Why Plans Are Changing

Among all segments of financial services, mutual funds have been the biggest beneficiaries of the participant-directed wave. According to the Investment Company Institute, mutual funds hold about 50% of all 401(k) assets, up from just 8% in 1989. Mutual funds "turnkey plans" – which bundle a menu of fund choices with prototype plan designs and administrative/recordkeeping services – have served small and medium-size plans well, while compensating financial professionals with front-end share loads or

12b-1 trails. However, today's typical mutual fund turnkey plan is not aligned with trends of the future, for the following reasons:

• Investment choices – Many turnkey plans now offer menus of up to 30 mutual funds, but participants want more choice. Many participants are watching nightly TV shows like CNBC's Mad Money or Fast Money and following individual stocks, bonds and ETFs that they want to hold in their retirement plans. Most mutual fund turnkey plans still offer limited choices for investing outside the U.S., in foreign currencies, real estate, sectors and industries, or hard assets and commodities. There is a growing belief that large institutional investors are benefiting from "alternative strategies" designed to hedge risks. Although several types of ETFs offer hedging applications, they are available to few investors in participant-directed plans.
• Costs – Turnkey mutual fund plans tends to load similar costs burdens on all participants in a given plan, regardless of personal cost preferences, risk tolerance or investment strategies. Effectively, these plans create a "cost of admission" that all participants must pay. Over the past 20 years, as U.S. stocks have earned long-term returns averaging more than 10% per year, participants did not object to "all-in" plan costs averaging 1.5% to 2.0% per year. However, if a gradually maturing and slowing U.S. economy generates lower stock market returns in the future, plan costs will become more critical. For an average U.S. participant, a cost differential of just 50 basis points annually can mean up to $50,000 more money for retirement after 30 years of compounding.
• Cost Disclosure – Most participants have never understood the "real deal" in turnkey plans: The mutual fund company subsidizes plan design, administration, record-keeping and distribution services through "revenue-sharing arrangements" in return for the right to capture plan assets and retail-priced management fees. Although many participant-directed plans have enough buying clout to qualify for "institutional pricing," most have not received the lower-priced shares, and participant accounts have suffered. With the help of class action lawsuits and the attention of the Department of Labor and U.S. Rep. George Miller (D-California), Chairman of the House Education and Labor Committee, participants are gaining the power to demand clearly disclosed costs and institutionally-priced asset management.
• Pension Portability and IRA Integration – In today's mobile workforce, most participants have the option of rolling over vested plan balances to an IRA when they leave a job. In self-directed IRAs, investors can choose their own investments, control their own costs, and hire their own personal advisors. In a popular type of employer-sponsored plan for small business, a SIMPLE, participants can move money from workplace plans to personal IRAs without penalty after two years. In many 401(k)s, workers are eligible to roll over in-service distributions to IRAs after attaining a specified age (e.g., 59 1/2 ), even if they keep working. The concept of "pension portability" makes sense when there is coordination between workplace plan money and personal IRAs. Also, it makes little sense for the vast numbers of people in participant-directed plans to have far less investments choice at far higher cost than they can obtain in self-directed IRAs.
• Baby Boomers and Advice – As Baby Boomers move into retirement, rollovers from participant-directed plans into IRAs will represent the "golden egg" of U.S. financial services. Financial advisors' ability to offer objective investment advice to participants (and capture rollovers) is enhanced when advisors' loyalty is aligned with the "new boss." The evolution of U.S. pension laws and regulations is creating a new model in which advisors receive fees directly from participants who choose to pay for advice.

Shopping in the Retirement Plan Wal-Mart

To understand the combined weight of these changes, envision each participant-directed plan as a Wal-Mart-like store. At 8 a.m., when the doors open, hundreds of plan participants go inside to shop. Some want high-end merchandise while others want low-cost economy shopping with no frills. Some want to fill a shopping cart with diverse investments while others want simplicity. Some shoppers want a do-it-yourself experience while others need assistance.

In a traditional turnkey mutual fund plan, there are only a limited number of products on the store shelf ? all mutual funds and perhaps none very cheap. In many cases, these products don't have clearly marked price tags. However, the greatest weakness of the turnkey plan is the fact that it forces all people to shop in the same way. Because it is a packaged product built around one investment/cost structure (retail mutual fund shares), it can't accommodate the diverse personal needs of even a small plan with perhaps 25-50 employees.

Now, compare this to the "gold-standard" plan of the future. This store offers virtually unlimited investment choices among mutual funds, stocks, bonds and ETFs. All investment choices have clearly-marked price tags. A shopper who wants to economize can select index funds, ETFs or buy-and-hold stocks and bonds, resulting in a diversified portfolio that costs as low as about 50-75 basis points per year. On the other hand, shoppers who want high-end merchandise can shop for outstanding mutual fund money managers at higher costs. The gold-standard plan also includes a choice of paying perhaps $150 to $300 per head annually for objective, personalized investment advice. Naturally, many people who participate in gold-standard plans will want to continue working with the same investment strategies and advisor after they leave work and take a rollover. Thus, the gold-standard plan also accommodates long-range planning by promoting continuity across multiple jobs and life phases.

Three Developments on the Horizon

Today, the gold-standard isn't generally available to most plan participants, but it is coming. The closest approximation, a "self-directed brokerage window" inside a turnkey plan, still layers-on extra costs that participants don't want or need, including some that may not be clearly disclosed. However, three developments in the retirement plan market will force many plan sponsors to adopt the gold standard within the next decade:

1. Cost disclosure guidelines - In the fall of 2006, a St. Louis law firm, Schlichter, Bogard & Denton, filed class action lawsuits against fiduciaries of seven large 401(k) plans that collectively have more than 400,000 employees. The lawsuits charged that these plans and their senior executives breached fiduciary duties under ERISA with excessive fees, undisclosed revenue-sharing arrangements, and confusing cost disclosures. The text of one of the lawsuits, against fiduciaries of International Paper (IP), may be accessed online here:

http://www.plansponsor.com/pdfs/beesley.pdf

One of the suit's most serious allegations is that the IP plan's master trusts made undisclosed revenue-sharing payments to plan service providers totaling millions of dollars per year. The suit labeled revenue-sharing arrangements "the big secret of the retirement industry" and claimed that "…participants of the plans are forced to pay, from their retirement savings, excessive and unreasonable fees and expenses that are not incurred solely for their benefit."

Whether or not these lawsuits are successful, these are troubling charges for today's retirement plan industry. They could lead to new laws passed by Congress or new regulations by the Department of Labor (DOL) that will require all costs paid by participants to be fully disclosed. Regulations also could prohibit the practice of bundling a variety of plan services together and paying for them with asset management fees, in ways that are not clearly disclosed. Eventually, the DOL could require most participant-directed plans to offer some low-cost index fund options as a way of helping participants avoid the impact of bundled fees. According to Rep. Miller, a powerful advocate for rank-and-file plan participants: "We have to ask whether all these fees are necessary and we have to examine whether they are undermining workers' retirement security." The Congressional committee that Rep. Miller chairs currently is holding hearings on the matter.

Under ERISA's prohibited transaction rule (Section 406), a "Chinese Wall" exists between fee-based investment advice offered to retirement plan participants and investment services delivered to the same plan. For example, a company that provides the investment choices for a 401(k) can't be the provider of fee-based investment advice to the same plan. Likewise, a financial professional who distributes investments to a plan can't offer fee-based advice to the same plan's participants. This rule is designed to ensure that objective advice is delivered solely for the benefit of participants by an ERISA fiduciary, and that the advice does not influence participants to purchase specific investments in which the advisor has an interest. For more details, see:

How to Become a Fee-Based Advisor to Retirement Plans

The Pension Protection Act of 2006 (PPA) included a new exemption to the prohibited transaction rule for "eligible investment advice arrangements." This exemption allows providers of plan investment services to offer fee-based investment advice to the same plan's participants, provided requirements are met. The advice must be provided by a "fiduciary adviser" who is an RIA, bank, insurance company, broker-dealer, or an affiliate of these entities. Unless the advice consists solely of computer model output, the exemption requires the fiduciary advisor to offer a "level-fee" arrangement, so that any compensation received from the purchase, sale or holding of plan investments does not depend on which investment choices are selected by the participant. To the extent that a fiduciary advisor who delivers fee-based advice also receives investment-related compensation, that compensation may not vary based on investment choices, sales or results.

Plan participants who have access to independent fee-based advice, including asset allocation models, are more likely to follow disciplined investment programs. Thus, plans that offer their participants access to objective advice potentially will be able to increase the legal protections of fiduciaries.

Action Steps to Plan for the Future

How can financial advisors make a transition from mutual fund turnkey plans to the gold-standard era of the future? Here are some ideas:

• Keep your eye on the prize - The great opportunity in today's plan market is the potential to capture the large rollovers of Baby Boomers nearing retirement. The smartest way to compete for rollovers is to begin offering fee-based advice to plan participants long before they retire or leave the company. Even if you have to give away some advice to put yourself first in line for rollovers, do it!
• Educate participants about plan costs - Most retirement plan participants don't have a clue what they are paying, and that's a problem America will soon start to solve through increased regulations and disclosures. Help clients and prospects understand that every extra dollar of annual plan fees they pay could eventually cost $103 of retirement assets (@ 7.5% return over 30 years, with compounding). Try to estimate the all-in plan costs that each participant is paying. For those who want "economy shopping," suggest ways to reduce the impact, such as index funds.
• Help participant groups advocate for a better deal - The new bosses of participant-directed retirement plans may not obtain more power unless they demand it. In plans where participants are paying high costs for too few choices and too little service, they should and must speak up for their own retirements, ideally with a unified voice. The message of empowerment is: "It's our money and our plan." Help to organize meetings at which all participants of a given plan are invited to discuss preferences and needs. Then, follow up by presenting consensus recommendations to the plan sponsor. This can be an effective way to develop new clients for plan advice and rollover counseling services, especially if participant advocacy word-of-mouth buzz spreads from plan to plan. Some plan sponsors may appreciate your efforts, too, because they may be out-of-touch with what their participants really want.
• Study the advice provisions of PPA 2006 -Provisions of the new law covering investment advice to plan participants are highly complex. They favor an approach in which the fiduciary advisor to participants: 1) charges a flat per-head fee (e.g., $250 per person per year) paid voluntarily by those participants who want advice; and 2) does not offer investment distribution services to the same plan.
• Avoid prohibited transactions by partnering - It will makes sense for two separate financial firms (or advisors) to develop referral-based partnerships in which each partner works on a different side of the "Chinese Wall." One partner will sell plan services and receive investment-based compensation; the other will provide fee-based advice to participants. Although the relationship between partners must be at arm's-length, the law probably will allow a degree of cooperation between entities on both sides of the wall.
• Help clients understand opportunities for in-service rollovers - Many participants can start using the gold-standard plan before they retire. These opportunities include: 1) small businesses that are candidates for SEP-IRA plans; 2) participants who have been in SIMPLEs for at least two years and can make a penalty-free transfer to a personal IRA; and 3) participants in 401(k) plans that allow in-service withdrawals after a certain age.
• Network with third-party administrators (TPAs) - Gold-standard plans are available today from several leading online brokerage firms; however, you will need to team with TPAs to package cost-effective solutions that integrate all the services a sponsor needs including reports, filings, non-discrimination tests, and participant disclosures. In anticipation of increased DOL cost disclosure requirements, make sure TPA's costs are competitive and separate from investment-related services.
• Be cost-minded in turnkey plans - If you make a living representing mutual fund turnkey plans, accept the changing environment by choosing vendors that: 1) offer low-cost index fund choices; 2) will offer institutionally-priced shares to volume purchasers; and 3) provide clear cost disclosures to plan participants, especially if they use revenue-sharing arrangements. Always be willing to disclose to participants the fees that you personally earn.

The future of the U.S. retirement plan industry will be just as dynamic and opportunity-filled as the past, and it is now becoming clear what types of plans and services the new bosses will want. Make sure your practice is facing the future of participant-directed plan growth, not the past.