From the July 2014 issue of Research Magazine • Subscribe!

The Search for Better 401(k) Advice

The retirement account system isn't perfect, but fixing it is a formidable task

Illustration by Carlo Giambarresi Illustration by Carlo Giambarresi

Most Americans don't get any professional financial advice about retirement. And boy, do they need it. Many small employers desperately want help initiating a 401(k) plan and wading through the myriad investment options they know nothing about. Employees have little idea how much to save or how to pick the right fund. Enter the financial advisor to save the day.

Or not. The American 401(k) system was never really constructed to provide the best retirement savings platform for individuals.

What started out as an executive tax shield evolved over time to provide retirement security for millions of American workers through changes in the marketplace and regulation. Average fees have fallen, services have been streamlined, and policy changes have improved savings and investing outcomes for participants. But it is obviously not perfect—it's too expensive, leads to wide variation in outcomes, lacks effective decumulation strategies, and it has a big issue with financial advice. In many cases, the employers and employees who need hands-on help the most are least able to get it.

Fiduciary Issues

The system works reasonably well for big employers. They can put together committees of ERISA attorneys and financial experts to select the right provider, record keeper, independent investment advisors and managed account providers. Disaggregation of defined contribution services is the name of the game, and each component is becoming more and more efficient. As competition among the big players gets tougher and outcomes continue to improve for employees of large companies, it is hard to argue that the DC system needs much additional regulatory tinkering. And the quality of advice, while not perfect, continues to improve.

As many in the industry know too well, advisors who hope to avoid straying over the fiduciary line must limit the scope of their advice to both plan sponsors and participants. Pete Swisher, senior vice president at Pentegra Retirement Services, prefers to refer to non-fiduciary advisors as “consultants” to better differentiate them from advisors who are ERISA fiduciaries. He also recognizes that many advisors and their clients don't necessarily see the difference. A non-fiduciary advisor is “virtually indistinguishable in a client's mind from a fiduciary advisor, with the key difference being the words that are used; the non-fiduciary is not supposed to recommend anything, and the advisor is.”

But not recommending anything is obviously tough for an advisor who is helping out a business owner who just needs some help creating a plan. Entrepreneurs may not know much about investments or 401(k) rules—and it isn't necessarily a topic they want to know. So they hire someone who promises to help. Very often that someone is not a fiduciary advisor.

Of course, hiring a non-fiduciary doesn't mean they’ve shifted legal responsibility for managing the plan. In fact, it keeps them on the fiduciary hook as a plan sponsor. In many cases, the advisor is performing an important service to small businesses and their employees. They are often very knowledgeable and want to do the right thing. Some would even like to be perceived as a fiduciary, but the plan provider who pays them wants to avoid what they see as an increasingly frightening ERISA lawsuit quagmire.

Saddling small businesses with a fiduciary burden doesn't strike me as an efficient system. It's pretty obvious that many don't have the knowledge to effectively monitor the plan provider. I asked University of Michigan professor and ERISA law expert Dana Muir about the wisdom of placing the fiduciary burden on employers. “Many small business owners lack the expertise and interest to select investment options for a 401(k) or other pension plan,” said Muir. “It makes no sense to burden them with fiduciary liability. Instead, the financial experts that recommend investments for those plans should have the fiduciary obligation to ensure the advice they give is in the best interests of plan participants.”

Except the industry isn't exactly clamoring to grab the hot fiduciary potato from the hands of small business owners. The ongoing battle with the Department of Labor over whether the non-fiduciary advisor will continue to exist in the future is starting to heat up. A recent study by Greenwald Associates informed small business owners that “The Department of Labor is considering prohibiting both retirement plan providers and the advisors who sell retirement plans to employers from assisting the employers in the selection and monitoring of the funds in the retirement plan.” Not surprisingly this didn't sound like a great idea to a lot of small business owners.

To its credit, the survey also reminded employers that they do have a fiduciary duty to their employees when selecting investment options within a 401(k). Then the survey also reminds employers that many of them rely on their investment advisor to help select and monitor these fund choices. So, a small business has a fiduciary responsibility to their employees to select the right investments, they don't know much about investments, and they rely on a helpful investment advisor to choose the right ones. Except the helpful advisor can recommend investments that will get the business owner sued.

According to Ron Rhoades, fiduciary law expert and Alfred State assistant professor: “If I were called upon to testify as an expert, I would opine that the use of a non-fiduciary advisor by a fiduciary plan sponsor is a breach (by the plan sponsor) of its fiduciary duties, with very rare exception. In other words, it is NOT ‘prudent’ to ‘depend’ upon non-fiduciary providers of funds for ‘assistance in the selection and monitoring of funds.’” Of course, plenty of non-fiduciary advisors make recommendations that are in the best interest of the participant. But not being a fiduciary gives an advisor more latitude to make suggestions that aren't.

Having Ron Rhoades on the wrong side of an ERISA lawsuit should strike fear in any employer who might consider creating a retirement plan for themselves and their employees. But many of the small employers don't have much choice. Martha Tejera, a search consultant at Tejera & Associates and a retirement plan expert, notes that “the cost of hiring an independent advisor in a fiduciary capacity can be prohibitive for many small employers and/or small plans.” Small companies need an inexpensive plan and they don't have the money to hire a fiduciary advisor. And many of them do get high quality, personalized services from these advisors that would be difficult to find elsewhere.

In fact, many of these non-fiduciary advisors aren't making much by dealing with small employers. According to Tejera, “the cost of acquiring new clients, establishing the investment structure, then monitoring the investment managers, will often exceed the related compensation in the early years.” Retirement plans can be a way for an advisor to establish a relationship with the employer and their employees, and brokers hope to capture revenue as assets increase and eventually move into IRAs. But the fact remains that Yale professor Ian Ayres’ recent analysis of 401(k) plan costs show that they are significantly higher for employees in smaller plans.

Unexplored Territory

Although the retirement industry has been moving toward fee neutrality over the last decade, it is this business model in which a non-fiduciary advisor is compensated by a plan provider that is most vulnerable to changes in the current DOL fiduciary rules. Swisher refers to 12b-1 compensated advisors in a fiduciary world as a “case study of a potential prohibited transaction in my book” that would “require some legal gerrymandering” to justify. Swisher thinks that won't happen—advisors will need to move to a fee-based model.

Brokers who are paid by providers may be going the way of the dinosaur one way or another. Even if the DOL is stalled, attorneys could apply pressure on employers, and on advisors and plan providers, by questioning whether the model is really in the best interest of employees. That's not happening right now since most attorneys are targeting larger plans.

Will the exit of non-fiduciary advisors lead to the tragic consequences envisioned in the Greenwald Associates report? Rhoades is more optimistic: “Fiduciary advice nearly always results in lower-total-fees-and-costs mutual fund selection, even taking into account the compensation of the fiduciary advisor (however paid).” Tejera isn't so sure. Although she is “uncomfortable” with the conflicts of interest in the way these advisors are compensated, she does believe that the DOL proposal will raise costs and reduce the number of advisors willing to take on a plan below $10 million.

Who is going to pick up the slack when non-fiduciary advisors go away? Nobody knows. The Treasury Department's new myRA plan can help small employers get started, but putting employees in T-bills and providing no advice and then transferring them into IRAs outside the reach of fiduciary rules doesn't sound like a solution. Will new low-cost, online platforms make it easy for employers to set up a plan? Maybe, in a world where employers don't need a human being to guide them through the process, or in a world where the DOL provides safe harbor for employers who select simple, efficient plans.

How do we maintain access to high quality, personal financial advice so that employers and employees can get help when they need it? Does it even make sense to provide retirement savings through employer plans? Swisher believes that it is still the best solution. “Is the employer based retirement system the right model for the U.S.?” asks Swisher. “The answer is unequivocally yes. Should employers have to be the named fiduciary, trustee and administrator of their plans? Not if they don't want to be.”

Some in the industry believe that the death knell of the non-fiduciary advisor will take advice away from millions of employees and employers who badly need it. Others point to the rapid efficiencies that have resulted from fiduciary responsibility among large employers who continue to look for ways to provide retirement plans whose quality can be defended in court. Tejera believes we should focus first on a compensation model that is generous enough to keep advisors in the game while minimizing conflicts of interest. “To me, the whole shell game of ‘blame the fiduciary’ is a legal construct that will enrich lawyers and only make the system ever more costly.”

Will the market provide a solution if all advisors become fiduciaries? I’m not sure if I would bet against the nimble and creative financial services business coming up with a solution, but it may be a bumpy ride.

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