This is the second article in our series on navigating retirement risks, based on our White Paper, Creating Sustainable Retirement Income in 401(k) Plans Using Managed Risk Funds (www.milliman.com/new401k). The first article addressed how long a 401(k) participant will need his retirement money to last. We also discussed how market fluctuations at the wrong time – what we called timing risk – impact the participant’s account. In this article, we discuss the importance of investing retirement savings properly. You can read the article here.
The Essence of the Fiduciary Proposal . . . for Advisors
By now, you’ve probably read about some of the details of the Department of Labor’s fiduciary proposal. This article isn’t about the details; it’s about the essence. What’s the big picture?
First, the proposal significantly expands the definition of fiduciary advice. As a result, almost every person who makes an investment recommendation to a plan, a participant or an IRA owner will be considered a fiduciary.
For “pure” level-fee advisors (which are typically RIAs), there won’t be any change for their services to plans, participants or IRAs . . . with one exception. The exception is “capturing” rollovers.
For any advisor—broker-dealer, RIA, insurance broker—who makes a recommendation to a participant to take a distribution and roll over, and who will be paid more in the IRA than from the plan, it will be a prohibited transaction. In other words, the recommendation of a rollover will be considered fiduciary advice under the new proposal.
However, there is an exemption—the Best Interest Contract Exemption (BICE)—that allows for recommendations concerning rollovers, if they are in the best interest of the participant and if the advisor satisfies a number of contractual and disclosure requirements. However, it will be difficult to satisfy those requirements.
As a result, it is likely that most advisors will decide to provide “education” about distribution alternatives and about the most important considerations for participant in making those decisions. Education is treated differently than a recommendation. If a participant is provided unbiased and relatively complete education about his options, it will not be considered a recommendation. As a result, a participant can make a decision to roll over into an IRA and, after the roll over, the advisor can help with the IRA investments. In this context, “education” needs to be unbiased and complete in material regards. For risk management, it should be documented.
For non-level fee advisors, for participants, IRAs and certain plans, BICE is available — but compliance is complex and difficult. (An advisor is not a level-fee advisor if his compensation could vary depending on the recommendations that are made, or if his supervisory entity –for example, the broker-dealer or an affiliate—makes more money because of the recommendation, e.g., a management fee for an affiliated mutual fund manager.) For non-level fee advisors, the BIC exemption only provides relief for investment recommendations to participants, IRAs and small pooled plans (e.g., profit sharing plans). However, BICE does not provide relief for recommendations to participant-directed plans (e.g., 401(k) plans). For those plans, advisors must be level fee (or get relief from a different exemption).
One of the BICE requirements is that the advisor’s compensation (with limited exceptions) needs to be level. As a part of that, there cannot be any bonuses, incentives, etc., for the advisor to encourage the sale of proprietary products, investments that pay revenue sharing to the broker-dealer, and so on.
However, if BICE is satisfied, the compensation of the supervisory entity and its affiliates is not required to be level.
Another requirement is that there be a contract with the investor (for example, the IRA owner) where the advisor and the broker-dealer agree to adhere to the new “best interest” standard of care. (That standard is remarkably similar to the fiduciary standard under ERISA.)
In addition, there are stringent financial disclosures before the sale, before each new transaction, and after the end of each year. For example, after the end of each year, the investor must be given the dollar amount of all expenses resulting from the investment recommendations (for example, in the IRA) and the dollar amount paid to the advisor and the supervisory entity in the preceding year.
My belief is that very few, if any, RIAs or broker-dealers currently have the systems in place to be able to do that kind of reporting . . . and that it would be very expensive to create the systems.
There are other requirements that make compliance with BICE even harder, but this gives you the basic idea.
At this point, there is about another 60 days left in the comment period. After that, there will be hearings. If the regulation does become final, which is a distinct possibility, it will probably be in the first or second quarter of next year, with an “applicability” date of late 2016 or early 2017.
What’s Hot . . . in the First Quarter of 2015?
Over the last few months, the most common questions asked by clients . . . and most of my work . . . have been about three issues:
- The DOL’s new fiduciary proposal . . . not surprising.
- Capturing rollovers from retirement plans. Again, not surprising because of the large amount of money coming out of plans and in light of the attention being given to rollovers by the SEC, FINRA, DOL and GAO.
- The use and allocation of revenue sharing in 401(k) plans.
I will be writing about the first two points in the future, so let’s focus on the third one now.
For about 20 years, mutual funds have paid revenue sharing to 401(k) recordkeepers for services provided to the mutual funds. That includes 12b-1 shareholder servicing fees, 12b-1 distribution fees, and subtransfer agency fees. The view was that the money was paid for services to the mutual funds . . . and only incidentally involved the plans. However, that is changing—at least partially because the 408(b)(2) regulation treated those payments as compensation to the recordkeeper for services to the plans. Because of that change, there is a growing perception that the revenue sharing payments belong to the plan, and not to the provider.
Regardless of those perceptions, the DOL’s position, and the 408(b)(2) regulation, treat the payments as compensation to recordkeepers for their services related to the plans and their investments. As a result, if the total compensation from revenue sharing exceeds the reasonable cost of recordkeeping services, the plan sponsor has a fiduciary obligation to be aware of that and to recoup the excess compensation for the benefit of the participants.
The “new news” is that some providers and some plan sponsors are allocating all of the revenue sharing back to the participants and then charging participants’ accounts for the recordkeeping costs. Why? The general answer is because it is seen as being fair. The more detailed answer is that fiduciaries have a duty to oversee the use of revenue sharing by the recordkeeper and, when they delve into the matter (in order to understand the issues and fulfill their fiduciary responsibilities), the fiduciaries often determine that the equitable allocation of revenue sharing, and then proper allocation of plan costs, produces a result that is fair and that manages the fiduciary risk.
That raises the obvious question . . . what fiduciary risk am I talking about? The risk is that there is no guidance from the DOL on the proper use and allocation of revenue sharing. In other words, plan sponsors, advisers and ERISA attorneys are operating in a vacuum. We are making educated guesses about what will ultimately happen in terms of DOL guidance or ERISA litigation. When “walking on thin ice,” it is often preferable to take a relatively conservative position. In this case, the conservative position is to allocate the revenue sharing back to the participants.
To give you an example, think about a large plan where 50% of the participants’ money is in revenue sharing mutual funds, 40% of the participants’ money is in non-revenue sharing mutual funds, and 10% is in a company stock fund (that does not pay any revenue for recordkeeping). In this case, the 50% of the participants in the revenue sharing mutual funds are carrying the cost of the whole plan. Expressed slightly differently, half of the participants are in the plan for free, because the other half are paying the cost of recordkeeping. If we assume that the half of the participants in the revenue sharing mutual funds are paying higher expense ratios, then the problem becomes obvious. Not only are those participants paying for the plan, but they are bearing a financial burden to do that.
A similar case could occur where some of the participants (probably high-compensated ones) are in stock brokerage accounts, while the rank-and-file employees are in mutual funds that pay revenue sharing. The brokerage accounts aren’t paying anything to support the plan, while the rank-and-file employees are bearing the full cost of the plan.
The fundamental question is, how should your plan sponsor clients be positioning themselves in light of the lack of DOL guidance and the potential risk?
The Fiduciary Exemption for Commissions
The hottest ERISA issue of 2015 is the DOL’s proposal to expand the definition of fiduciary advice. That proposal has become highly publicized because of the White House endorsement and the aggressive Wall Street opposition. Unfortunately, political rhetoric on both sides has dominated the discussion . . . to the detriment of thoughtful analysis. Hopefully, this brief article adds to the “thoughtful” side of the ledger.
The current fiduciary rule – and presumably the proposal — has three basic requirements: a fiduciary must act solely in the interest of the participants and beneficiaries; a fiduciary must act for the exclusive purpose of providing retirement benefits and paying only reasonable expenses; and a fiduciary must engage in a prudent process to make decisions. That’s pretty much it.
While some of the attention is on that standard of conduct, most of the opposition has been to the prohibited transaction rules that apply to fiduciaries. In other words, the greatest controversy isn’t over the fiduciary standard, but instead it is about the fiduciary prohibitions of certain conflicts of interest that apply to fiduciaries.
The most publicized of those prohibitions is that a fiduciary adviser must receive “level compensation,” so that the adviser is not, in effect, able to recommend investments that increase the adviser’s compensation. Obviously, that is a conflict of interest. However, under ERISA and the Internal Revenue Code, it is also a prohibited transaction. While, on the face of it, the prohibition seems reasonable, it has the practical effect of eliminating, or at least severely restricting, many well-established practices by broker-dealers and insurance brokers. In other words, it could be highly disruptive of common current practices.
The financial services industry has lobbied against that prohibition. The DOL is aware of their concerns and has, on the face of it, addressed them. In materials released about the fiduciary proposal, the White House said that it will include an explanation to:
“Preserve the ability of working and middle class families to choose different types of advice: The Department’s proposal will continue to allow private firms to set their own compensation practices by proposing a new type of exemption from limits on payments creating conflicts of interest that is more principles-based. This exemption will provide businesses with the flexibility to adopt practices that work for them and adapt those practices to changes we may not anticipate, while ensuring that they put their client’s best interest first and disclose any conflicts that may prevent them from doing so. This fulfills the Department’s public commitment to ensure that all common forms of compensation, such as commissions and revenue sharing, are still permitted, whether paid by the client or the investment firm.“
Unfortunately, it’s hard to tell if the proposed prohibited transaction “exemption” (that is, an exception to the prohibited transaction rules) will be reasonable. At first blush, it appears that the proposal will require more disclosure about compensation and conflicts of interest . . . and will also require that a fiduciary adviser act in the best interest of the participants. Of course, that’s difficult to measure . . . so the devil will be in the details, in the sense that we won’t know whether the exemption will be workable until we actually see it.
My best guess is that the Office of Management and Budget will release the proposed regulation and exemptions to the public somewhere between late April and mid-June. Other than that, we just have to wait and see.
Did you know …About the Fiduciary Requirements for Selecting an Insurance Guarantee for your Participants?
Insurance guarantees for retirement benefits — such as annuities, QLACs, and GMWBs—are increasing in popularity . . . because they guarantee that the money lasts for a lifetime. However, there is not much guidance about the fiduciary process for selecting a particular annuity or GMWB product to provide those guaranteed benefits. We have written a white paper about issues for selecting GMWB products for Lincoln Financial, which can be found at http://bit.ly/1rtMnFX. This article, found here: http://bit.ly/1yOnoS7, discusses key points from the white paper.
Managing Defined Contribution Plan Investment Policy Statements
I recently wrote an article for JP Morgan about the fiduciary process for implementing investment policy statements . . . with particular emphasis on the monitoring of investments and investment managers in participant-directed plans. The article outlines a step-by-step approach for identifying investments to be placed on a watch list, the use of the watch list, and the process for determining whether to remove and replace the investment. I believe that the article is both a good outline of ERISA’s requirements for a prudent process and an educational piece for plan fiduciaries. It can be found under the publications section of my blog, here: http://fredreish.wpengine.com/publications/, or directly at http://bit.ly/1MayGaf.
Navigating Retirement Risks
American workers are living longer. But a long life has its risks . . . especially the risk that retirement savings won’t last. Bruce Ashton and I have written an article about the sequence-of-returns risk created by market volatility (based on a white paper that Bruce Ashton and I wrote for Milliman). The article contains graphic examples of the impact of gains and losses in the years shortly before and after retirement. You can read the article here.
Did you know…?
Little has been written about how a plan fiduciary should prudently select insurance companies and guaranteed retirement income for participants. There’s a DOL “safe harbor” regulation, but it doesn’t give fiduciaries a checklist for compliance. To address this, Lincoln Financial hired us to work with an insurance consultant to develop a set of criteria that fiduciaries or their advisors can use to make those decisions. Bruce Ashton and I have written an article about the checklist that can be found here: Did you know…About the Fiduciary Requirements for Selecting a Lifetime Income Provider? The article has links to the white paper and the checklist.
ERISA Issues for Solicitor’s Fees
Not much has been written about ERISA considerations for referring investment managers to retirement plans . . . and the receipt of solicitor’s fees for a referral.
However, there are a host of legal issues.
First, the person making the referral is receiving “indirect” compensation (that is, the solicitor’s payment by the investment manager), which makes that person a “covered service provider” or “CSP.” As a CSP, he must make 408(b)(2) disclosures (i.e., services, status and compensation). The failure to make timely disclosures is a prohibited transaction.
Second, the compensation cannot be more than a reasonable amount . . . as measured by the value of the services to the plan. But, what if the CSP doesn’t provide any ongoing services to the plan? Does the “compensation” become unreasonable after five years of payments? Ten years? I am not aware of any guidance on that point.
Third, the referral can result in the CSP becoming an ERISA fiduciary adviser. The DOL takes the position that a referral to a discretionary manager is the same as the recommendation of an investment. If it is individualized, based on the particular needs of the plan (or a participant), the DOL says it’s a fiduciary act. For example, in the preamble to its participant advice regulation, the DOL said: “. . .the Department has long held the view that individualized recommendations of particular investment managers to plan fiduciaries constitutes the provision of investment advice within the meaning of section 3(21)(A)(ii) in the same manner as recommendations of particular securities or other property. The fiduciary nature of such advice does not change merely because the advice is being given to a plan participant or beneficiary.” That conclusion means that the CSP should engage in a prudent process and its compensation must be “level” (that is, cannot vary depending on which investment manager is recommended). I am not aware of any enforcement activity on these issues. However, the DOL position is clear.
While I have opinions about these unanswered questions, the purpose of this article is to alert people about the issues and risks.
Aging Boomers and Rollovers to IRAs
As baby boomers approach retirement in a defined contribution world, the regulators are focusing on distributions and rollovers to IRAs. The SEC, FINRA, DOL and GAO have all spoken on the subject. Their conclusion appears to be that plan fiduciaries, advisors and recordkeepers need to reconsider their current practices and, in some cases, change their practices.
Why? The reason is relatively straightforward. As large numbers of 401(k) and 403(b) participants approach retirement, regulators are becoming increasingly aware that they will be moving from a plan environment where they are “bubble wrapped” by plan fiduciaries . . . and have the benefit of being able to select from investments that have been vetted by the fiduciaries and that are, as a result, good quality and relatively low-cost investments. Based on current practices, most of those participants will rollover into IRAs with investments and advisors that are using retail pricing.
In addition, participants will go from a fiduciary environment that is protected from conflicts of interest into a retail environment that allows conflicts of interest. (Note that there is a difference between a conflict of interest and “succumbing” to a conflict of interest. In my experience, most—but not all—advisors provide good advice at reasonable costs.)
The regulators are asking, “Does it make sense for participants to leave the protected environment of retirement plans and go into the retail environment of IRAs?”
To create a worse-case scenario, imagine a 401(k) participant who is defaulted into a target date fund and stayed there during his working career. In effect, the participant has never selected an investment, and it is possible that the participant never learned anything about mutual funds. At retirement, that participant is encouraged to rollover his money into a retail market.
So, where does that leave us? For plan sponsors, I think that it means that they should consider allowing participants to stay in the plan, even after retirement, and should provide flexible distribution alternatives through their recordkeeper. For advisors and recordkeepers, I think that it means that they need to create meaningful educational materials and help participants make the right decisions, depending on the participants’ needs and preferences.
This is just the beginning of this story. There is too much at stake for it to end here. For example, it is estimated that over two trillion dollars will become eligible for distribution between January 1, 2014 and December 31, 2018.