More On Legal & Compliancefrom The Advisor's Professional Library
- Code of Ethics Rule The Code of Ethics Rule, found in Rule 204A-1, uses severe consequences for violation to help ensure investment advisors will do the right thing.
- Advertising Advisor Services and Credentials Section 206 of the Investment Advisers Act contains the anti-fraud provision of the statute and ensures that RIAs advertising and marketing practices are consistent with the fiduciary duty owed to clients and prospective clients.
A little known Department of Labor regulation has the potential to expand the reach of investment advice, improve its quality and untap a substantial flow of retirement money in motion.
So says Lou Harvey, head of the financial services market research firm Dalbar, with respect to ERISA 408(g), an exemption that permits advisors to use a certified computer model for advice delivery and be absolved of any fiduciary liability.
Under current law, an advisor serving the retirement plan market must disclose whether he is a fiduciary. Non-fiduciaries—which are the norm in the wirehouse broker-dealer world—are in a quandary, Harvey (left) told AdvisorOne. “If they go to their plan sponsors and say ‘We don’t give you advice and I’m not a fiduciary, the obvious question is ‘Why are you here?’”
If the advisor does offer advice and is not a fiduciary, there is no advantage to the plan sponsor; only the advisor’s ego is served here. Dalbar's CEO joked: Would you like advice from Merrill Lynch or would you prefer Charlie to offer his investment ideas?
But if the advisor can say, “I do offer advice, and the advice I provide comes from this super-duper, wonderful computer model,” a broker-dealer rep can suddenly compete with other players in the retirement marketplace, Harvey says.
The ERISA regulation went into effect on Dec. 27, but broker-dealers, who Harvey says are the biggest beneficiaries, have not examined it carefully. To date, Harvey knows of just two firms that are taking advantage of the exemption, only one of which, Rehmann Financial, has said so publicly.
Many of the large broker-dealers have looked at 408(g) and shrugged that the computer model it needs would require certification and an annual audit. But “virtually every firm out there uses some form of computer model,” says Harvey. “We’re not talking about something they have to go out and make a major investment in. The question is how do you convert it so that it will conform to the new requirement?
“It is not years of software development,” he adds. “You take input from an IRA participant and come out with some form of investment strategy. You have to make disclosures and have a contract—pretty minor. The certification process is simple and straightforward. The audit is a little more burdensome but nothing to be particularly worried about,” he says.
The key point, Harvey says, is that with a relatively modest investment, broker-dealers can make their fiduciary problem go away, reduce legal headaches and compete for a sizeable business.
“They can maintain their compensation structures and at the same time control what it is their advisors are doing in the field,” he says, noting broker-dealers spend vast sums on arbitration costs because clients sue a firm based on what their advisor told them to do. “With the computer model that goes away,” Harvey says.
Broker-dealers have long resisted regulatory efforts to impose a fiduciary standard on their financial advisor reps. ERISA 408(g) allows broker-dealers to attain fiduciary certification while enabling broker-dealer reps to engage in sales and service activities. “Our computer model is a fiduciary,” Harvey says the firms can say. “But our guys are not there to provide investment advice; they deliver the investment advice that comes out of the [computer program].”
Such a program would be designed by finance experts in strict accord with generally accepted investment theory, Harvey says. That means that clients don’t end up with portfolios built on oil and gas MLPs or commercial REITs that blow up. “I don’t know any generally accepted investment theories that support REITs as your only investments. [The computer program] adds discipline from a consumer perspective,” he says.
While the broker-dealer expands its business and reduces arbitration costs, and the consumer wins out with more and better advice, a computer model has powerful advantages for retirement advisors.
“You’re taking work off the advisor’s plate and giving him a solution that has the imprimatur of the firm,” Harvey says.
But the biggest opportunity for advisors and broker-dealers waiting to be tapped in the ERISA provision is on the IRA side of the market rather than in 401(k)s.
That is because, as things are currently structured under the Labor Department’s SunAmerica ruling, a firm — say, Merrill Lynch — escapes fiduciary liability if it hires a firm like Morningstar or Financial Engines to provide independent third-party advice to 401(k) plan participants.
But only with 408(g) does the financial industry have an exemption that works for IRAs.
“The idea here is that the Labor Department frowns on advisors who recommend that people roll over the assets out of their 401(k) into an IRA [in order to increase their] compensation,” Harvey explains. “But if you have a computer model, it’s the computer model that is the fiduciary. The Labor Department has been explicit that there are no restrictions on the non-fiduciary. The rep can be uninhibited in his pursuit of rollovers.”
In other words, advisors can capture the flow of funds occurring every day when people take distributions out of their 401(k) plans as they retire – if that is consistent with the certified and annually audited computer model’s unbiased investment recommendations.
Making use of the ERISA exemption in the field is not without challenges, but has been worthwhile, said Gerald Wernette, who directs retirement plan services for Rehmann Financial, a pioneer in using computer models in retirement plans according to Harvey.
“We’re in the early stages of [usage],” Wernette, based in Farmington Hills, Mich., told AdvisorOne. “Less than half the battle is the actual software and getting it approved; the other part of the battle is being able to use it out there in record-keeping land and getting it used on somebody’s platform.
“Now it’s starting to gain some steam,” Wernette added. “We’re looking at things really taking off now that we’ve cleared the compliance hurdles and cleared the integration hurdles.”
Overall, Wernette says the computer model—which Rehmann currently uses with 401(k) plans but not IRAs—has made the experience of retirement investing a “smoother” one for clients.
“Being able to give participants an easy tool they’re comfortable with that will help them make good solid investment decisions is what it’s all about at the end of the day,” he said.