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AdvisorNews - June 2016

Target Date Funds Are Not the 401(k) Solution

Ellen Chang Feb 19, 2016 5:15 PM EST

As more 401(k) plans chose target date funds as the default option, this strategy is likely to create more complacency about retirement among employees, encouraging us to be lazy, set-it-and-forget investors.

Too many people are already lackadaisical about planning for their retirement, and the advent of target date funds could create even more apathy. Target date funds were structured to help investors who did not want to manage their retirement actively. Simply put, they allow a person to choose the year he is planning to retire while having his allocation selected for him and adjusted from a large percentage of stocks to a smaller percentage as the person gets closer to his retirement target date.

Creating Less Engagement

Retirement strategies that push investors to be content about their investments are risky, said Jim Mitchell, a portfolio manager with Covestor, the online investing marketplace, and partner at The Rockledge Group, a registered investment advisor in Brooklyn, N.Y.

“I think these 'set it and forget it' strategies are dangerous for individuals, as well as for society,” he said.

Investors need to become more engaged since receiving a pension is a rarity now and 401(k)s are providing the majority of funds after people retire. Offering options where investors can remain passive in their investment decisions is only exacerbating the issue, Mitchell said.

“People need to be paying attention more frequently, not less,” he said. “These funds are pushing a hands-off approach to the entire investment process.”

Why They Are Popular

The popularity of investing in target date funds has not waned. The amount of assets rose to $763 billion by December 31, 2015, an increase of 9.8% in new funds, said Janet Yang, a director of multi-asset class research for Morningstar, the Chicago-based investment research firm.

“The reason why you see such a great growth rate in target date funds versus equities or fixed income options is because they are usually the default option within 401(k) plans,” she said. “Since there is a steady flow of assets, investor returns have done well because employees do not sell them even in times of market stress. That's good behavior to encourage, and it has worked out for investors who have stuck with them in good times and bad times.”

Vanguard, the Valley Forge, Pa.-based investment firm, emerged as the largest target date mutual fund provider in July 2014, ousting Boston-based Fidelity from its 16-year reign. Along with Baltimore, Md.-based T. Rowe Price, these three investment companies account for 71% of the industry’s target date fund assets, the report said.

The passage of the Pension Protection Act of 2006 allowed plan sponsors to choose a default retirement option if the employee does not select one, and many companies have opted for target date funds. Out of Vanguard’s 401(k) plans, 71% of companies designate an investment as the default option with 94% of companies choosing target date funds as the default, said Matt Brancato, head of defined contribution advisory services at Vanguard and a former target retirement fund product manager.

How the Fees Stack Up

The fees vary with each 401(k) plan, and larger companies pay less in fees, because they have a higher volume of assets. The combination of the expense ratio and the management fee often totals up to 1%, even among large 401(k) plans, Mitchell said.

“If I were in their business, I would offer my clients a target date fund, too,” he said. “From their point of view, they almost guarantee that they will hold the assets for 20 years and charge 1% fees.”

Vanguard, which has $221.7 billion in volume of target date funds charges an average expense ratio of 0.125%, including both 401(k)s and IRAs while Fidelity Investments, which has $171 billion in assets has an average expense ratio of 0.884%, according to Morningstar as of Jan. 31, 2016. The third largest provider of target date funds is T. Rowe Price, which manages $126.8 billion has an average expense ratio of 0.84%.

One piece of good news is that expense ratios have been falling, and Morningstar said 2014 was the sixth consecutive year of declines. From 2013 to 2014, the straight average of asset-weighted expense ratios fell to 0.78% from 0.84%.

Why Providers Like Them

Many investors were choosing money market accounts prior to the 2006 law being passed or not diversifying their portfolios enough, said Brancato.

“We saw a lot of extreme allocations of 100% in stocks or none of their money invested in them,” he said.

Five years ago the amount of extreme stock allocations declined to 22% while in 2014, it fell even further to 13%.

“Target date funds are not meant to be the perfect portfolio solution, but they are meant to be a better starting point,” Brancato said.

An investment which helps people “maintain an appropriate asset allocation is a good thing,” said Stuart Ritter, a vice president and senior financial planner with T. Rowe Price.

“These funds help people stick to their strategy and outcomes and stay on track. I am less concerned with how they got there,” he said.

Fidelity declined to comment.

As investment advisors for several 401(k) plans, the Vanguard target date funds are often used as the default investment option since they offer exposure to domestic and international bonds along with inflation protected bonds, said Jim Wright, a portfolio manager with Covestor, the online investing marketplace, and the chief investment officer of Harvest Financial Partners, a registered investment advisor in Paoli, Pa.

“We certainly think putting 100% of your contributions into the appropriate target date funds is a terrific option for many people,” he said. “It is one fund that provides exposure to U.S. and international stocks, large, mid and small companies.”

Better Investment Options

While target date funds are not “necessarily bad” for investors who do not want to choose their asset allocation,” the performance has not proven to be strong, said Edison Byzyka, vice president of investments for Hefty Wealth Partners in Auburn, Ind. The returns often lag other equity investments, the stock allocations are too conservative and the fees are “not justified,” he said.

“It has been very difficult to assess a true benchmark for the funds, allowing portfolio managers to produce significant subjective judgment with little accountability,” Byzyka said.

Sticking to the simple buy and hold approach of broad equity market indices such as the S&P 500 with “almost non-existent expense ratios” is a better option for Gen X-ers and Millennials, he said.

“The message is simple – avoid target date funds and try to educate yourself on why market volatility occurs and why it’s not a bad thing,” Byzyka said.

Many investors assume that target date funds are “managed for their benefit instead of for the benefit of the providers,” said Carl Sera, a portfolio manager on Covestor and managing principal of Sera Capital, a registered investment adviser in Annapolis, Md. Millennials and Gen X-ers could save a large amount of money from paying lower fees by simply choosing the exact same stock index funds that the target date fund uses, he said.

Even Google’s employees may not be savvy about paying for higher fees unnecessarily. Based on the data provided from Brightscope, a San Diego-based 401(k) research provider, about half of the Google workforce is in target date funds, he said. The 2040 and later funds within Google's 401(k) plan show that the allocation to stocks is about 90%.

Despite the fact that these employees could just invest in that same index fund, they are not doing so, because “they just don’t know any better and no one is pointing out the obvious,” Sera said.

Target date funds become more conservative over time by moving more assets into bonds, and while their “glide path” is created to ensure the right level of stocks and bonds, research has demonstrated that the majority of investors are “better off having a more level allocation over time and that a steady reduction in equities is not beneficial because the investor gives up too much upside,” said Jamie Hopkins, a retirement professor at the American College of Financial Services in Bryn Mawr, Pa.

“These funds are designed to be one-size fits all investment allocation strategy,” he said. “Make sure you understand how your target date fund is allocated since most do not have a large amount of international equities or real estate investments.”


Brokerage windows in 401(k) plans

By Fred Reish | February 2016

Plan committees need to ask questions, and get answers, before offering a brokerage window. Should the committee offer one at all? If it does, what is the process for selecting and monitoring the window and its provider? In this column, we look at these and other questions about brokerage windows in participant-directed plans.

Does it make sense to offer a brokerage window? Maybe. Unless there is significant participant interest in a brokerage account, there is no point in offering one. But where there is demand by investment-savvy participants and/or participants who work with investment advisers, committees may determine that brokerage windows are appropriate for their plans.

What are the fiduciary concerns?
Selecting a brokerage window provider is a fiduciary decision, and the committee needs to evaluate the brokerage costs and services. However, it is not responsible for monitoring the underlying investment decisions or the performance of the investments chosen by the participants.

What should a committee look at in deciding whether to offer a brokerage window?
In a 2012 Field Assistance Bulletin (FAB), the Department of Labor (DOL) said that fiduciaries must think about the nature and quality of services provided in the brokerage account. These considerations include: the qualifications of the provider, such as its experience and licensing; the quality of the provider, including its reputation for prompt, efficient and accurate service, especially in providing confirmations and account statements; the reasonableness of the provider’s fees; and the security of the account and stability of the provider, including whether protection against theft and loss is supplied through the Securities Investor Protection Corp. (SIPC).

Ideally, this examination would compare information from competing broker/dealers (B/Ds). But many recordkeepers offer only a single brokerage provider. In that case, a committee should still engage in a prudent process to evaluate the broker/dealer, including consideration of the issues raised in the DOL’s FAB. If the provider-offered brokerage window can’t be prudently selected, the plan should not offer that window.

If a window is offered, the committee has an ongoing obligation to monitor the brokerage provider. That includes reviewing any changes to the information previously examined and whether the provider is living up to contractual commitments. Also, a committee should consider whether there have been participant comments or complaints. And, of course, always consider costs and the quality and quantity of services.

What about selecting and monitoring advisers to assist participants who use the account?
The DOL’s 404(c) regulation makes it clear there is no duty for plans to provide investment advice to participants. However, if a committee designates an adviser should be available for participants to ask to assist them, the committee will need to prudently select and monitor the adviser. Where participants select a non-committee-designated adviser, the committee has no duty to monitor the adviser.

What does the plan have to communicate to participants?
The FAB provides guidance on this question: There is no obligation for the plan to provide disclosures about the investments inside the brokerage accounts. But the following disclosures must be made.

  • A general description of the arrangement, including: information on giving investment instructions; account balance requirements; restrictions or limitations on trading; how the arrangement differs from the plan’s default investment alternatives (DIAs); and whom to contact with questions.
  • An explanation of fees and expenses that may be charged for the account (but not for the underlying investments), including: account opening and closing fees; ongoing maintenance fees, including inactivity and/or minimum balance fees; and commissions, charges and sales loads.
  •  Quarterly statements of the dollar amount charged in the preceding quarter against the participant’s account, including a description of the services and details by the type of charges.

Make sure the brokerage provider makes complete, accurate and timely disclosures. And remember that for this purpose, “participants” includes all active participants, all eligible employees—even if not deferring—and former employees with account balances.

Brokerage accounts can be helpful to some participants. The main questions are whether the window is appropriate for the needs of the participants and whether the brokerage provider is a prudent choice.



Q&A on the DOL's Fiduciary Rule: BICE & PTEs

Posted by Duane Thompson on May 10, 2016 in Fiduciary Excellence

A few weeks ago, we presented webinars covering the DOL’s recently released fiduciary rule. A recording of that webinar is now available. During that webinar we received over 80 questions. We were not able to answer all of those during the one hour session, but we have compiled and answered them here. The questions are categorized, and we will do separate blog posts to address all of the questions within a given category. These questions are not comprehensive of the rule, they only address the questions that were submitted. Think of them as an addendum to the webinar. For a more comprehensive view of the rule, we recommend you view the recording, as well as download our Executive Summary and Client Memo documents.

In our sixth Q&A blog post from the webinar, we are answering questions about BICE and other Prohibited Transaction Exemptions. Please note: the views expressed herein are strictly informational, do not represent an official position of fi360 on regulatory or legislative matters, and should not be relied upon as legal, compliance or investment advice.                                                             

Q: Can you summarize the purpose of the Seller's Exemption?

A: The purpose is to exempt from the fiduciary definition arms-length transactions in which the investment advice is incidental to the sale and the plan fiduciary has a degree of financial sophistication.  The carve-out is available to transactions with plans sponsored by banks, insurance companies, BDs and RIAs.  It is also available for incidental advice to plans with more than $50 million in assets.  Among other things, the seller is also are required to disclaim fiduciary status and disclose that it is not providing impartial advice.

Q: If a new person is enrolled in an existing SIMPLE IRA or 403b after the rule is implemented, is BICE required for the new person that comes into the plan?

A: Partial compliance with BICE is required after Apr. 20, 2017, and full compliance after Jan. 1, 2018 if the advisor to the participant (not the plan) takes variable compensation for his advice.  However, certain 403(b) plans are not subject to the Rule.  Check with your compliance professional or attorney for details.

Q: With respect to the contract requirements for IRAs and non-ERISA plans under BICE, what content requirements are there?  Or, are we creating the content of the contract as we go along?

A: The contract requirements generally include written acknowledgement of fiduciary status, agreeing to adhere to the Impartial Conduct Standards, and affirming that statements on compensation and other conflicts will not be misleading.  Other disclosures such as how the client pays for services can be included in the agreement or a separate disclosure.   The Level Fee Exemption under BICE does not require a contract.  You should discuss these and other specific requirements with your attorney. 

Q: Just to clarify the carve-out for Investment Education using an asset allocation model.  If specific funds are being used within the core menu of investment options available, will this be deemed education?

A: Specific use of funds will be deemed “education” and not “advice” if certain conditions are followed.  These include, among others, oversight by a plan fiduciary independent from the person who developed or markets the investment option and asset allocation model.  In addition, all other investment options with similar risk and returns characteristics must be identified.

Q: What does BICE mean?

A: Best Interest Contract Exemption.  BICE (sometimes called the BIC Exemption), provides a safe harbor for brokers receiving commissions or third-party compensation in providing investment advice.  However, they must meet fiduciary conditions set out by the DOL.

Q: What type of swap are you referring?

A: The DOL rule provides a carve-out from the fiduciary definition for advice provided to a plan by a person who is a swap dealer, security-based swap dealer, or a swap clearing firm who meets certain conditions.

Q: What are your comments on the exemption for state-sponsored retirement accounts for small business employees such as California's Safe Accounts?

A: The DOL is working on a rule that would exempt the States and employers from ERISA’s fiduciary requirements.

Q: Which prohibited transactions occur most often?

A: In recent years, class-action suits under ERISA have alleged self-dealing by plan fiduciaries through revenue-sharing arrangements with service providers that are used to offset the cost of other corporate services provided by the TPA or record keeper.

Q: For the sellers carve-out, is providing a disclaimer in marketing materials and/or account opening documents that the firm is not a fiduciary sufficient?

A: No.  The seller must “fairly inform” the plan sponsor that the seller is not undertaking to provide impartial advice or doing so in a fiduciary capacity.  It doesn’t sound like burying something in a brochure would satisfy the disclosure requirement.  There are several other conditions that apply.

Q: Under BICE, what is the means through which a broker is to communicate to the DOL when they are operating under BICE on a particular relationship?

A: The broker has no obligation to notify the DOL.  However, her firm must notify the DOL the first time it intends to rely on BICE.  Ongoing notification of each transaction is not required.

Q: How does BICE dovetail - or not - with the eligible investment advice provisions of the Pension Protection Act of 2006?

A: BICE dovetails with the PPA safe harbor only in the context that robo-advisors must use the PPA safe harbor and meet those conditions if the robo firm or an affiliate accepts variable compensation in connection with the advice arrangement.  The Level-Fee Exemption is available to level-fee robos.


DOL Fiduciary Rule’s Conflict-of-Interest Split Personality

May 10 01:152016

A little more than a year ago, the White House announced its passionate support for a new “Conflict-of-Interest” rule that would eliminate specific self-dealing fees that academic studies have shown can cost retirement savers trillions of dollars. The DOL subsequently repurposed its proposal originally called the “Fiduciary Rule” as a brand new “Conflict-of-Interest” Rule that attempted to stay true to the White House announcement. But in the zero sum reality of the business world, those trillions of dollars of savings for retirement savers would come at a cost to the brokerage industry. This wasn’t news. Nor were we surprised by the response.

Unlike all those individual mom and pop retirement savers, the brokerage industry had the capacity to assemble a formidable lobby campaign. And they did. As a result, we saw a new “improved” final version of the DOL’s “Conflict-of-Interest” (nee “Fiduciary”) Rule. Unlike the stark simplicity of the original proposal, the finished form presented what might be characterized as a Yin and Yang regarding those supposedly evil conflicts-of-interest. They were at once both vilified and honored. This ambiguity has created a split personality that ERISA attorneys and advisers alike can easily point out.

How Does the New DOL Rule Prevent Conflicts-of-Interest?
It’s commonly understood that the new Rule places a client’s “best interests” above all else, leading many to believe this will have the effect of averting conflicts-of-interest. Ben Offit, Partner and Financial Planner at Clear Path Advisory in Baltimore, Maryland, says, “The DOL Rule prevents conflicts-of-interest because it is forcing advisors to adhere to the highest level of service and morality for their clients by law. If advisors don’t work within these laws, there are serious ramifications for their career and potential civil and criminal penalties. Because of this, the envelope will be pushed in a better direction to filter out advisors who are doing things the right way and will also shine a bright light on those not practicing the right way.”

It’s clear the DOL is attempting to reframe the broker-advisor service model from one based on “suitability” to that of a traditional investment adviser model of “best interests.” ‘The new DOL Rule prevents conflicts-of-interest by imposing a fiduciary standard upon all financial services professionals,” says Ryan Brown, partner of CR Myers & Associates in Southfield, Michigan. “Being a fiduciary in its most basic sense means that the fiduciary must put the client’s interests above his own. Physicians and lawyers are common fiduciaries. Up until the DOL Rule, most financial transactions only had to be deemed ‘suitable’ (i.e., appropriate given the totality of the client’s circumstances, objectives, and financial condition). All financial services professionals must make sure that the advice and recommendations given are for the client’s best interests – not theirs.”

The new Rule does contain specific language that increases the hurdles for service providers involved in self-dealing conflict-of-interest fees. Unlike what many people thought (and some continue to think), the Rule does not outlaw this conflict-of-interest fees. “The new rule doesn’t uniformly prevent conflicts-of-interest, but it certainly deters them,” says Jason Grantz, Institutional Retirement Consultant at Unified Trust Company in Lexington, Kentucky. “The primary deterrents will be increased difficulty in compliance and significant penalties for non-compliance. The new rules codify that conflicts-of-interest are prohibited transactions subject to penalty unless mitigated by one of the prescribed prohibited transaction exemptions – this will certainly act as a deterrent.”

The DOL is specifically targeting the abuse of proprietary products. While it doesn’t outright eliminate these conflicts-of-interest, the new Rule requires broader and more rigorous disclosures should these types of self-dealing fees continue. Hugh D. Berkson, a Principal at McCarthy, Lebit, Crystal & Liffman Co., L.P.A. in Cleveland, Ohio, says, “The DOL Rule doesn’t actually prevent conflicts-of-interest. What it does is ensure that, when there is a conflict-of-interest, the conflict is disclosed and any advice given be in the client’s best interest. A broker who can demonstrate that a proprietary product is in a client’s best interest will be required to disclose any compensation arrangement that could be influencing his recommendation.”

No matter how demanding the regulation, there will always be those who attempt to skirt the rules. “No rule will completely prevent rogue advisors from engaging in bad behavior and hoping they will never get caught,” says Charles Field, Partner and Co-Chair of the Financial Services Litigation Practice at Sanford Heisler & Kimpel LLP in San Diego, California. “But for the rest, the rule seeks to deter conflicts-of-interest by now imposing liability against those financial advisers who put their interests ahead of the interests of the retirement plan.”

In the end, the intent of the DOL’s “Conflict-of-Interest” Rule is to dissuade the use of self-dealing fees by increasing the service provider’s fiduciary liability when relying on them. “Simply put, it enforces penalty if practiced and/or enables litigious action,” says Michael Zimmer, Owner of Fluent Technologies in Boston, Massachusetts.

How Does the New DOL Rule Allow Conflicts-of-Interest to Continue?
Although the new Rule clearly intends to discourage and reduce the use of self-dealing conflict-of-interest fees, the DOL did make some significant concessions to industry lobbyists. “Under certain circumstances, the rule allows the financial adviser to charge an asset based fee and a transaction based fee,” says Field.

In these “certain circumstances,” the DOL now requires some form of written disclosure in order to use or continue to use some proprietary products. Zimmer says the new Rule “allows a contractual agreement to advise of products outside of those in the clients ‘best interest’.”

It may surprise many to learn of the Rule’s flexibility when it comes to permitting the use of self-dealing transactions. “The DOL Rule still allows some conflicts-of-interest continue but only in a narrow sense,” says Brown. “For example, captive financial services professionals would technically have a conflict only being able to recommend proprietary products. To give an analogy, Cadillac car salesmen can only sell Cadillac just like Fidelity or Merrill Lynch professionals can only sell what their respective companies allow them to sell. The DOL recognized this and therefore allows captive agents to sell captive financial products. Disclosure to the client is absolutely critical. As long as a financial professional discloses the possible conflict and the client knows it, the DOL won’t be able to come down with an axe on them.”

In general, different types of situations will demand their own form of disclosure in order to mitigate the service provider’s fiduciary liability. “There are a couple of scenarios here,” says Grantz. “The first scenario has to do with existing financial arrangements that, unless changed, would be a conflict-of-interest as defined within the new rules. However, these arrangements will be allowed to continue without penalty with a simple negative election notice to clients, meaning no action is required by the clients. This might cause some clients to question their existing arrangements, but many will do nothing and the conflict-of-interest will continue. The second scenario is through several prohibited transaction exemptions. These exemptions are essentially in place to allow a conflict-of-interest to occur, mainly by following certain procedures to ensure that the client is aware of the conflict and OK with the arrangement anyway. We expect the Best Interest Contract Exemption (BICE) will be the exception used most within the industry.”

Some remain concerned that the Rule will encourage the use of higher fee alternatives. Offit says, “The DOL Rules allows conflicts-of-interest to continue because by forcing advisors to essentially use a level compensation model, they will not be bringing to the table as often commission based options which ultimately can be cheaper and in a better interest of the client. The advisor will be put in a position to always use fee-based investment models, which may not always be in the client’s best interest.”

Offit’s example may be one way to justify continuing the use of self-dealing fee models. “Again, the DOL Rule doesn’t prevent conflicts of interest,” says Berkson. “Accordingly, proprietary products will still exist and will still be sold. It is conceivable that a proprietary product’s specific benefits are worth the cost for a particular investor. Although, if a broker wants to sell the product and comply with the DOL Rule, the sale must demonstrably be in the client’s best interest and the client must have been advised of the compensation to be paid to the broker and his firm if the sale goes though.”

For individual retirement savers and plan sponsors alike, the complexity of the Rule might make it more difficult to determine if and when they are being presented with optimal solutions. will explore this issue from their perspectives in future articles.