Small 401(k) plans aren't cost-effective to service, but leaving them to a generalist advisor can be risky for a BD.

If and when the U.S. Department of Labor’s fiduciary rule survives several legal challenges, the small and midsize 401(k) plan market stands to be revolutionized.

The rule requires all advisors to 401(k) plans with less than $50 million in assets to serve as fiduciaries. Under the Employee Retirement Income Security Act, all plan sponsors assume fiduciary obligations upon offering a defined contribution strategy, irrespective of plan size.

But those sponsors were not required to hire fiduciary advisors prior to finalization of the Labor Department’s rule.

Critics of the Labor Department’s rule have argued that requiring advisors to serve as fiduciaries to the small and midsize plan market will negatively affect access to 401(k) plans at a time when policymakers at the federal and state level are crafting and passing legislation intended to broaden access to retirement savings for employees of small employers.

Requiring all plan advisors to serve as fiduciaries will impose new regulatory costs and expose both advisors and sponsors to new liabilities, argue opponents of the Labor Department rule.

That will disincentivize advisors from servicing the massive segment of small and midsize plans, potentially motivate some existing sponsors to drop their plans, and discourage other small employers not offering a plan from doing so in the future, say the rule’s opponents.

The Labor Department and its advocates obviously disagree with that analysis. In imposing a fiduciary standard of care on all plan advisors, smaller sponsors will be relieved of liability, as advisors will be contractually obligated to serve plan participants’ best interests under the rule.

With fiduciary advisors at the helm, sponsors and participants will benefit from improved plan design and investment options with lower costs, as advisors will be prohibited from designing plans loaded with higher costing options that are not in a plan’s best interest.

How many plans will be affected?

At least one court will consider the potential impact of the Labor Department rule on the small and midsize plan market in determining whether the agency overstepped its statutory authority in crafting the rule.

The U.S. Chamber of Commerce, which has argued the rule will negatively impact small and midsized plans throughout the rulemaking process and after, is part of a consolidated lawsuit in the U.S. District Court for the Northern District of Texas.

If the rule survives legal challenges, the question will be how many 401(k) plans will be affected by the rule.

Consolidated data is hard to come by, according to several sources that consolidate data on the 401(k) market.

Recent data from Judy Diamond Associates, a provider of 401(k) analytic tools, shows there are about 481,000 plans with a median balance at or below $58 million in assets.

And there are nearly 469,000 plans with a median value at or below $5.2 million in assets, according to Judy Diamond, a business unit of ALM Media, the parent company of BenefitsPRO.

In 2015, analysts at Cerulli Associates set out to examine the impact of 401(k) specialist advisors on the 401(k) market.

Nearly half of the $1.3 trillion advisor-sold defined contribution market is controlled by what Cerulli calls “retirement specialists,” which the firm defines as advisors that generate at least half of their revenue from defined contribution retirement plans.

While their reach and influence on the 401(k) market is powerful, Cerulli says retirement plan specialists comprise only 5 percent of the total advisor population. Furthermore, within that small segment, 45 percent of those plan specialists do not offer services as an ERISA fiduciary.

By Cerulli’s numbers, less than 3 percent of the total advisor universe operated as an ERISA fiduciary plan specialist prior to finalization of Labor Department’s fiduciary rule.

Broker-dealers weigh options

James Smith, head of workplace strategy and business development at Morningstar, says many broker-dealers are taking a proactive approach to measuring the rule’s impact on their 401(k) advisory business, and not waiting for courts to determine the Labor Department rule’s fate.

“We don’t have hard numbers on just how many plans stand to be impacted, but some of the bigger broker-dealers have up to 30,000 plans under advisement,” said Smith. “Right now, industry is focused on what their risks are, and what practices they will need to change to comply with the rule.”

By January, several months before the rule’s first April 10 compliance deadline, Morningstar is slated to roll out Morningstar Plan Advantage, an automated small 401(k) plan advisory tool that provides 3(38) fiduciary services for plan sponsors.

The technology will use Morningstar’s existing fiduciary advisory capability, offered through Morningstar Investment Management LLC, a registered investment advisor subsidiary of Morningstar Inc. that services 13,000 plan sponsors.

The platform is designed to address the tens of thousands of small plans serviced by nonspecialist broker-dealer advisors.

At this point, Morningstar is not hoping to compete for all 401(k) plans under the Labor Department’s $50 million threshold, but is thinking in smaller terms, said Smith.

“As we talk to industry, we’re finding that different broker-dealers have different definitions of ‘small plan’,” said Smith. “Most broker-dealers already have 401(k) plan specialist advisors. And they are going to be in very high demand.”

The question for broker-dealers, says Smith, is what to do with small plan sponsor clients that are serviced by generalist wealth managers.

Often, successful wealth managers will have a handful of small 401(k) plans in their book, typically acquired as a result of relationships with wealthy retail clients that are business owners.

Those sponsor clients tend to have 401(k)s with less than $10 million in assets, and often substantially less, said Smith. The plans are not pure profit drivers within retail wealth managers’ businesses, but are worth servicing to retain the sponsors that are also high net-worth retail clients.

“For the plan advisor specialists, plans that small are not cost-effective to service,” said Smith. “But leaving them to a generalist advisor opens the broker-dealer up to compliance risk.”

Simply walking away from small, or micro plan clients in order to avoid that risk once the rule is implemented is not a good option for broker-dealers, added Smith, because the risk of losing the associated high net-worth sponsors as retail clients is too great.

Smith said the Plan Advantage platform’s user interface is still being built. Sponsors will have an “expansive” number of recordkeepers to choose from, and the option to stay with existing service providers. “The platform will not favor a single recordkeeper, nor will we be recommending a recordkeeper,” he explained.

The value for broker dealers is a no-brainer, thinks Smith.

“This moves a lot of liability off their plate. If I’m a broker-dealer with 8,000 generalists, I have to make sure everyone is complying with the DOL rule. With the Plan Advantage platform, now all they have to do is monitor us,” he said.

— Check out Why Aren’t Retirement Savers Choosing Annuities? on ThinkAdvisor.