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The New Fiduciary Rule and Rollovers

The New Fiduciary Rule and Rollovers

The new standard for advisors to retirement accounts will have dramatic consequences for advisors, not least on the initial decision whether to roll over a 401(k) plan into an IRA. 

The fiduciary fight isn’t over yet—but we’re getting close. Barring an unexpected upset, the U.S. Department of Labor soon will finalize regulations redefining the term “fiduciary” for purposes of advising retirement clients.

These long-overdue reforms have been debated to death, and despite the short-term disruption, they’ll be good for the standards and professionalism of the advisory business in the long haul. A standard that requires advisors to act in the best interest of clients is especially critical in light of the retirement challenges facing so many Americans.

The new rules come with complex implications for the financial services industry, and will keep lawyers busy for some time—but one area that clearly will be impacted is the huge rollover market from workplace retirement plans to Individual Retirement Accounts (IRAs). The new rules will govern any recommendation to roll money out of a qualified plan in the first place, and the investment advice provided once a rollover is completed. The rules will apply to plan advisors who work with individual participants, and to independent advisors—unaffiliated with the plan or sponsor—who are advising clients on their retirement rollovers.

Americans held $7.4 trillion in IRA assets last year, according to the Investment Company Institute (ICI)—just ahead of the $6.8 trillion held in defined contribution plans. And rollovers are the key driver of the IRA market: 48 percent of IRAs contain rollover funds, according to ICI data. A recent report by the White House Council of Economic Advisers estimated that $300 billion is rolled over annually by workers retiring or changing jobs. And these figures are accelerating along with baby boom generation retirements.

A 2013 U.S. Government Accountability Office report to Congress raised concerns about solicitations for rollovers to 401(k) participants that aren’t in the participants’ best interests, and a recent Financial Industry Regulatory Authority (FINRA) regulatory notice reminded brokers of their existing “suitability” standard requirements.

Now, the DOL rule will change the way that advisors operate within this huge, lucrative market, starting with advising a client (or potential client) to roll over in the first place. Many large 401(k) plans have improved dramatically in recent years, especially on costs. IRA expenses run 25 to 30 basis points higher than 401(k)s, according to the U.S. Government Accountability Office. That sets the bar high, as 71 percent of all 401(k) assets are concentrated in just 1 percent of workplace plans, according to one recent analysis, and larger plans tend to have the lowest fees.

Expense won’t be the only consideration defining whether a rollover recommendation is in the client’s best interest under the new rules—but it will be a big one, according to Jason Roberts, CEO of the Pension Resource Institute, a consulting firm that provides compliance services to investment advisors and broker/dealers. “The key issue is, what value are you providing that is valued by the participant?”

Retirement savers could have many reasons to roll over an account. ICI survey data finds the top reasons include preservation of tax deferral, seeking more investment options, and a desire not to leave assets with a former employer. Consolidation of assets or a desire to use a different financial services provider are also cited often as reasons for a rollover.

More Holistic Planning

Many of those reasons could justify a rollover from a best-interest perspective, experts say. But many believe that advisors will also need to provide more holistic planning that gets far beyond advising on investments and portfolio allocation to justify the higher fee. That might include retirement income and drawdown projections, informed recommendations about claiming Social Security, Medicare enrollment, and assessment of long-term care needs. “It’s going to take more than just providing investment or asset allocation advice,” says Matt Sommer, vice president and director of retirement strategy at Janus Capital Group.

“If your fee is going to be more than what the client paid inside the 401(k) plan, that’s not necessarily bad or wrong, but the question is—what is the participant receiving above and beyond what he had inside the plan?”

Sommer thinks advisors also will need to be very familiar with the client’s total benefit package. That includes whether the employer plan includes a Roth option, whether in-service distributions are available, and how outstanding loans are treated on termination. Advisors also need to get a comprehensive picture of other retirement accounts, defined benefit pensions, and deferred compensation.

Sheryl Garrett, founder of the Garrett Planning Network and a key advocate of the fiduciary standard, agrees with that—but offers a caveat: “I do think we will see more holistic planning come out of this, but it’s not really a natural requirement of the rulemaking. There will be a much greater demand to really know your client and all that is going on with her.” That implies getting an understanding of the entire balance sheet—not just retirement accounts, but also liquid savings, all forms of debt, and insurance protections.

The key issue is, what will determine value under the new fiduciary regime? “It’s an outstanding question, and hard to get a grip on,” Garrett says. “The fiduciary rules aren’t black and white—they are principles.”

Roberts—an attorney with ERISA expertise—notes that navigating the rules will be complex for plan advisors. He thinks rollover recommendations will be defensible under the new fiduciary regime if there’s a clear client desire for services or investment options that aren’t available inside the 401(k)—or the client is paying for plan services that she no longer needs. But if the plan advisor’s compensation will be higher in the IRA, the advisor will be required to sign a “best interests” contract with the client acknowledging the higher compensation and that the financial standard of fiduciary care will be followed, to avoid running afoul of the self-dealing prohibition in Section 406(b) of the Employee Retirement Income Security Act (ERISA).

'A Death By A Thousand Cuts'

“I hope that an advisor can still serve that client and stand behind a best-interest representation—If the client tells me that they want access to personalized, holistic advisory services not available through the plan, and I will receive level compensation in the IRA, I can stand behind that one all day long provided my compensation is within industry averages for similar services.”

A more troubling example, Roberts says, might involve a buy-and-hold client, who would not be well served paying ongoing advisory fees—even though the fees may be level—or a participant with a small balance, which doesn’t meet the minimum account size for advisory services. A recommendation that this client roll over to a brokerage account, where compensation will be based on investment recommendations and frequency of trades, would leave the advisor vulnerable.

“Under the proposal, I’d have to state in the contract that everything I do will be solely in the client’s best interest, but it will be death by a thousand cuts,” he says. “Whenever there’s a market correction, people get sued, including good advisors—clients don’t like to lose money. You’re going to be playing defense on every transaction.”

In particular, the variable annuity market appears headed for major disruption due to their complexity and high cost.

A study of 44 brokerage firms issued recently by the Securities and Exchange Commission (SEC) and FINRA found that the post-recession climate of low interest rates has boosted the risk of “more complex, and possibly unsuitable, securities” to retiring investors seeking to invest income streams. In particular, the report raised concerns about recommendations of unsuitable transactions by broker/dealers and lack of proper disclosures.

The study found that variable annuities were among the top revenue-generating securities, at 68 percent of the firms. The report also found that 34 percent of the firms made unsuitable variable-annuity purchase recommendations—a higher percentage than was found for other types of non-traditional securities (structured products, REITs) and far more often than for traditional mutual funds, equities or fixed income investments.

“It’s going to be much harder for someone with fiduciary duty to make the argument for a variable annuity going inside a qualified plan or IRA because of extra layers of cost and illiquidity,” says Garrett. “That will require some companies to make drastic shifts in their businesses. If most of their transaction revenue is coming from stocks and bonds, fine—but insurance commissions from annuities are going to be a problem.

“It’s something the industry needs to fix, because it’s overcharging and underdelivering. And it’s going to be a huge positive for the investing public.”

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