Obama’s proposed IRA regulations could help retirement savers

New rules from the White House could soon impose fiduciary duty on financial advisors to stop rogue investment brokers from bilking their clients.

In late February, President Obama proposed new rules for investment brokers who handle retirement funds or offer financial advice. The rules are touted as tougher regulations on dishonest brokers that will protect people who invest in IRA retirement savings accounts. The new White House-initiated rules could mean more money in the pockets of savers, and less pilfering by the hands of dishonest brokers.

If approved, the rules would block many of the often-unseen ways that brokers can chip away at retirement accounts, such as through hidden fees, higher returns for the broker, or investing in funds that possess innate conflicts of interest between the broker and the seller, which the White House has said costs retirement savers millions, even billions, each year.

In a report released by the Council of Economic Advisors, investors who receive conflicted advice from their broker earn roughly one percentage point lower annually than investors with advisors who act in a fiduciary capacity.

“Financial advisers absolutely deserve fair compensation,” Obama said in recent remarks to the AARP, the nation’s biggest lobby for retirees, which supports the proposed rules. “But they shouldn’t be able to take advantage of their clients.”

Investment brokers buy and sell financial products on behalf of their clients, and often receive a commission for their work. Under current regulations, brokers are allowed to recommend which products their clients buy or sell, so long as they are “suitable” investments based on the client’s existing financial portfolio, age and risk tolerance. Some say that this standard for what is suitable and what is not, however, leaves the door wide open for abuses at the expense of retirement savers.

Although a broker today is forbidden from pitching penny stocks or real estate investment trusts to an 85-year-old woman living on a pension, that doesn’t mean all brokers have to divulge conflicts of interest or reveal information about any hidden fees they receive for the sale. Brokers can nudge clients toward investing in a mutual fund that pays the broker a higher commission without telling the client, for example.

The proposed rules would require brokers handling retirement accounts to act in a fiduciary capacity, meaning they must put their clients’ interests ahead of factors such as their own compensation or company profits when they recommend or sell stocks, bonds, annuities and other investments. The proposal would make them fiduciaries for their clients, so by law they would be considered trustees for their clients and obligated to disclose potential conflicts, fees they receive, or if they, or their firm, receive money from a mutual fund company to promote a product.

According to Bloomberg, the president proposed the rules because current regulations on brokers are decades old and were devised in the era when most Americans could count on a traditional pension from employers. That’s not the case today, and retirement savers increasingly use private retirement accounts, such as IRAs, either as their primary nest egg or to supplement employer-sponsored plans.

While brokers are helpful to savers navigating the confusing options available to them through self-directed retirement accounts, such as IRAs, others are skimming significant sums annually from small investors, Obama said.

To back up their claims, the White House released a 30-page report from its Council of Economic Advisers noting that an estimated $1.7 trillion of individual retirement account assets are invested in products that pay fees or commissions that pose conflicts of interest.

The new rules could change how Americans receive investment advice. The Securities Industry and Financial Markets Association, which is lobbying against the regulations, is concerned that the rules would hurt investors, because brokers would be more limited in the investment options they can propose. They warn that mid- and low-income employees with smaller retirement balances may be especially harmed because the added costs from the regulations will probably prompt brokers to drop client accounts with less than $50,000 of assets, leaving those investors to manage their own savings.

Spokespersons from the White House have said that the new regulations will include specific provisions to assuage those fears. The White House also said the new higher standards would not apply to advisors providing “general education” about employer-sponsored retirement plans and IRAs.

The proposed rules could still be months away from implementation. After an internal review by the White House budget office, the rules will likely be put out for public comment for several months. President Obama can put the rules in place without congressional approval.

Supreme Court hears a
case that may have broad implications for 401(k) savers

On Feb. 24, the nation’s highest court began to hear
arguments in an initial class-action lawsuit, Tibble, et al v. Edison
International, regarding higher-than-necessary investment fees paid by 401(k)
plan participants. This lawsuit is the first of many class-action 401(k)-related
lawsuits of its kind to be heard by the U.S. Supreme Court.

According to the national Employee Retirement Income
Security Act (ERISA), companies sponsoring 401(k) plans must act in a fiduciary
capacity – that is, in the best interest of their employees participating in
the retirement savings plan. According to the common law of trusts, which helps
inform ERISA, a fiduciary is “is duty-bound ‘to make such investments and only
such investments as a prudent [person] would make of his own property having in
view the preservation of the [plan] and the amount and regularity of the income
to be derived.’”

Edison employees claimed that the company breached this
fiduciary duty by failing to monitor excessive fees, favoring six retail-class
mutual fund options with high administrative fees when comparable institutional-class
offerings were available for lower fees.

As reported in numerous studies, 401(k) investment fees that
are levied within a retirement plan can eat away a substantial amount of one’s
savings, resulting in the difference of up to tens of thousands of dollars in
one’s nest egg.

“These issues
have been off in a dark closet for 40 years without scrutiny of any significant
amount,” said the petitioners’ lawyer, Jerome Schlichter,
who has filed 13 similar lawsuits over the past eight years. “Whenever you have
a situation like that, some people are going to act in their self-interest.”

The petitioners, including past and present employees of
Edison International, allege that their retirement plans had been managed
“imprudently” and in a “self-interested fashion” by their plan sponsor, and
they have the backing of organizations such as the AARP, the Pension Rights
Center and U.S. Solicitor General in their claim.

There has been one technical flaw in the petitioners’ claims
that has set them back in lower courts, however. According to ERISA’s statute
of limitations, plan participants can only sue for funds that have been in the
plan for six or fewer years, and three of the six investment options in
question have been in the plan since 1999 – eight years before the lawsuit was
initially filed in 2007.

Petitioners argued that regardless of the amount of time the
funds have been in the plan, it remains the plan sponsors’ responsibility to
monitor the investment options and leverage their purchasing power to get the
best 401(k) deal for their employees.

The district court issued summary judgment with Edison,
agreeing that the Act’s limitations period and safe harbor provisions are, in
fact, hindrances to the petitioners’ claim. According to the U.S. District
Court for the Central District of California, ERISA’s limitations period barred
recovery for claims arising out of investments that were included in the plan
more than six years before beneficiaries had initiated the lawsuit.

The lower court did agree, however, that Edison had been
imprudent because they failed to investigate institutional-class alternatives
to the eligible high-fee mutual funds that were purchased within the past six
years, and, for that, the court awarded damages of $370,000. United States
District Court of Appeals for the Ninth Circuit affirmed the district court’s
decision.

“We have little difficulty agreeing with the district court
that Edison did not exercise the ‘care, skill, prudence, and diligence under
the circumstances’ that ERISA demands in the selection of these retail mutual
funds,” said Judge O’Scannlain in the appeals court’s opinion.

However, O’Scannlain also stated that “under ERISA’s
six-year statute of limitations, the district court correctly measured the
timeliness of claims alleging imprudence in plan design from when the decision
to include those investments in the plan was initially made. The panel held
that the beneficiaries did not have actual knowledge of conduct concerning
retail-class mutual funds, and so the three-year statute of limitations set
forth in ERISA § 413(2) did not apply.”

The Supreme Court appeal hinges on a technical statute of
limitations issue – whether or not the three funds purchased in 1999 are
applicable recoverable claims – however, the high court’s decision will likely
have broad implications that further define the scope of duty of prudence among
401(k) fiduciaries, as well as lead to more similar lawsuits surfacing in the future.

Average 401(k)
savings reach record highs, consistent savers fare best

Skyrocketing stock market activity coupled with greater
contributions from employees last year has led to a record high of $91,300 in
average 401(k) savings balances in the fourth quarter of 2014, according to a recent
Fidelity study.

With the S&P 500 surging more than 10% last year and 2014
experiencing the third consecutive year of double-digit growth, workers are
seeing greater gains in their 401(k) plans than usual. The study has shown that
employees are also stashing away a greater amount into their 401(k) savings,
contributing an average 8.1% of their salaries last year – 12% including
employer matches – which is the highest savings percentage recorded in Fidelity’s
studies.

What are the causes
of the 401(k) savings increase?

Today, more and more employers are automatically enrolling
workers into 401(k) plans with contribution rates of 5% and higher, which may
account for some of the greater amount of savings last year. Also, with waning
confidence in social security, there is a heightened awareness about the
importance of putting money into a 401(k) plan, which may be one’s only
retirement savings vehicle.

While employee contributions are a significant source to be
credited for these savings, Fidelity attributes soaring stock market
performance for approximately 60% of these savings gains last year. Although
stock market gains certainly helped boost 401(k) savings last year, Fidelity
experts warned investors that they cannot always count on the ebbs and flows of
the stock market entirely to build up their nest egg and that a steady
contribution strategy must play a role.

Lower unemployment rates and record-setting stock market
performance may have made it a good year for retirement savers, but Jim
MacDonald, Fidelity’s president of Workplace Investing, urged savers to take a
long-term view of their retirement savings, not react to short-term market
swings.

“The typical American worker will see markets go up and down
many times during their career, so commitment to a long-term savings and
investing strategy will put individuals in the best position to meet their
retirement goals,” he said.

How are Baby Boomers
faring?

Among Baby Boomers, the average 401(k) savings balance
amounted to approximately $151,200 in the fourth quarter of 2014, an increase
of 6% from last year and a 67% increase since the darkest hours of the Great
Recession in 2009.

According to Fidelity spokesman Mike Shamrell, there are
positive trends among the Baby Boomer generation — namely how engaged they have
gotten in their savings as they near retirement.  According to the study, there is a 15%
increase in people reaching out for guidance for their retirement planning,
which indicates that savers are serious about reaching their financial goals in
retirement.

“While $91,300 is an all-time high, no one feels that is
enough to retire on,” he said. “We’re headed in the right direction, but we
still have work to do.”

For consistent savers who have held 401(k) plans for 10
years or more, their savings amounted to an average balance of $248,000,
proving that a steady long-term strategy works best to reach one’s retirement
goals.

Are these savings
enough for retirement?

While 401(k)s are just one type of savings vehicle used to
build up their retirement savings, 401(k)s have become – or at least been
considered as — the sole source of retirement income for some. While these
average 401(k) balances alone are insufficient to enjoy a comfortable
retirement, the greater the percentage of one’s paycheck that is consistently put
toward retirement savings, the better.

Generally, financial advisors recommend saving 10% to 15% of
one’s salary in order to save a sufficient sum to enjoy a comfortable
retirement. According to another recent Fidelity study, IRA savings also
increased last year, averaging $92,200 in 2014.

“It’s always great to see the behavioral indicators pointing
upwards whether it be the average balance of average contribution rate and
average savings rate,” Shamrell said. “Whenever that’s the case, it’s a good
sign and shows a lot of people are starting to understand and taking the right
steps to save for their retirement.”

While 401(k) and IRA savings have reached record highs, much
of that number is as a result of record-setting bull runs in the stock market.
Keep in mind, however, that while you cannot control stock-market returns and
economic volatility, you can control many other factors including your
contribution amount and schedule, your portfolio diversification, risk
exposure, investment fees, and execution.

Whether you are nearing retirement or just beginning to
accumulate savings in an IRA or 401(k), it is important to take a disciplined,
proactive approach to retirement saving. While market swings can impact your
401(k) in the immediate-term, a consistent, long-term savings strategy mapped
out with a financial professional is the best way to withstand the ebbs and
flows in the economy and ultimately achieve a comfortable retirement. 

I
sometimes come across articles that I feel investors would enjoy, and
last week one of them caught my attention in particular. The author is Jim
Parker, vice president in the Communications group in Sydney, Australia of
Dimensional Fund Advisors, and he talks about the Art of Letting Go. 

By Jim Parker (with permission) 

In
many areas of life, intense activity and constant monitoring of results
represent the path to success. In investment, that approach gets turned on its
head.

The
Chinese philosophy of Taoism has a word for it: “wuwei.” It literally means
“non-doing.” In other words, the busier we are with our long-term investments
and the more we tinker, the less likely we are to get good results.

That
doesn’t mean, by the way, that we should do nothing whatsoever. But it does
mean that the culture of “busyness” and chasing returns promoted by much of the
financial services industry and media can work against our interests.

Investment
is one area where constant activity and a sense of control are not well
correlated. Look at the person who is forever monitoring his portfolio, who
fitfully watches business TV, or who sits up at night looking for stock tips on
social media.

In
Taoism, by contrast, the student is taught to let go of factors over which he
has no control and instead go with the flow. When you plant a tree, you choose
a sunny spot with good soil and water. Apart from regular pruning, you leave
the tree to grow.

But
it’s not just Chinese philosophy that cautions us against busyness. Financial
science and experience show that our investment efforts are best directed
toward areas where we can make a difference and away from things we can’t
control.

So
we can’t control movements in the market. We can’t control news. We have no say
over the headlines that threaten to distract us.

But
each of us can control how much risk we take. We can diversify those risks
across different assets, companies, sectors, and countries. We do have a say in
the fees we pay. We can influence transaction costs. And we can exercise
discipline when our emotional impulses threaten to blow us off-course.

These
principles are so hard for people to absorb because the perception of
investment promoted through financial media is geared around the short-term, the
recent past, the ephemeral, the narrowly focused and the quick fix.

We
are told that if we put in more effort on the external factors, that if we pay
closer attention to the day-to-day noise, we will get better results.

What’s
more, we are programmed to focus on idiosyncratic risks—like glamor
stocks—instead of systematic risks, such as the degree to which our portfolios
are tilted toward the broad dimensions of risk and return.

Ultimately,
we are pushed toward fads that the financial marketing industry decides are
sellable, which require us to constantly tinker with our portfolios.

You
see, much of the media and financial services industry wants us to be busy
about the wrong things. The emphasis is often on the excitement induced by
constant activity and chasing past returns, rather than on the desired end
result.

The
consequence of all this busyness, lack of diversification, poor timing
decisions, and narrow focus is that most individual investors earn poor
long-term returns. In fact, they tend to not even earn the returns available to
them from a simple index.

This
is borne out each year in the analysis of investor behavior by research group
Dalbar. In 20 years, up to 2012, for instance, Dalbar found the average US
mutual fund investor underperformed the S&P 500 by nearly 4 percentage
points a year.¹

This
documented difference between simple index returns and what investors receive
is often due to individual behavior—in being insufficiently diversified, in
chasing returns, in making bad timing decisions, and in trying to “beat” the
market.

Recently,
one of Australia’s most frequently quoted brokers broke ranks from the industry
and gave the game away on this “busy” investing. In his final note to clients
before retiring to consultancy work, Morgan Stanley strategist Gerard Minack
said he had found over the years that investors were often their worst enemies.²

“The
biggest problem appears to be that—despite all the disclaimers—retail flows
assume that past performance is a good guide to future outcomes,” Minack said.

“Consequently,
money tends to flow to investments that have done well, rather than investments
that will do well. The net result is that the actual returns to investors fall
well short not just of benchmark returns, but the returns generated by
professional investors. And that keeps people like me employed.”

It’s
a frank admission and one that reinforces the ancient Chinese wisdom: “By
letting it go, it all gets done. The world is won by those who let it go. But
when you try and try, the world is beyond the winning.”

1.
“Quantitative Analysis of Investor Behavior,” Dalbar, 2013.

2.
Gerard Minack, “Downunder Daily,” Morgan Stanley, May 16, 2013.