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Deciphering the Rules of Retirement Advice

Some advisors have long ignored parts of ERISA when consulting participants of 401(k) plans. Now they don't have to. Still, the Street is confused over what the new pension laws really mean when it comes to reirement advice

Tom is one of Merrill Lynch's top brokers. He has more than a $1 billion in assets under management. But Tom (not his real name) has been living with a dark secret, which explains the need to conceal his identity: He built most of that book by selling 401(k) plans to dozens of businesses and, in the process, he repeatedly violated regulations that forbid registered persons from dispensing anything that could be construed as investing advice to plan sponsors or participants.

Tom — and other advisors who sell retirement plans — have worked around the strictures of the 1974 Employment Retirement Income Security Act (ERISA), which forbade them from assuming a fiduciary role because lawmakers assumed that brokers could not be trusted not to hornswoggle plan participants. The closest they could come to offering advice was providing educational information, which guys like Tom say is not sufficient to convince first-time investors to make wise decisions about participating in company-sponsored plans.

“If you got me in a court of law I'd say I only give education,” Tom says. “But I give advice. Look, we give a seminar and guys will walk up afterwards and say. ‘What's a stock?’ We're just looking out for their interests.”

In June, Congress enacted the Pension Protection Act, the most sweeping retirement legislation since ERISA, which incorporated changes that the securities industry lobbied long and hard for, including permission for reps who sell retirement programs to start dispensing investment advice, albeit within strict limitations. So, is Tom — and perhaps thousands of Toms across the country — ready to come out of the closet and declare himself to be a retirement advisor without shame.

Not exactly. Title VI of the legislation, the provision dealing with investment advice, is designed to remove some of the barriers preventing players in the 401(k) business from assisting plan sponsors and their participants. But major firms such as Merrill Lynch say for now they prefer to stick to the computerized third-party advisory plans that they have been using under a Department of Labor (DOL) exemption to ERISA's “prohibited transaction” rule, which forbids any activity that would actually result in transactions (i.e., sales of products or services for a fee).

Title VI, which goes into effect as of Dec. 31, 2006, extends the exemption to all reps who do not work directly for a 401(k) service provider, as long as they take on fiduciary status and:

  • the investment advice is either generated by a third-party computer model that uses objective criteria and meets certain other specific requirements, or

  • a fee-neutral compensation arrangement is used, meaning any fees generated from, say, the use of different fund-share classes that rise above the fee of the fiduciary are returned to the plan. (Fiduciary advisors affiliated with a 401(k) record-keeper and/or investment manager — such as Fidelity — must use both the computer model and a fee-neutral compensation arrangement.)

Advice About Giving Advice

Title VI, far from being a clear-cut signal for reps to dive into the retirement advice business, does, however, open the door wider to advice giving. But, because of the provision's confusing legalese and multiple terms and conditions, firms are not at all clear yet about how far they can go. For example, the provision allows plan participants to get additional advice from the advisor — but only after using the computer model and only if the advisor does not solicit the additional advice business from the plan participant. Fred Reish, an ERISA attorney with Los Angles-based Reish Luftman McDaniel & Reicher, says that no one knows what that means. “How would anyone know they can ask for advice if they're not told they can ask?” says Reish.

Because of unknowns like these, Bo Bohannon, the director of retirement plans at Raymond James & Associates, says his firm is eagerly waiting for the Secretary of Labor's clarifications, expected in the coming months. In the meantime, Don Trone, CEO of Fiduciary360, a fiduciary research and consulting firm, says “a number of firms from the smallest to the largest b/ds,” including wirehouses he wouldn't name, “have been seeking advice on implementing fiduciary standards of care.” So firms are getting ready to push the DOL to interpret the law in a way that will give them the clear signal that it's safe for their reps to become 401(k) fiduciaries. But, until then, they won't be changing their policies.

“The new law really codifies what we've been doing for the past three years,” says Kevin Crain, director of institutional product and sales for Merrill Lynch's retirement group. With a waiver from DOL, in 2003, Merrill Lynch created Advice Access, a computer system that takes information about investment goals and risk tolerance of 401(k) plan participants and spits out asset allocation and fund recommendations. Because the system is run by Ibbotson & Associates, Ibbotson is the fiduciary, not Merrill Lynch. Advice Access is available to 300,000 plan participants and 60,000 have used it to select retirement-savings portfolios. Crain says he expects the program to expand as a result of the new PPA legislation and says he hopes it can be used for IRAs and nonretirement accounts, too.

Smith Barney parent Citigroup allows members of Citigroup Institutional Consulting (CIC), the firm's elite institutional advisor force, to serve as fiduciaries to 401(k) plan sponsors on a “case-by-case basis,” but does not allow Smith Barney advisors to serve as fiduciaries to plan participants. Smith Barney advisors can sell its proprietary TRAK 401(k) program to plan sponsors. TRAK works like the Merrill/Ibbotson system, directing employees to any of 11 asset-allocation models, depending on their inputs. Participants receive ongoing investment advice, portfolio monitoring and performance analysis, all for a level annual fee. TRAK was exempted by the DOL in 1997 from the prohibited transaction rule because of the fee arrangement. As with Merrill's Advice Access, the owner of the system (in this case Citigroup), not the advisor, is the fiduciary.

For now, Smith Barney's only reaction to the Title VI rules will be to spruce up TRAK, says Norm Nabhan, the head of Smith Barney's Consulting Group. But, he acknowledges, there is growing pressure from plan sponsors (employers) to obtain investing advice from the securities firms. “The plan attorneys, the lawyers who draw up all the documents, are more and more asking for fiduciary representation,” he says.

Trone predicts that all firms will eventually permit reps to assume fiduciary roles in the 401(k) business. “What I think is starting to happen — and will happen — more is that plan sponsors, fed up with the lack of results from education, will say, ‘I want advice,’ and that comes with a fiduciary duty,” says Trone. He adds that, in considering their options, the brokerage firms will have to acknowledge the new competition from firms like Fidelity and other record-keeper/invest managers that the Act now allows to provide advice.

The most forceful argument for allowing advice, says Trone, is the falling participation rates in retirement plans and the specter of millions of Americans without adequate retirement savings — a big impetus for the reforms in the PPA bill (see main bar). Participation rates in 401(k) plans linger around 70 percent of eligible employees, but less than 10 percent contribute the maximum amount allowed. According to the Employee Benefit Research Institute (EBRI), the average account balance among its database of 17.6 million 401(k) participants — 37 percent of the estimated total in the U.S. — was $58,328 at the end of 2005. The median account balance was $19,398.

But those numbers are likely to rise because of the Act. The immediate goal of the Pension Protection Act, as the name telegraphs, was to shore up traditional defined benefit retirement plans — and protect the federal insurer, the Pension Benefits Guarantee Corp. (PBGC), from perhaps hundreds of billions of dollars in claims from participants in failed plans. Since the introduction of 401(k) plans, which employees mostly fund, the majority of employers have opted out of traditional retirement plans. According to the PBGC, less than 40,000 companies offer defined benefit plans today, down from more than 100,000 in 1985.

The PPA forces traditional defined benefit pension plans to be fully funded on an ongoing basis — underfunded plans have seven years to catch up — and it requires more conservative (read: costlier) actuarial and investment assumptions. The result, corporate-finance experts predict, will be to encourage more companies to scrap traditional pension plans. Before Congress passed the PPA, Verizon and IBM had already announced plans to freeze their defined benefit plans and move all new retirement benefits to their 401(k) plans, producing estimated savings in the billions of dollars.

The new law also encourages greater employee participation in 401(k)s, IRAs and other retirement vehicles by providing or extending over 20 tax benefits.

The good news for financial advisors — even if they never wade into the 401(k) business — is that the greater the participation in employee-directed retirement plans, the bigger the pot of money that will be available for rollovers. According to Financial Research Corp., a market researcher, $1.9 trillion in rollovers will come out of company-sponsored plans between 2005 and 2010. “That's what all the firms want,” says Tom, the Merrill advisor who says a good chunk of his business already comes from clients who started out as students in his 401(k) “education” classes.

The best route to those rollovers, however, is selling the 401(k) plans first. And, as Tom attests, the way to cultivate that business is to provide something more substantial than a half hour in the cafeteria and a literature drop.

So, will the firms help make this possible? Will they open the closet door and let their Toms come out as fiduciaries? In his rounds with firms, Trone thinks change is definitely afoot. “I'd advise anyone thinking about leaving their firm because it doesn't provide fiduciary services to wait six months.”

32 Years of ERISA

From legislative act to implementation, a look at major developments relevant to ERISA since its birth.

Sept. 2, 1974 — President Gerald Ford signs the Employee Retirement Income Security Act of 1974 (ERISA), Public Law No. 93-406.

Revenue Act of 1978 — Congress establishes the concept of 401(k) and cafeteria plans.

Multi-Employer Pension Plan Amendments Act of 1980 — Congress establishes rules relating to union pension plans and withdrawal ability.

Tax Equity Act of 1984/Retirement Equity Act of 1984 — Congress continues to revamp welfare benefit plans and deals with the gender gap in retirement plans.

Tax Reform Act of 1986 — Congress makes sweeping changes in the Internal Revenue Code by tightening discrimination testing under Section 401(k) plans and imposing salary deferral limits.

Unemployment Compensation Amendments of 1992 — Congress changes distributions from qualified pension plans, including rollover rules relating to transfers to IRAs and qualified plans.

Uruguay Round Agreements Act of 1994 — General Agreement on Tariffs and Trade — Congress increases premiums for defined benefit plans and imposes additional requirements on underfunded plans to provide detailed funding and financial information.

Small Business Job Protection Act of 1996 — Congress authorizes a new type of simplified retirement income plan for small employers and amends the distribution requirement for pension plan distributions.

Tax Relief Act of 1997 — Congress provides for Roth IRAs.

Economic Growth and Tax Relief Reconciliation Act of 2001 — Congress increases limitations on elective deferrals to 401(k) plans and creates additional contribution rights for employee/participants age 50 and over.

Pension Protection Act of 2006 — forces corporations to shoulder their defined benefit obligations, seeking to relieve the strain on the already underfunded Pension Benefit Guarantee Corporation (PBGC). The bill also allows 401(k) and like sponsors to offer employees automatic enrollment, increases contribution limits to IRAs and allows qualified fiduciary investment advisors to provide previously forbidden investment advice to defined contribution plan participants.*

Source: The law firm of Sachnoff & Weaver in Chicago, with the exception of the “Pension Protection Act of 2006.”

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