Letter from the US: Move to put clients first
Who will manage the new My Retirement Account (MyRA) pension savings vehicle? This is a big question for the US pension fund industry now that President Barack Obama has created the new programme.
Anybody who manages other people’s money should act as a fiduciary. In other words, they should put clients’ interests first. That’s a no-brainer for Vanguard Group founder Jack Bogle. So the 85-year-old index fund guru is one of the staunchest supporters of the White House’s new push to impose fiduciary responsibilities on anybody recommending retirement-account investments.
Currently, according to the Employee Retirement Income Security Act (ERISA), only employers that sponsor retirement plans and registered investment advisers (RIAs) who act as retirement advisers are required to meet a fiduciary standard. This means they must ensure that the investment options available to plan participants are ‘prudent’ and the plan costs are ‘reasonable’. All the other professionals who offer services in the retirement industry, including stockbrokers and broker-dealer representatives, adhere to a weaker standard.
Many small 401(k) plans hire plan recordkeepers and advisers who are not fiduciaries and who might be tempted to recommend investments that are profitable mainly for themselves, due to high commissions. Non-fiduciary professionals can also advise individuals looking to roll over 401(k) accounts into individual retirement accounts (IRAs) upon leaving a job or retiring.
As a consequence of bad advice and expensive mutual funds, Americans get a full percentage point lower annual return on their retirement savings, with an aggregate loss of $17bn (€15.9bn) annually, according to a report issued by the President’s Council of Economic Advisers (CEA).
This explains why President Obama announced at the end of February that the Department of Labor (DoL) will issue new rules requiring all pension advisers to put clients’ interests ahead of personal gain. By coincidence, at the same time, the Supreme Court decided to hear a case regarding the definition of fiduciary duty for a company that sponsors a 401(k) plan. The case is Tibble versus Edison International, and the issue is whether the employer had a continuing duty to periodically monitor investment options available to plan participants for prudence, or whether that duty ended when the investment was initially made.
The Edison employees who sued the company allege that the firm failed to act in the best interest of its 401(k) plan participants because it kept retail shares of certain funds in the plan, even though identical, lower-cost institutional shares of those funds were available. Edison initially said that those claims were barred by the statute of limitations, because the funds were originally purchased more than six years before the claim was brought. But on 24 February 2015 at an oral argument in front of the Supreme Court both sides agreed the duty to monitor was a continuing one. Now the court has to define the scope of that duty.
The combined effect of new DoL rules and the Supreme Court’s ruling could roil the whole defined contribution pension industry and especially small 401(k) plans and IRAs.
Overall, $4.5trn is invested in 401(k) plans, representing 18% of all retirement assets. According to BrightScope, a company that monitors 401(k) plan costs, almost all large plans with over $100m in assets have total costs – administrative, advice, and other costs, as well as asset-based investment management fees – below 1%, with the largest plans below 50 basis points. The average cost for small plans is 1.5-2%, with plenty of plan members paying more than 2% a year. The reason is, in part, the higher operational costs associated with offering smaller plans, but BrightScope also points out that a key driver of cost is investment options proprietary to the plan’s record keeper, which may be affected by conflicts of interests.
Conflicts of interests affect IRAs too. The CEA study estimates that $300bn is rolled over annually from workplace 401(k)s to individual retirement accounts, whose expenses are 0.25 to 0.30 percentage points higher than 401(k) funds, according to the US Government Accountability Office. CEA reports that as much as $1.7trn of the $7trn IRA market is in inappropirate or high-fee products that provide sub-par returns.
However, a similar attempt by the DoL to widen the definition of who has fiduciary duty was unsuccessful back in 2011 due to strong opposition from the financial industry, backed by the Republicans and also by some Democrats, who feared the new rules would limit retirement products available to investors and especially to small savers.
To complicate matters further, the Securities and Exchange Commission (SEC) is also at work defining new fiduciary standards for retail brokers and advisers. And it is not clear whether there is any co-ordination between the SEC and the DoL. The latter is not expected to publish the proposal for months but financial firms with large networks of brokers, such as Fidelity and Charles Schwab, are already trying to understand how to adjust to the new environment.
Definitely in favour of the new rules are RIA firms that provide fiduciary investment advice, such as Financial Engines, the first independent online advice platform, co-founded by Nobel Laureate William Sharpe in 1998.