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| Sales Insight - January, 2007 |
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Meet the New Boss of
Participant-Directed Plans
In 1981, the Internal Revenue Service published
regulations authorizing 401(k)s, the first participant-directed retirement plans
in the U.S. Six years later, about 15 million Americans were actively
participating in 401(k)s.
At that time, few people would have believed a
prediction such as this: Over the next two decades, participant-directed plans
will grow to cover 60 million U.S. workers, hold over $3 trillion in assets, and
dominate the U.S. retirement plan market. Yet, this has happened.
Here is a prediction for the next 20 years:
Participant-directed plans, as we know them today, will become dinosaurs. By
2027, perhaps 100 million U.S. workers will participate in workplace retirement
accounts that resemble today’s self-directed IRAs. These accounts will let
workers choose their own investments from a vast array of stocks, bonds, mutual
funds and ETFs. Each participant will be able to control personal plan costs and
decide whether and how to receive objective financial advice from a qualified
professional.
This article describes a new business model for
retirement plan advisors who specialize in participant-directed plans. In this
model, financial professionals will not work primarily for the old boss, plan
sponsors. Rather, they will work for the new boss, individual plan participants,
as fee-based advisors and rollover specialists. This article identifies trends
driving the new model, plus ideas for positioning your practice to capture
changing opportunities.
Why Plans Are Changing
Among all segments of financial services, mutual
funds have been the biggest beneficiaries of the participant-directed wave.
According to the Investment Company Institute, mutual funds hold about 50% of
all 401(k) assets, up from just 8% in 1989. Mutual funds “turnkey plans” – which
bundle a menu of fund choices with prototype plan designs and
administrative/recordkeeping services – have served small and medium-size plans
well, while compensating financial professionals with front-end share loads or
12b-1 trails. However, today’s typical mutual fund turnkey plan is not aligned
with trends of the future, for the following reasons:
- Investment choices – Many turnkey plans
now offer menus of up to 30 mutual funds, but participants want more choice.
Many participants are watching nightly TV shows like CNBC’s Mad Money or Fast
Money and following individual stocks, bonds and ETFs that they want to hold
in their retirement plans. Most mutual fund turnkey plans still offer limited
choices for investing outside the U.S., in foreign currencies, real estate,
sectors and industries, or hard assets and commodities. There is a growing
belief that large institutional investors are benefiting from “alternative
strategies” designed to hedge risks. Although several types of ETFs offer
hedging applications, they are available to few investors in
participant-directed plans.
- Costs – Turnkey mutual fund plans tends
to load similar costs burdens on all participants in a given plan, regardless
of personal cost preferences, risk tolerance or investment strategies.
Effectively, these plans create a “cost of admission” that all participants
must pay. Over the past 20 years, as U.S. stocks have earned long-term returns
averaging more than 10% per year, participants did not object to “all-in” plan
costs averaging 1.5% to 2.0% per year. However, if a gradually maturing and
slowing U.S. economy generates lower stock market returns in the future, plan
costs will become more critical. For an average U.S. participant, a cost
differential of just 50 basis points annually can mean up to $50,000 more
money for retirement after 30 years of compounding.
- Cost Disclosure – Most participants
have never understood the “real deal” in turnkey plans: The mutual fund
company subsidizes plan design, administration, record-keeping and
distribution services through “revenue-sharing arrangements” in return for the
right to capture plan assets and retail-priced management fees. Although many
participant-directed plans have enough buying clout to qualify for
“institutional pricing,” most have not received the lower-priced shares, and
participant accounts have suffered. With the help of class action lawsuits and
the attention of the Department of Labor and U.S. Rep. George Miller
(D-California), Chairman of the House Education and Labor Committee,
participants are gaining the power to demand clearly disclosed costs and
institutionally-priced asset management.
- Pension Portability and IRA Integration
– In today’s mobile workforce, most participants have the option of rolling
over vested plan balances to an IRA when they leave a job. In self-directed
IRAs, investors can choose their own investments, control their own costs, and
hire their own personal advisors. In a popular type of employer-sponsored plan
for small business, a SIMPLE, participants can move money from workplace plans
to personal IRAs without penalty after two years. In many 401(k)s, workers are
eligible to roll over in-service distributions to IRAs after attaining a
specified age (e.g., 59 ½), even if they keep working. The concept of “pension
portability” makes sense when there is coordination between workplace plan
money and personal IRAs. Also, it makes little sense for the vast numbers of
people in participant-directed plans to have far less investments choice at
far higher cost than they can obtain in self-directed IRAs.
- Baby Boomers and Advice – As Baby
Boomers move into retirement, rollovers from participant-directed plans into
IRAs will represent the “golden egg” of U.S. financial services. Financial
advisors’ ability to offer objective investment advice to participants (and
capture rollovers) is enhanced when advisors’ loyalty is aligned with the “new
boss.” The evolution of U.S. pension laws and regulations is creating a new
model in which advisors receive fees directly from participants who choose to
pay for advice.
Shopping in the Retirement Plan Wal-Mart
To understand the combined weight of these
changes, envision each participant-directed plan as a Wal-Mart-like store. At 8
a.m., when the doors open, hundreds of plan participants go inside to shop. Some
want high-end merchandise while others want low-cost economy shopping with no
frills. Some want to fill a shopping cart with diverse investments while others
want simplicity. Some shoppers want a do-it-yourself experience while others
need assistance.
In a traditional turnkey mutual fund plan, there
are only a limited number of products on the store shelf – all mutual funds and
perhaps none very cheap. In many cases, these products don’t have clearly marked
price tags. However, the greatest weakness of the turnkey plan is the fact that
it forces all people to shop in the same way. Because it is a packaged product
built around one investment/cost structure (retail mutual fund shares), it can’t
accommodate the diverse personal needs of even a small plan with perhaps 25-50
employees.
Now, compare this to the “gold-standard” plan of
the future. This store offers virtually unlimited investment choices among
mutual funds, stocks, bonds and ETFs. All investment choices have clearly-marked
price tags. A shopper who wants to economize can select index funds, ETFs or
buy-and-hold stocks and bonds, resulting in a diversified portfolio that costs
as low as about 50-75 basis points per year. On the other hand, shoppers who
want high-end merchandise can shop for outstanding mutual fund money managers at
higher costs. The gold-standard plan also includes a choice of paying perhaps
$150 to $300 per head annually for objective, personalized investment advice.
Naturally, many people who participate in gold-standard plans will want to
continue working with the same investment strategies and advisor after they
leave work and take a rollover. Thus, the gold-standard plan also accommodates
long-range planning by promoting continuity across multiple jobs and life
phases.
Three Developments on the Horizon
Today, the gold-standard isn’t generally
available to most plan participants, but it is coming. The closest
approximation, a “self-directed brokerage window” inside a turnkey plan, still
layers-on extra costs that participants don’t want or need, including some that
may not be clearly disclosed. However, three developments in the retirement plan
market will force many plan sponsors to adopt the gold standard within the next
decade:
1. Cost disclosure guidelines - In the
fall of 2006, a St. Louis law firm, Schlichter, Bogard & Denton, filed class
action lawsuits against fiduciaries of seven large 401(k) plans that
collectively have more than 400,000 employees. The lawsuits charged that these
plans and their senior executives breached fiduciary duties under ERISA with
excessive fees, undisclosed revenue-sharing arrangements, and confusing cost
disclosures. The text of one of the lawsuits, against fiduciaries of
International Paper (IP), may be accessed online here:
http://www.plansponsor.com/pdfs/beesley.pdf
One of the suit’s most serious allegations is
that the IP plan’s master trusts made undisclosed revenue-sharing payments to
plan service providers totaling millions of dollars per year. The suit labeled
revenue-sharing arrangements “the big secret of the retirement industry” and
claimed that “…participants of the plans are forced to pay, from their
retirement savings, excessive and unreasonable fees and expenses that are not
incurred solely for their benefit.”
Whether or not these lawsuits are successful,
these are troubling charges for today’s retirement plan industry. They could
lead to new laws passed by Congress or new regulations by the Department of
Labor (DOL) that will require all costs paid by participants to be fully
disclosed. Regulations also could prohibit the practice of bundling a variety of
plan services together and paying for them with asset management fees, in ways
that are not clearly disclosed. Eventually, the DOL could require most
participant-directed plans to offer some low-cost index fund options as a way of
helping participants avoid the impact of bundled fees. According to Rep. Miller,
a powerful advocate for rank-and-file plan participants: “We have to ask whether
all these fees are necessary and we have to examine whether they are undermining
workers’ retirement security.” The Congressional committee that Rep. Miller
chairs currently is holding hearings on the matter.
2. Rule 404 [c] fiduciary protections –
ERISA rule 404(c) gives plan fiduciaries a limited shield of liability against
investment decisions made by plan participants, when the plan elects to qualify
for this protection and then follows guidelines for diversification, investment
choices, education and disclosure. Among charges made in the Schlichter, Bogard
& Denton lawsuits was a claim that fiduciaries of defendant companies had not
met the 404(c) standard for clear cost disclosure.
Many plan sponsors are concerned about the
potential investment losses and legal claims that could result if participants
are given virtually unlimited access to stocks, bonds and ETFs. However, there
is a potential solution that could give participants gold-standard plans without
undermining fiduciaries’ legal protections. That solution is to make objective
personal advice available to participants who choose to use it.
Under ERISA's prohibited transaction rule
(Section 406), a “Chinese Wall” exists between fee-based investment advice
offered to retirement plan participants and investment services delivered to the
same plan. For example, a company that provides the investment choices for a
401(k) can’t be the provider of fee-based investment advice to the same plan.
Likewise, a financial professional who distributes investments to a plan can't
offer fee-based advice to the same plan’s participants. This rule is designed to
ensure that objective advice is delivered solely for the benefit of participants
by an ERISA fiduciary, and that the advice does not influence participants to
purchase specific investments in which the advisor has an interest. For more
details, see:
http://www.freeerisa.com/Insight/september_2003.asp
The Pension Protection Act of 2006 (PPA) included
a new exemption to the prohibited transaction rule for “eligible investment
advice arrangements.” This exemption allows providers of plan investment
services to offer fee-based investment advice to the same plan’s participants,
provided requirements are met. The advice must be provided by a “fiduciary
adviser” who is an RIA, bank, insurance company, broker-dealer, or an affiliate
of these entities. Unless the advice consists solely of computer model output,
the exemption requires the fiduciary advisor to offer a “level-fee” arrangement,
so that any compensation received from the purchase, sale or holding of plan
investments does not depend on which investment choices are selected by the
participant. To the extent that a fiduciary advisor who delivers fee-based
advice also receives investment-related compensation, that compensation may not
vary based on investment choices, sales or results.
Plan participants who have access to independent
fee-based advice, including asset allocation models, are more likely to follow
disciplined investment programs. Thus, plans that offer their participants
access to objective advice potentially will be able to increase the legal
protections of fiduciaries.
3. New platform technology – To deliver
broad investment choices with cost-efficiencies, the gold-standard plan may
require a new type of platform. The current model for accessing stocks, bonds
and ETFs in participant-directed plans is a self-directed brokerage option (SDBO),
often packaged inside a turnkey mutual fund plan. Since mutual fund companies
must acquire sufficient assets in their funds to support the cost of plan
designs and administrative platforms, they do not always make SDBOs very visible
or economical to access.
However, new platform technologies will unbundle
investments from administration and recordkeeping services, increase plan
efficiencies and economies, and expand participant access to investment choices
and advice. One promising new model has been developed by Darwin Abrahamson, CEO
of Invest n Retire, a small Portland, Oregon company. The firm provides a
low-cost administration/recordkeeping platform for financial advisors who wish
to offer retirement plans built around asset allocation models and ETFs. In
addition, the Invest n Retire model saves participants the usual brokerage fees
on ETF purchases by making all trades (in each ETF) once per day, through an
omnibus account.
Action Steps to Plan for the Future
How can financial advisors make a transition from
mutual fund turnkey plans to the gold-standard era of the future? Here are some
ideas:
- Keep your eye on the prize – The great
opportunity in today’s plan market is the potential to capture the large
rollovers of Baby Boomers nearing retirement. The smartest way to compete for
rollovers is to begin offering fee-based advice to plan participants long
before they retire or leave the company. Even if you have to give away some
advice to put yourself first in line for rollovers, do it!
- Educate participants about plan costs –
Most retirement plan participants don’t have a clue what they are paying, and
that’s a problem America will soon start to solve through increased
regulations and disclosures. Help clients and prospects understand that every
extra dollar of annual plan fees they pay could eventually cost $103 of
retirement assets (@ 7.5% return over 30 years, with compounding). Try to
estimate the all-in plan costs that each participant is paying. For those who
want “economy shopping,” suggest ways to reduce the impact, such as index
funds.
- Help participant groups advocate for a
better deal – The new bosses of participant-directed retirement plans may
not obtain more power unless they demand it. In plans where participants are
paying high costs for too few choices and too little service, they should and
must speak up for their own retirements, ideally with a unified voice. The
message of empowerment is: “It’s our money and our plan.” Help to organize
meetings at which all participants of a given plan are invited to discuss
preferences and needs. Then, follow up by presenting consensus recommendations
to the plan sponsor. This can be an effective way to develop new clients for
plan advice and rollover counseling services, especially if participant
advocacy word-of-mouth buzz spreads from plan to plan. Some plan sponsors may
appreciate your efforts, too, because they may be out-of-touch with what their
participants really want.
- Study the advice provisions of PPA 2006 –
Provisions of the new law covering investment advice to plan participants
are highly complex. They favor an approach in which the fiduciary advisor to
participants: 1) charges a flat per-head fee (e.g., $250 per person per year)
paid voluntarily by those participants who want advice; and 2) does not offer
investment distribution services to the same plan.
- Avoid prohibited transactions by partnering
– It will makes sense for two separate financial firms (or advisors) to
develop referral-based partnerships in which each partner works on a different
side of the “Chinese Wall.” One partner will sell plan services and receive
investment-based compensation; the other will provide fee-based advice to
participants. Although the relationship between partners must be at
arm’s-length, the law probably will allow a degree of cooperation between
entities on both sides of the wall.
- Help clients understand opportunities for
in-service rollovers – Many participants can start using the gold-standard
plan before they retire. These opportunities include: 1) small businesses that
are candidates for SEP-IRA plans; 2) participants who have been in SIMPLEs for
at least two years and can make a penalty-free transfer to a personal IRA; and
3) participants in 401(k) plans that allow in-service withdrawals after a
certain age.
- Network with third-party administrators (TPAs)
– Gold-standard plans are available today from several leading online
brokerage firms; however, you will need to team with TPAs to package
cost-effective solutions that integrate all the services a sponsor needs
including reports, filings, non-discrimination tests, and participant
disclosures. In anticipation of increased DOL cost disclosure requirements,
make sure TPA’s costs are competitive and separate from investment-related
services.
- Be cost-minded in turnkey plans – If
you make a living representing mutual fund turnkey plans, accept the changing
environment by choosing vendors that: 1) offer low-cost index fund choices; 2)
will offer institutionally-priced shares to volume purchasers; and 3) provide
clear cost disclosures to plan participants, especially if they use
revenue-sharing arrangements. Always be willing to disclose to participants
the fees that you personally earn.
The future of the U.S. retirement plan industry
will be just as dynamic and opportunity-filled as the past, and it is now
becoming clear what types of plans and services the new bosses will want. Make
sure your practice is facing the future of participant-directed plan growth, not
the past.
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