A Model for 401(k) Advice, Pt. 1 – Must be Conflict-Free
Many 401(k) sponsors, providers and advisors eagerly await the DoL’s new advice proposal, which is due to be released within the next 30-45 days. In an effort to put in our two cents, we thought we would share our hopes for the proposal based on our experience in delivering advice, our understanding of other options in the marketplace, and the feedback we have received from employers and investors alike. Keep in mind most of our clients exist in the top end of the small market (250+ employees) to large sized employers (1,000+ employees).
Goal #1 – Advice Must be 100% Conflict-Free
For those of you that aren’t 401(k) geeks like us (it’s understandable), the DoL proposed advice regulations in January of ’09. The proposal received immediate backlash in the media and from the legal and advisor community, especially those that operate as fiduciaries. The issue resonated from the idea of being a “level fee” advisor.
- Level Fee Advisor – The idea here is that mutual funds have revenue sharing arrangements that are different on a fund by fund basis. For example, if you have three large cap funds in your plan from three different mutual fund companies, it is highly likely the revenue arrangement for each fund is different.
- Conflicted Level Fee Adviser – The DoL proposed to require the advisor to charge a level fee while not requiring the advisor’s affiliated firms (broker dealer, mutual fund company, insurance company, bank, etc.) to receive level compensation from the funds in the plan as well. Here is a secret of the advice industry: someone provides advice to the advisor, because understanding the markets, determining asset allocations, etc. is a full time job. Therefore, if the advisor is receiving the advice recommendations from the affiliated firms, the advice has the potential to be conflicted as the affiliated firms could steer the advisor towards funds that provide themselves a greater benefit than the participants receiving the advice.
- Conflict-Free Level Fee Adviser – Under the conflicted approach, employers would have to determine whether the advice the advisor/team is delivering to their participants is biased or not. A conflicted (even those that are “managed”…whatever that means) environment will likely create a barrier of entry for employers considering advice. Thus, the use of an outsourced third party or 100% fee-only advisor (not just fee-based, as that means they can collect fees and commissions) seems to be a more reasonable choice for those who wish to provide participant advice they can trust as well as a service they feel good about promoting.
Using the “Keep It Simple, Stupid” principle, here is a simple model that allows employers and participants to easily understand the business structure of the advice provider:
- No Compensation from Financial Institutions, Period – If the advice provider does not receive any compensation from any investment, insurance, or banking institution, it allows them to be objective in the advice that is delivered to 401(k) investors.
- No Under-the-Table Arrangements with Recordkeeper – There should be no undisclosed arrangements with the recordkeeper of the plan to use specific investments that may benefit the recordkeeper more than participants. We have heard rumblings about such arrangements, specifically under the SunAmerica Opinion, but have no concrete evidence. However, such discrepancies have been alluded to in discussions with regulatory bodies, with one example being a recent article by PlanSponsor.
- Annual Audit – Did you say audit? Yeah, we don’t like them either. However, when an advice provider is required to be audited by an independent, unrelated third party, that’s a huge benefit to the provider’s clients. How so? It provides peace of mind that a professional auditor is likely going to ask the questions an employer wouldn’t know to ask and look for disparities that have created or potentially could create conflict in the advice delivered to investors.
- Full Disclosure of Business Revenue Sources – Full disclosure to employers by service providers is seemingly going to make its way into reality (finally), so it would seem logical to have this enforced for advice providers as well. If there is any revenue coming from a mutual fund, insurance, recordkeeping, or TPA company coming to the provider, then they are conflicted. Period. Employers evaluating advice providers should be informed of any conflicts before making it available to their colleagues. Full disclosure can help provide employers the peace of mind that a service they communicate for the benefit of their participants is in their benefit, not the advice provider’s.
Benefits to Conflict-Free Advice
- Increased Availability to Investors – We would argue that it’s not a lack of advice solutions that has kept more employers from providing advice, but the need for it to be conflict free. The vast majority of employers want to do right by their participants, so they evaluate services offered on their merit, value, deliverables and cost.
- More Conversations About Advice by Providers/Advisors With Employers – Additionally, it our belief and experience that advice has not been discussed with a lot of employers because the provider/advisor is waiting for the ability to deliver it themselves in a “managed conflicts” manner. Once the advice requirements are defined, the companies that can and cannot deliver advice will as also be defined, allowing the smoke to clear and available solutions to come to the forefront. This will end the wait-and-see period for providers, brokers, and advisors and will instead allow such entities to look at conflict-free solutions that can help their clients’ employees better succeed in managing their 401(k) assets.
- Empower Employers to Focus on Service Options, Instead of Fearing PR Nightmare of Offering Conflicted Advice – If there is one thing we have noticed over our years, it’s that companies are very careful about the services and benefits they offer so to ensure they reflect the company in good light to their employees. Imagine a company delivering communication campaigns illustrating the benefits of 401(k) advice to their participants. The campaign is a reflection of the 401(k) committees’ due diligence, and it is intended to be a message the participants can trust. If the advice is conflicted, this could create dissent among employees wondering why such an offering was given the thumbs up.
In summary, we believe the foundation of 401(k) advice must be conflict-free before you even start talking about how the rest of it works. The beneficiaries include employers, their participants, and though they do not realize it yet, advisors, brokers and the mutual fund/insurance companies who provide 401(k) platforms. If the DoL starts with a conflict-free foundation, it will be a huge win for 401(k) investors.
The next edition of this series will come out early next week. We would welcome any comments.
Chad, this is a very comprehensive and well thought-out plan. Hopefully you’ve forwarded it on to the proper regulators. The bottom-line is this: Absolutely no conflict. If that’s the case, then that means disclosure of a conflict is not enough – even in the case of the recordkeepers.
Two questions:
1) Regarding the audits: Since the advisers would not be handling client funds, what’s being audited? The performance records?
2) The second question is one I haven’t been able to find an answer for myself: Should advisers charge asset-based fees or a flat rate? The former case makes sense for larger accounts since there might be more work and definitely more liability associated with those accounts. The latter makes sense for smaller accounts, but can advisers then earn enough to pay their own normal operating expenses? Or, does the adviser charge the plan directly (either asset-based or (larger) flat fee) so the adviser has no vested interest in favoring larger accounts over smaller accounts?
Fantastic post Chad – you nailed it.
How does a practice that makes so much common sense not reach a tipping point? Perhaps we are on the verge and hopefully the DOL’s new advice regs will add some wind to our fiduciary sails.
Chris,
Thank you for your comments on the post, and I have forwarded this post to Asst. Secretary Borzi.
I will attempt to answer your questions as best I can.
1) An annual audit by an independent, unrelated third party would hopefully evaluate the provider’s investment process and management methodology, disclosure processes, contracts (plan sponsor and employee), IT infrastructure, and most importantly the revenue and partner agreements they have it place…a good start at least. The key is not just to look at the functional delivery of the ongoing advice, but also the potential conflicts that exist in their revenue and agreements in place with industry partners. If I were an auditor, I would want to make sure the agreements with providers/advisors/brokers do not show any language that speaks to required asset allocations or necessity to use or avoid any specific investments available on the retirement plans menus that are available to participants to invest in for themselves. If that type of language exists, with any requirements toward specific proprietary investments or revenue sharing arrangements the provider has with various investment companies, then a conflict of interest could be “hardwired” into the offering. I hope that makes sense.
2) That’s the million dollar question. How do you charge for advice, and more importantly, is it a profitable enterprise? I think the approach of charging an asset-based fee in the micro market makes sense, as it is simple to understand and has been in practice for RIAs for years. When you enter the 100+ employee market and especially the 1,000+ employee market, then a process must be present/solution to deliver ongoing advice to participant. As you know, fiduciary advice needs to be ongoing, so their needs to be a process for delivering it, and face-to-face simply doesn’t work for the ongoing portion of the advice relationship. The economics of advice and ongoing nature are actually going to be some of the posts in this series, so I will leave that to go into more detail.
Michael – Thank you for the comment, and I too hope the regs reflect a true ERISA fiduciary standard, and not an SEC standard.
So then, under this model, the current fee-based (or commission-based) advisor would be barred from providing advice. The simple act of receiving compensation for the provision of services makes the advisor makes the advisor “conflicted”. For years, IAs have been providing advice to employers and plan participants “in their best interests” without regard to the amount of fees (or commissions) received for any particular investment options under the plan. These are the folks who truly understand the plan and the plan’s participants. By painting all of them with the “conflicted” brush would then required additional compensation be paid to the “new” advisor(s). Doesn’t make a lot of sense to me.
Chad,
Your comments are spot on. Its going to be up to the FEE ONLY Advisor community to properly articulate to plan sponsors WHY their 401k plan is broken, and how it can be fixed. The amount of sponsors I speak to that dont know who their recordkeeper is, how much their hard and soft dollar costs amount to over time, and who they are to turn to for education is astounding. Those in our business need to be able to provide medicine to sick 401k plans. The hard part being the patient (sponsor) does not even know that they have underlying conditions that will have devasting negative results over time.
Chad,
Have you been introduced to Matt Hutcheson? Fee transparency is his calling card, so if you haven’t reached out to him, you should. Those of us that operate in the World you are referring to are delighted to embrace your forward thinking. Keep it up!
John – Thank you for your kind words and support. Yes, Matt actually endorsed us as an Independent Fiduciary back in ’08. He has been very supportive of our efforts on this front. Thanks again
It is my understanding that the PPA already requires an annual audit of the Fiduciary Adviser.
Lynne – You are absolutely correct. We are simply saying that continuing the requirement would be a big benefit to both plan sponsors and participants as last January’s provisions did not seem to have it included (at least from what we saw). Additionally, the ability of the auditor to inspect the advice provider’s contracts not only with plan sponsors and participants but those with partner firms such as recordkeepers, TPAs, mutual fund and insurance companies. It would simply be an added degree of evaluating whether conflicts of interest are hardwired into the original agreements with the various firms. I hope that makes sense.
Chad, this post is right on the money. Conflict free is the only way to go for participant advice. The whole world of financial advice (in and outside of retirement plans) is very confusing to the average consumer. At least within their plan they could be assured that the person providing advice is not subject to conflicts of interest regarding how they are compensated.