We all know that our government and its agencies are very good at reacting to a real or perceived crisis with new laws and regulations designed to reduce the chances of another similar event occurring. The most recent example of this concerns the cost and availability of health care. The solution designed and implemented into law, affectionately known as Obamacare, was well intended. However, we all know that it has major problems that will need correcting.
The financial services industry has had many crises over the years. And just as with Obamacare, our elected leaders and their bureaucrats took steps to try to fix the problems. When new laws and regulations are enacted, affected organizations are forced to make major changes in operations. These changes can make ongoing business stressful while compliance and marketing departments scramble to catch up. The Great Depression brought us the Securities and Exchange Commission, the Investment Advisors Act, Glass Steagall, and the FDIC. In most cases the laws and regulations were modified over the years, or as in Glass Steagall, eliminated, to meet the reality of societal changes.
We are currently in the middle of a modification to a four decade old law, the Employee Retirement Income Security Act of 1974 (ERISA). This act was the result of a crisis taking place in the funding, administration, and investing of pension plan assets. It forced public corporations and unions who offered pensions to their employees to meet the fiduciary standard of care in all aspects of handling and investing funds for the beneficiaries of their plans. It required a minimum funding level, a minimum level of insurance coverage based on the value of the plan assets, and, like the FDIC, a member funded insurance program, the Pension Benefit Guarantee Corporation (PBGC). While the Act also established Individual Retirement Accounts (IRAs), unlike corporate and union plans, there was little oversight specified regarding the management and care of IRA assets. In 1978, the Internal Revenue Service made 401(k) plans possible, and as defined contribution plans, they were also subject to ERISA regulations, which gives a level of comfort for plan participants.
Laws created decades ago can often either lose effectiveness or, as in the case of ERISA, change the very nature of what they were established to correct. At the time of the ERISA enactment, the average person’s plan for retirement was based on a pension check and social security. The individual worker did not have to rely upon personal savings to supplement social security. Corporations realized they could eliminate the cost and liability of meeting the defined benefit plan rules of ERISA, as well as the cash flow needed to fund these plans, if they switched their participants to 401(k)s. In essence this passes all of the retirement risk from the corporation onto the individual worker. As we know, when individuals are given a choice to spend today or to defer spending for thirty years, many if not most individuals will just not save. The result has been a great crisis in retirement readiness for the majority of American citizens.
Here are a few facts as stated by the Economic Policy Institute:
The EPI has stated, “The large gap between mean retirement savings ($95,776) and median retirement savings ($5,000) indicates inequality – that the large account balances of families with the most savings are driving up the average for all families.”
The National Institute on Retirement Security estimates that the short-fall in current dollars needed to ensure all citizens are retirement ready is between $6.8 and $14.0 Trillion.
The Department of Labor (DOL), the agency that has the primary responsibility for interpretation and enforcement of ERISA, has recognized the retirement readiness problem and the change from employer funded to self-funded retirement savings plans, and has decided to act in hopes of improving the odds that our retirement will be funded.
The rule in written form is hundreds of pages long, so I will take the liberty to give you a quick but important overview:
I am somewhat disappointed in the DOL’s reasoning for the rule. It seems they believe the main reason that people are not ready for retirement is because of failings of the distribution network of financial advisors and their firms. They do not address that perhaps individuals have failed to save enough, or that the ERISA rules covering defined benefit plans (traditional pension plans) have become so costly to providers that they have had to close plans in order to continue as profitable businesses.
The following paragraphs are directly from the rule:
As noted above, changes in the financial marketplace have further enlarged the gap between the 1975 regulation’s effect and the congressional intent as reflected in the statutory definition. With this transformation, plan participants, beneficiaries, and IRA owners have become major consumers of investment advice that is paid for directly or indirectly. Increasingly, important investment decisions have been left to inexpert plan participants and IRA owners who depend upon the financial expertise of their advisers, rather than professional money managers who have the technical expertise to manage investments independently. In today’s marketplace, many of the consultants and advisers who provide investment-related advice and recommendations receive compensation from the financial institutions whose investment products they recommend. This gives the consultants and advisers a strong reason, conscious or unconscious, to favor investments that provide them greater compensation rather than those that may be most appropriate for the participants. Unless they are fiduciaries, however, these consultants and advisers are free under ERISA and the Code, not only to receive such conflicted compensation, but also to act on the conflicts of interest to the detriment of their customers. In addition, plans, participants, beneficiaries, and IRA owners now have a much greater variety of investments to choose from, creating a greater need for expert advice. Consolidation of the financial services industry and innovations in compensation arrangements have multiplied the opportunities for self-dealing and reduced the transparency of fees.
Unfortunately, the price of meeting the new rules is being paid for by both the thousands of qualified individual advisers who have been doing the best they can to place their clients’ interest first, and by those few bad apples, described above, who are selling products with the maximum payoff to themselves, taking advantage of the people to whom they sell products.
So far we have seen very few traditional brokerage firms announce the steps they are taking in order to meet the new standards from these rules. Two major brokerage firms, Merrill Lynch and Edward Jones, along with one large insurance company, State Farm, have acted. Here, briefly is what they have announced:
Merrill Lynch will no longer offer new, advised commission-based IRAs. Spokeswomen Susan McCabe stated the following (in Fiduciary Focus, by Greg Lacurci):
‘We have determined that for most of our Merrill Lynch clients, the best way for us to deliver retirement-related investment advice that meets the fiduciary standard is through our Investment Advisory Program.’
Edward Jones has approached the rule somewhat differently. As stated by Jim Weddle, Managing Partner (in The Wall Street Journal, Michael Wursthorn):
…the St. Louis-based brokerage firm will instead offer commission-based IRAs to its four million clients in retirement accounts, using the Labor Department’s so-called best-interest contract, an agreement that requires the firm to act in the investor’s best interest and includes information about the firm’s conflicts of interest.
State Farm has taken a direct approach and has virtually removed their agents from servicing retirement accounts, stating that “Beginning in 2017, State Farm will offer mutual funds, variable products and tax-qualified bank deposit products through a self-directed customer call center. State Farm agents can continue to serve customers for all other insurance and financial services needs.”
These announcements are just the beginning, as all brokerage firms and insurance companies will need to make changes to commission based retirement accounts. As you can see from the few responses we have, the firms themselves seem to admit that their brokers, financial advisers, and agents do not have the technical expertise to manage investments independently and meet all other requirements of fiduciary advisers. Because of this they are turning the process over to a centralized self-directed call center, a third-party qualified money manager, or entering into a separate best-interest contract in which their clients will effectively allow them to charge a commission when selling them a product.
As with every major legislation, it will take years to see if the results are beneficial to current and future retirees. It will be interesting to see how the rest of the industry adapts to the new rules.
Until next time,
Kendall J. Anderson, CFA
Kendall J. Anderson, CFA, Founder
Justin T. Anderson, President