Recent study on rollovers identify emerging issues

Sometime later this year (it is said that the Department of Labor is targeting July, but many think that date will slip), DOL is expected to re-propose its re-definition of ‘fiduciary’ under ERISA. The original 2010 proposal was withdrawn in 2011 after a ‘storm of criticism’ by the investment industry, plan sponsors and Congress. A key target of that proposal (and likely to be a feature of any re-proposal) was advisor conflicts of interests.

Two recent reports — one from the Center for Retirement Research at Boston College (CRR) titled “Will Regulations To Reduce IRA Fees Work?” (February 2013) and one from the Government Accountability Office (GAO) titled “401(k) Plans — Labor and IRS Could Improve the Rollover Process for Participants” (March 2013) — focus on the issue of advisor conflicts of interest, particularly in the distribution/rollover context, and the consequences for retirement savings.

Both reports make an argument for robust regulation of the distribution/rollover process and of advisor conflicts of interest both in the context of a re-proposed re-definition of ERISA fiduciary and more generally. Indeed, the CRR report suggests that a change in the definition of fiduciary will not go far enough and that “Bolder Proposals” are needed to reduce retirement investment fees. Many of the changes suggested by both CRR and GAO would mandate changes in sponsor practice.

In this article we will review the two reports’ criticisms of current policy and practice with respect to distributions and rollovers and proposals for change.

The IRA “environment” vs. the plan “environment”

Generally, 401(k) plan participants leaving employment with their current plan’s sponsor have (up to) four options: (1) leave their 401(k) money in the plan; (2) roll or move the money into a new qualified employer plan (a ‘new plan rollover’); (3) roll the money into an Individual Retirement Account (IRA); or (4) take a lump sum distribution.

CRR sees options (1) and (2) — in effect, keeping money in the 401(k) system — as clearly preferable:

Keeping money in 401(k)s has three advantages: 1) 401(k)s are covered by ERISA fiduciary standards, which require financial advisers to act solely in the participant’s interests; 2) recent DOL disclosure requirements have helped shine a spotlight on fees; and 3) 401(k)s operate in a wholesale environment, lending them potential pricing advantages in dealing with investment managers.

The GAO report is, in places, neutral on this issue, stating that “Rolling over to an IRA can be a reasonable choice for many participants …, [b]ut other options, such as staying in their current plan or rolling over into their new employers’ plans, may also be viable alternatives and could even be better options depending on an individual’s unique circumstances.” But elsewhere, like the CRR report, the GAO report implies a preference for keeping retirement assets in the ‘plan environment,’ because that environment “has lower fees, better comparative information, and ERISA plan fiduciaries required to select and monitor reasonable investment options.”

An unusual amount of 401(k) assets are rolled over to IRAs

As noted by CRR (explicitly) and GAO (implicitly) either leaving money in the ‘old plan’ or rolling it into the ‘new plan’ may be preferable to rolling it into an IRA. And, as the CRR report notes, “participants are typically passive in their interactions with their 401(k) plans.” Thus, one would think that participants would be inclined to simply leave their money in their old plan. According to GAO, however, “[r]ollovers from 401(k) plans and other employer-sponsored retirement plans [to IRAs] are so prevalent that they are the predominant source of contributions to IRAs. Approximately 95% of money contributed to traditional IRAs in 2008 was from rollovers, primarily from employer-sponsored retirement plans.”

What accounts for this “extraordinary” (as the CRR report describes it) prevalence of IRA rollovers?

Regulations and sponsor and provider practice encourage IRA rollovers

Supporting this (apparent) IRA-rollover bias are Tax Code rules and sponsor and provider practice. The GAO report describes:

Regulations that make new plan rollovers difficult, including the prohibition on accepting non-tax qualified money (as a result of which some sponsors discourage rollovers from ‘old’ plans), a complicated and hard to understand description of tax rules, and tax withholding on indirect rollovers.

Sponsor policies that make it harder for participants to leave their money ‘behind’ in their old employer’s plan, including higher or additional fees for separated employees and restrictions on the ability of separated participants to manage their assets or take withdrawals.

Sponsor policies that make new plan rollovers harder, including issuance of checks in connection with direct rollovers (rather than a direct transfer of funds), rollover waiting periods and complex verification procedures to ensure a rollover is tax-qualified.

Provider practices that make IRA rollovers ‘easier’ and that explicitly encourage them. GAO describes a variety of cases in which plan service providers make a rollover to the service provider’s IRA simpler than any other distribution option. It describes the ‘pro-IRA rollover’ message as “pervasive.” E.g.: “One plan provider told us that the marketing of IRA rollover products by service providers can be pervasive throughout plan documents, and even the summary plan descriptions might steer participants into a provider’s retail products.”

The “fiduciary” issue

A key feature of the discussion in both reports is DOL’s project to re-define ‘fiduciary’ for purposes of ERISA. The original (now withdrawn) proposal raised a host of issues. The CRR and GAO reports focus on one issue raised in the proposal: whether and to what extent interaction between an advisor, plan service provider, or call center representative “at the point of distribution” should be subject to ERISA fiduciary rules. At issue is whether that person may provide ‘advice,’ and receive compensation from a third party, with respect to the distribution. For instance, may that person recommend distribution to a particular IRA and receive 12b-1 fees from funds the IRA is invested in?

Even within this narrow focus there are a host of issues. What constitutes ‘advice’ (as opposed to mere education) in this context? May this person (the advisor, plan service provider, or call center representative) receive compensation if the conflict is disclosed? Is this person a fiduciary? When do the distributed assets cease to be ‘plan assets?’

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It’s clear that there is going to be a concerted campaign to ‘do something’ to reduce the flow of retirement assets out of qualified plans and into IRAs. Both reports include many proposals to accomplish this.

GAO proposals

Quoting GAO’s report: “To help reduce obstacles and disincentives to keeping retirement savings in the 401(k) plan environment, we recommend that [IRS and DOL] review policies that affect separating employees leaving retirement savings in an employer’s plan and, for those who choose to roll their distributions into another 401(k) plan, the process of plan-to-plan rollovers.” Specifically, GAO proposes that:

IRS and DOL review “the lack of standardization of sponsor practices related to plan-to-plan rollovers and of policies affecting participants who leave plan savings in a former employer’s plan, with the aim of … [addressing] obstacles like sponsors refusing to accept rollovers from other plans, and disincentives like plans restricting participants’ control over savings once they separate from the employer, and charging different fees for inactive participants.” This sounds a lot like a proposal to mandate that sponsors change their rollover rules.

IRS and DOL “work together to communicate to plan sponsors IRS’s guidance on the relief from tax disqualification provided for plans that accept rollovers later determined to have come from a plan that was not tax qualified.” The idea here is that the main reason sponsors are reluctant to take rollovers is a misunderstanding (and exaggeration) of the risks with respect to taking ‘non-qualified’ assets.

IRS “revise rules that allow plans and providers to send direct-rollover distribution checks to individuals rather than to the receiving entities to which the checks are written.” Again, this would involve a mandated change in sponsor practice.

DOL develop “a concise written summary explaining a participant’s four distribution options and listing key factors a participant should consider when comparing possible investments, and require sponsors to provide that summary to a participant upon separation from an employer.”

DOL finalize its “initiative to clarify the ERISA definition of fiduciary, and, in doing so, require plan service providers, when assisting participants with distribution options, to disclose any financial interests they may have in the outcome of those decisions in a clear, consistent, and prominent manner; the conditions under which they are subject to any regulatory standards (such as ERISA fiduciary standards, SEC standards, or others) and what those standards mean for the participant.”

CRR proposals

While the CRR report supports DOL’s (now withdrawn) fiduciary definition proposal, CRR believes that it would only have a “modest impact” on retirement investment fees. So, in addition to adopting that proposal, CRR recommends the following “Bolder Proposals:”

Make it easier to keep money in 401(k)s by requiring that workers switching jobs always be allowed to either keep their 401(k) assets with their old employer or transfer their assets to a new employer.

Make any rollover transaction subject to ERISA. “Such a change would mean that an adviser could recommend a rollover only when it was solely in the client’s interests …. Participants considering a rollover could also be presented with disclosure forms comparing fees in their 401(k) plan with those in their proposed IRA and showing the respective impacts on projected wealth at retirement. Finally, if a 401(k) participant does decide to go ahead with an IRA rollover, policymakers could set a default investment vehicle of a life-cycle index fund.”

Extend ERISA protections to all rollover IRAs. “The rationale is that rollover money has been accumulated in the employer plan arena, which is protected by ERISA’s fiduciary standards and fee disclosure, and that the concern for protecting these funds is not lessened by their movement into another form of account.”

Control fees by “establishing benchmarks for 401(k) fees; requiring reporting and benchmarks for IRA fees; requiring 401(k) plans to offer index funds; and eliminating high-cost, actively-managed funds.” Note that mandating that plans offer index funds was a (controversial) element of Congressman Miller’s (D-CA) fee disclosure proposal.

Obviously, these are ‘bold’ proposals and would have a significant effect on the way plan distributions are handled.

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The CRR and GAO analyses are ‘just’ reports. But it is clear that there is a concerted effort by some to focus on the issue of the ‘de-institutionalization’ of qualified plan assets. In that regard, we note that while the CRR and GAO reports focus on 401(k) plan rollovers, the issue of the ‘de-institutionalization’ of DB money, e.g., in connection with sponsor de-risking programs, is also a concern of policymakers and is one of three discussion topics of the 2013 ERISA Advisory Council.

Later this year we will see a re-proposal of the re-definition of ERISA fiduciary, which is likely to address some of the issues discussed in the reports. We may also see legislation.

We will continue to follow this issue.