Fiduciary Standards: In the Retirement Savers’ Best Interest?

By Ann Cleven

On April 14, the Department of Labor proposed a new rule that would hold financial advisers of 401(k)s and IRAs to a fiduciary standard that would require them to look out for the best interest of a client.

“401(k)s and IRAs are retirement savings, and retirement savings are extremely important for folks,” said Laura Hearn in an interview, vice president and wealth adviser of RMB Capital Management.  “Consumers should receive higher quality advice on their investments due to the standards. They should also see a decrease in commissions and fees on investment recommendations.”

Currently there are different standards for financial advisers and brokers dealing with these funds, but the new rule would apply to everyone giving financial advice on 401(k) plans and IRAs.  The goal of implementing this fiduciary standard is to ensure retirement savers get full disclosure of the risks and benefits of certain plans, and hold brokers and 401(k) managers to the standard of a financial adviser.

The rule, proposed earlier this month, has a 75 day public comment period before it can be passed in Congress.

BACKGROUND ON RETIREMENT FUNDS

retirement_plans

There are three types of tax-preferred retirement plans: defined benefit plans, defined contribution plans, and individual retirement accounts (IRAs).  A defined benefit plan includes a monthly payment from an employer to the retiree, with the monthly income being dependent on the employee’s’ work history, salary and standing with an employer.

A defined contribution plan includes an employee’s regular payments to a retirement fund along with contributions from an employer.  401(k)s, 403(b)s, the Federal Thrift Savings Plan, and profit sharing plans are all considered defined contribution plans.  IRAs are outside of an employer, and benefits are dependent on the retiree’s savings and investment returns.

In addition to choosing from different retirement plans, savers can choose a few different forms of financial advice.  If a person has the designation of a financial or third party adviser, she must act in the best interest of her client.  Because 401(k) plans are offered by an employer, the employee can hire someone from her company to be her financial adviser.  When a person is hired or has the title of financial adviser, she is paid at an hourly rate and held to the fiduciary standard, or acts in the best interest of the client.

Employees can also take more informal advice from their colleagues that manage 401(k) plans.  This isn’t technically considered financial advising, so the person giving financial advice is held to the suitable standard.

“Often time they will steer a client towards a fund that most likely someone from their company manages,” Denis Liburkin, a Financial Analyst for Fannie Mae said in an interview.  “They’re not acting as a financial adviser, per say, even though the 401(k) plan manager is the one giving financial advice.”

This creates an issue because the person giving financial advice for 401(k)s is not legally bound to a standard that would require advice in the best interest of the client.  A person from the company giving financial advice may still benefit from the deal, but is not held accountable for the advice he gives other employees.

Brokers also deal with retirement funds.  A person with an IRA, for instance, may opt to use a broker to manage retirement funds because it is dealt with outside the realm of an employer.  Technically, brokers are not considered financial advisers, even though they give financial advice on how to manage retirement plans.  Yet, brokers receive commissions when dealing with these funds, so some say there is a conflict of interest between the broker and client’s best interest.

Because of this perceived conflict of interest, the Department of Labor proposed the fiduciary standard, that would make all of these parties giving advice on 401(k) plans and IRAs to act in the best interest of their clients.

broker_vs_adviser

THE CURRENT STANDARD

The Department of Labor’s proposal to create a fiduciary standard has been backed by the White House, which released a report in February on the costs of not holding all advisers and brokers of retirement funds to a fiduciary standard.

Currently only a half of IRA holders have a financial adviser, according to the White House report.  That means that 50 percent of IRA holders do not seek formal advice from a financial adviser, and their account management through a broker is not held to the fiduciary standard.

IRAs also have other fees, such as rollover costs.  When an employee changes a job, her retirement savings and investments can be “rolled over” into a different retirement fund without tax.  These funds can be transferred to the new employer’s 401(k) plan or an IRA.  It is not until the funds are withdrawn from the retirement fund that they will be taxed.

The White House report finds in its report that “rolling over” balances into an IRA account can be costly to the client.  401(k)s have low trading costs and mutual fund expenses, but expensive management fees.  With a 401(k), an employee’s plan will earn around 6 percent, after half a percent of his earnings are subtracted for the plan’s different expenses.

IRAs on the other hand have no management expenses, but higher mutual fund expenses and trading costs.  Because the stocks in IRAs are managed more frequently by brokers on the stock market, the trading costs are higher.  Instead of earning 6 percent in dividend earnings, a retirement saver will only earn 5 percent with a broker, after 1.5 percent of earning are subtracted for costs, according to a White House report.

Ira_401kgraphic

The White House finds that the average person between ages 55-64 lose $100,000 in retirement earnings through rolling over previous retirement savings into an IRA account with the account’s additional fees and $12,000 is lost with the funds’ transfer.

The White House’s report calls this “conflicted advice,” as a person who rolls over investments into an IRA will be losing one percentage point in earnings per year.  The report finds that 12 percent of retirement earnings are lost in retirement due to “conflicted advice.”

THE PROPOSED STANDARD

The Fiduciary Standard rule proposal would hold all managers of retirement plans to a higher standard. Instead of allowing employees managing 401(k) plans to give informal investment advice, the new rule would require these employees give advice in the clients’ best interest.

“The fiduciary standard helps protect those folks who do not have good knowledge,” said Hearn.  “Client interests should be first when it comes to selecting investments. When advisers and administrators are held to the fiduciary standard, they must put client interests first. I believe it is a good thing for the consumer to have the regulation in place.”

The proposed fiduciary standard would extend the title of what a financial adviser is.

“I would think it would make advice more strict” Liburkin said.  “You would no longer advise someone for free without being under contract.”

With the new standard requiring all advice be held to higher legal standards, some argue low income and minority communities will suffer.  Instead of being able to receive more informal and free advice through other employees, people will have to pay for a financial adviser’s advice.  Though the advice will be in the best interest of the client with the new proposed rule, the retirement saver will now have to pay for this advice.

“I went to a seminar held by my company earlier in the year on 401(k) plans and the benefits of the different plans,” said Jess Halvorsen, an accountant at Calibre CPA group.  “Seminars like those can no longer take place unless I contract the 401(k) manager as my financial adviser and hire him, if the rule is passed.  I will no longer be able to get this type of advising for free.”

The new fiduciary standard proposal would also resolve the misleading nature of senior designation titles.  These titles are given to financial advisers or brokers that have earned a special license to deal with senior citizens and the management of their retirement funds.  These titles mislead clients to think they are dealing with someone that is looking out for their best interest.

A report by the CFPB finds that these titles are not indicative of an adviser’s ability to manage retirement funds, as they often do not require much training.  Often times these titles are easy to attain and can, in some instances, be earned in the course of a lunch seminar.

The fiduciary standard, would make designation titles less misleading, a solution that is backed by the AARP.  Currently, a broker holding a designation title is not bound by regulation to act in the best interest of her client.  The concern is that brokers can use these titles to their advantage and attract senior retirement savers, yet make commission off of what they sell.

“If somebody is trying to mislead people and just turn commissions for themselves for instance, if they’re commission salesmen, what they would get out of that is more people through the door,” said T. Ryan Wilson, a senior policy adviser at AARP.

This creates a principal agency problem, where one party knows more than the other, and what is in the best interest of the client is not in the best interest of the broker.

ISSUE OF ELDER ABUSE

The new fiduciary standard plays into the greater issue of elder abuse.

“We used to do more to ensure financial advisers aren’t taking advantage of our elders,” said Senator Elizabeth Warren at a senate committee meeting on elder abuse in February.  “A one percent increase in fees could cost a retiree 100,000 dollars in savings.”

The committee meeting featured testimonies of financial abuse of elders, in most cases the abuser is a relative, according to the National Center on Elder Abuse.  Because many seniors suffer from some type of mental decline, they are increasingly vulnerable to abuse or exploitation.

The new fiduciary standard rule, if passed, would help protect seniors from being taken advantage of for the sake of commission and would resolve this issue when dealing with retirement accounts, seniors’ main source of income.

Yet the scope of financial abuse is huge, affecting an estimated 7-10 percent of seniors, according to the National Center on Elder Abuse.  The fiduciary standard proposal is merely a drop in the bucket towards a solution for elder abuse.

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