Thursday, April 7, 2016

Protection for your IRA (N&O Column of 2/2/15)

Protection for your IRA

A loyal reader contacted me a few weeks ago to ask me why her 401(K) investments always perform better than her IRA Rollovers.   Over the course of her career as she’d moved from one job to another, her broker had encouraged her to move her corporate 401(K) assets into an individual rollover retirement account. My reader had been careful to keep the same asset allocation in her 401(K) and IRA Rollover, and yet the results were markedly different. 

By coincidence, the President’s Chairman of the Council of Economic Advisers had the same question.  In a memo to senior White House advisors, Jason Furman concluded that IRA investors lose between 0.5% and 1% in underperformance per year, or between $8 billion and $17 billion due to conflicts of interest.  Framed differently, individual investors consume between one and three years worth of retirement withdrawals due to excessive fees.  The factors identified by Mr. Furman have been quietly at work sapping performance from my reader’s and your IRA accounts.

When your retirement nest egg is in a 401(K) it is subject to a higher legal standard of conduct and also enjoys substantially lower fees than an IRA.  In fact, your broker would be serving your interest and not his own if he advised you that most 401(K) plans allow you to keep your money in the retirement plan even though you are no longer employed by the firm.   If you leave the money in the old 401(K), it continues to enjoy lower institutional fees.  If it is rolled into an IRA, it will likely incur commissions, higher management fees, and higher maintenance fees.

In Washington, D.C. an epic battle is underway over a Department of Labor regulation that is yet to be proposed.  The rule would make it far more difficult for the brokerage industry to lace their retirement products with excessive fees.  The brokerage industry and the U.S. Chamber of Commerce have already found sponsors in the House and Senate for a bill to repeal the rule even though it doesn’t yet exist.   In simple terms, the DOL rule would require stockbrokers to act as fiduciaries when they sell individual retirement products to consumers. 

A fiduciary has a duty to serve the best interests of its clients, including an obligation not to subordinate clients’ interests to its own.   A traditional defined benefit plan and a corporate 401(K) plan are subject to this higher standard.  In addition, a financial advisor (someone who manages a client’s assets for a fee) is a fiduciary.  However, a broker is subject to a weaker standard of care, called suitability, which means that he is supposed to make recommendations that are consistent with the interests of his customer.

I’ll bet you have little or no idea about the legal standard applicable to your brokerage or retirement account and can’t tell the difference between a stockbroker and a financial advisor.   However, this battle over the standard of care governing your investments has at least two important consequences for you and the brokerage industry.  First, you are more likely to recover damages if something goes wrong and your broker or advisor is subject to a fiduciary standard.  Second, you are apt to pay lower fees under a fiduciary standard.  Thus it’s no small wonder why the brokerage industry is gearing up to fight the DOL’s rule.  The industry’s profits might suffer if the DOL ultimately adopts the fiduciary standard. 

Unfortunately, the regulations governing your investment accounts are extremely complicated.  While the DOL oversees retirement accounts, the SEC and state regulators govern financial advisors, and the SEC and the Financial Industries Regulatory Agency (FINRA) supervise brokers.  FINRA is a self-regulated agency run by the brokerage industry.  Thus your investment accounts are probably governed by a series of different regulators.  While the industry likes this fractured regulatory system, it makes life difficult for an aggrieved customer.

For the brokerage industry, the potential DOL rule has even broader consequences.  In the aftermath of the credit crisis, Congress ordered the SEC to issue a report on the appropriate investment standard for all retail investment accounts.  Four years ago, the SEC issued a 208-page report calling for a uniform fiduciary standard.  In the face of intensive industry lobbying, the report’s recommendations were never implemented.  I’m sure brokerage firms fear that the successful promulgation of the DOL rule would provide an impetus for the SEC to dust off its report and extend the fiduciary standard beyond retirement accounts.

In attempting to win reforms, a lot of consumer groups like to paint the picture of the unscrupulous stockbroker preying on unsophisticated customers.  The industry also tries to distance itself from the few dishonest brokers who harm the reputation of all stockbrokers.  Corrupt brokers undoubtedly exist, but they aren’t at the heart of the problem.  Individual brokers don’t create excessive fees and commissions.  In fact, the average broker only earns about 30% of the fees or commissions on a trade or investment.  It’s the executives who run marketing and oversee branches who put most of the pressure on individual brokers.  When your broker calls you about an investment opportunity or proposes an IRA rollover, he’s probably responding to pressure from his firm to push certain products or strategies. If the broker doesn’t sell enough product, his share of the commissions will fall, or he’ll soon be looking for another job. 

The industry is warning anyone who will listen (mainly Washington politicians) that the enactment of a fiduciary standard for retail retirement accounts would result in mass layoffs and a lack of products for small retail accounts.  At the same time, they argue that the new rule will dramatically increase compliance costs.  This is the same argument the industry uses every time Congress or a regulatory agency proposes a law or rule that favors the consumer.  In addition, the opposition to any particular reform is always accompanied by massive increases in political contributions to individual Congressman and industry PACs.  

In reality, a wide array of low cost investment products can meet the retirement needs of even the smallest retail retirement account.  Clearly these products would weigh on the bottom line of brokerage firms.    From my perspective, the industry’s position is hard to defend.  Why should a corporate 401(K) be subject to a higher standard of conduct than an individual retirement account?  If anything, retail investors should enjoy greater protections than a 401(K) program overseen by corporate managers.  The economics of retail brokerage are built on a standard (suitability) that exploits the consumer; it should end.


To be clear, establishing a fiduciary standard of conduct is not really about raising the ethical standard of your broker.  Most brokers are indeed trying to do right by their customers.  The new fiduciary standard is aimed at the executives who create and push the products that are good for their bonuses and bad for the firm’s customers.  Given political reality, I’m betting that it will be many years before your IRA enjoys the protection and lower costs of a fiduciary standard of conduct.

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