive investments. However, if you are approaching retirement your appetite for risk is much lower and therefore you are best suited to avoid aggressive investments.
4. What is your time horizon?
The first questions were all about money, but this one covers the other important component of investing—time.
Your time horizon is the number of years between now and your planned age of retirement. Everyone tends to use 65 as the default age of retirement, and this is a good benchmark to use to calculate your own time horizon.
Many people today want to work longer, beyond the typical retirement age of 65. Many more think they will have to work longer for the income. If it’s possible, it’s smart to delay your retirement if you can—it gives you more time to build your savings and contribute to Social Security as well.
But keep this reality in mind—the average age at which current retirees entered retirement is much lower than 65. You may not be able to work as long as you want to due to health factors. This would also lengthen the number of years you would need your retirement savings to last. All things to keep in mind as you craft your personal investor profile.
5. What’s your risk tolerance?
The standard spectrum of risk runs from conservative (risk averse) to aggressive (risk tolerant). Most likely, you’ll be somewhere in between.
Your risk tolerance is really a factor of your personality; if you’re comfortable taking more risk to seek greater returns, then you’re probably a more aggressive investor. If the thought of losing money in your retirement account would keep you awake at night, you’re likely more conservative in your investment approach.
The best way to learn more about your risk tolerance is to take a quiz. Many companies offer a risk tolerance questionnaire or risk profiling tool to help investors as part of the planning process. This questionnaire will ask you emotional questions related to money—how you feel about a drop in your investment value, for instance.
The answers you provide will help place your risk profile on the spectrum between conservative and aggressive. You can then use this profile as you consider investments for your portfolio or select an investment strategy to align with your comfort level with risk.
Sometimes, these profiles lead you directly to a strategy or portfolio that lines up with your personality. These recommendations can be helpful but be sure to consider other factors in your investor profile as you begin to carry out your investment plan.
How Potomac Can Help (Going At It Alone VS. Getting Help)
What If You Want To Go It Alone?
- Review the fund and investment options available in your 403(b) lineup and pick a mix of investments that aligns with your goals.
- Diversify your portfolio with a broad range of fund types to manage market and investment risk.
- Monitor the market and adjust your portfolio if necessary.
- Take life changing events into consideration (e.g., college savings, recent grandchildren, illnesses, inheritance etc.) and adjust your retirement strategy accordingly.
Most 403(b) participants lack the time, knowledge and inclination to study all the options available to them. So, it remains likely that many will make the wrong choice for their investment profile and risk tolerance.
In addition, it takes even more time to monitor the market, respond the market changes and continue to keep investment selections aligned with retirement goals regardless of personal or market changes.
The current lineup of 403(b) investing options woefully underserves teachers, doctors and nurses—a few of our country’s most important professions.
Plans are filled with underperforming funds, complex rules meant to confuse participants into inaction, and annuities not suitable for anyone’s long-term financial goals except for the product provider who issues them. We are here to change that!
At Potomac Fund Management, we help you understand your 403b plan and how to navigate its plan options, so you can feel confident you’re making the right financial decisions for your situation.
Potomac has been managing client assets since 1987. We specialize in helping teachers, doctors and nurses like you select the right funds to match your risk preference and financial goals.
Knowing Your Tolerance for Risk Gets Your Closer to Protecting Your Investments
To get the right answers you must ask the right questions! We get to know your true risk tolerance by discussing your goals, financial situation and how low your investments can go before you feel uncomfortable.
How we put together a plan:
We analyze your current holdings and make a recommendation based on your tolerance for risk. If you aren’t sure if your current investments align with your risk tolerance, take our questionnaire for a free analysis.
- Complete a risk questionnaire.
- Verify if your current holdings match your tolerance for risk.
- Have a call with a Potomac financial advisor to discuss your custom needs and develop a plan.
- Turn over investment management duties to Potomac so you can go enjoy life!