The last thing that most broker-dealers that sell and service 401(k) plans want is for regulators to classify their representatives as fiduciaries.
Under the Employee Retirement Income Security Act of 1974 (ERISA), brokers who give plans or participants advice on specific investments are considered to be acting as fiduciaries. As regulators step up enforcement of these rules and new layers of regulation are added, the likelihood that a broker may become a fiduciary inadvertently is increasing sharply.
When this happens, routine practices can run afoul of rules governing fiduciaries and thus become prohibited transactions, with penalties that include disgorgement and excise taxes. Moreover, brokers' potential legal liability increases, but because they hadn't classified themselves as fiduciaries, they lack insurance coverage for this far broader exposure.
EWZ? IWM? FXI? XLE? XLF? Click here for model ETF portfolios, new for November, in Jim Lowell's Forbes ETF Advisor.
The pressure on 401(k) brokers has been building in recent months. Regulatory agencies, including the Department of Labor and the Securities and Exchange Commission, have developed formal information-sharing programs to pinpoint conflicts of interest among 401(k) service providers, including brokers.
Meanwhile, class-action suits brought by participants against brokers for purportedly giving conflicted advice have been mounting. And now, as the Obama administration institutes reforms for the financial industry, the Treasury Department is ramping additional regulations that echo the ERISA rules.
This mounting regulatory pressure is beginning to force broker-dealers to clearly distinguish their representatives' actions from any that might be construed as fiduciary. In making these distinctions, brokers will have to change the way they do business if they're to retain 401(k) client relationships.
This sea change is just beginning after years of brokers' running what compliance lawyers call "fiduciary risk." Some have argued that they weren't acting as fiduciaries because they weren't exercising discretion over clients' investments. After all, they've maintained, decisions on what to buy or sell are ultimately up to clients. But ERISA rules don't limit the assignment of fiduciary status to those who have discretion over client assets.
ERISA's test for the fiduciary role is functional. What matters isn't the label that brokers put on their services but what they actually do. When regulators decide that brokers are advising on selling or buying specific securities, they automatically classify them as fiduciaries.
Ultimately, the mounting regulatory pressure will likely have the effect of requiring that, if plans and their participants have advisors, they be separate fiduciaries; that is, free of potential for conflicts. The conflict-free posture of fiduciaries is inherent in their duty of care as set down in the Investment Advisers Act of 1940. This duty means that, as fiduciaries, registered investment advisors (RIAs) must act in the utmost good faith, never taking advantage of the high level of trust clients have in them precisely because of their fiduciary status.
To deal with all this, some broker-dealers may become RIAs or assure the provision of RIA services from existing divisions of their firms. However, many financial professionals who act as brokers to 401(k) sponsors will choose not to become RIAs. These individuals in particular will need the services of what are known as "remote RIAs," outside RIA firms that take on fiduciary duties directly for plans or participants.
Richard Lehmann's fixed-income portfolios have beaten the Dow in 7 of the past 9 years. Lock in yields of 7% to 14%. Click here to try Forbes-Lehmann Income Securities Investor to gain access to all four model portfolios now.
Remote RIAs typically contract directly with plan sponsors to explicitly take on the fiduciary role by providing investment advice--to counsel sponsors or plan participants on the advisability of buying or selling specific securities and any other assets plans may hold. Their duties include designing plans, continually monitoring investment performance, making recommendations (usually during quarterly reviews), culling out underperforming funds and suggesting replacements consistent with investment objectives.
At the participant level, remote RIAs advise each individual on appropriate allocations to fit their situations and risk tolerances. They also provide participants with pre-selected fund portfolios. Ideally, remote RIAs are available to answer participants' questions regarding their retirement-investing situations.
For plans, the cost of remote RIAs tends can run from five to 100 basis points across plan assets, depending on size. The remote participant RIA typically charges about the same rates; this expense is sometimes charged to the individual instead of across the plan.
Escalating regulatory pressure makes this transition critical for brokers. Their relationships with 401(k) clients hang in the balance, for those who don't assure the provision of RIA services run the risk of losing clients to those who do.
Scott Revare is CEO and co-founder of Smart401k, a registered investment advisor firm in Overland Park, Kansas, that provides investment advice to employees who have 401(k), 403(b) or Thrift Savings plan accounts.