New DOL rule effectively kills off open-architecture option favored by some big plan participants -- and sets off the 401(k) industry

Brooke’s Note: If there are two Holy Grails of good investing, you could say they are open architecture and careful monitoring. Often they are compatible but in this case it has pitted members of the 401(k) industry with good intentions against each other. It’s a matter of whether 401(k) participants should be able to avail themselves of the thousands of choices on offer through a self-directed brokerage account. Phyllis Borzi says “no,” that it opens the door to trouble, but she’s not winning many friends by taking this stance.

The 401(k) industry remains up in arms after getting blindsided by an eleventh-hour move by the Department of Labor requiring that self-directed brokerage accounts receive the same level of monitoring as other investments in a 401(k) plan.

The DOL issued a bulletin last month alerting the industry that brokerage windows should be treated the same way as other plan investments. Since then, widespread criticism has come from the nation’s biggest retirement providers, including Fidelity Investments and firms like TD Ameritrade, to industry leaders, associations and advisors alike.

Industry leaders say white-collar workers at smaller companies like the idea of choosing their own funds through self-directed brokerage accounts.

The new rules spelling out fee disclosure of plan sponsors go into effect July 1, and rules for participants must be sent out by Aug. 30.

It’s “a needless requirement that just can’t be met,” says Phil Chiricotti, president of Center for Due Diligence. “It seems like the regulators are setting up the industry … by making disclosures and other requirements so complicated, time-consuming, costly and murky.” See: 401(k) advisors get a lobbying voice in Washington.

This isn’t the only controversy in place regarding the new rules. See: After years of DOL bluster, new 401(k) rules appear to make RIAs’ low expenses look higher than those of brokers.

Why now?

The real question is why the DOL never addressed this issue before now, considering that these brokerage accounts have been in 401(k) plans since the 1990s, says Fred Reish, an attorney with Drinker Biddle & Reath LLP. See: RIAs and online brokers are winning the market-share game.

Phyllis Borzi is standing firm on
the rule, saying monitoring brokerage accounts
is something plan sponsors should have
been doing for years.

“I understand why the DOL thinks the policy should be, but they’re too late. All of the animals are out of the barn door and they’re just now closing the barn door. They’re going to have to refine their new policy so it takes better into account two decades of common practices by retirement plans,” he says. See: DOL tells employers when they must fire advisors to 401(k) plans.

Consulting group Aon Hewitt’s most recent study shows that nearly 30% of defined-contribution plans offer self-directed brokerage accounts.

Borzi plays defense

After outcry from the industry, Phyllis Borzi, assistant secretary of Labor for the Employee Benefit Security Administration, spoke Monday at the SPARK Institute’s national conference in Washington, telling industry leaders that she is remaining firm on her department’s decision that the industry needs to carefully monitor funds in brokerage windows.

Reports of her remarks indicate she was worried that some companies would try to skirt the ERISA rules by simply offering brokerage accounts and not offering a menu of investment options. To prevent that from happening, the Labor Department wants to ensure that the industry understood that self-directed accounts would require monitoring. See: Fidelity tries out new DOL-influenced 401(k) fee disclosures on clients — and gets plenty of response.

Monitoring brokerage accounts is not a new concept and is something plan sponsors should have been doing for years, Borzi told conference attendees, according to published reports. See: A Q&A with Phyllis Borzi, the DoL powerbroker aiming to remake the retirement market.

Off balance

Fidelity Investments’ plan sponsors have been caught up short by the rule and have serious concerns on how to respond, spokeswoman Jennifer Engle wrote in an e-mail.

“This change in position through the announcement of an enforcement policy did not provide either service providers or plan sponsors an opportunity to comment or otherwise provide input on an important change in long-standing rules governing self-directed brokerage accounts,” she wrote. “In addition, the implications of providing disclosures under the new regulations for investments held in self-directed brokerage accounts are considerable from an operational and participant perspective. “

Fidelity plans that utilize brokerage accounts cover 38% of the participant base, but just 2.4% of those participants actually use them. See: Fidelity reports 57% boost in 401(k) sales as it sets its sights on smaller plans and advisors.

Late-breaking ball

Craig Watanabe: We have all heard
stories of the participant that wants
to be 100% into gold or
some other undiversified investment.

“This is a late-breaking curveball for the industry,” says Skip Schweiss, president of TD Ameritrade Trust Co. “The DOL’s policy and position in Answers 29 and 30 were unexpected, as the 'final’ regulation said self-directed brokerage accounts were excluded.” See: Bernie Clark and Skip Schweiss head to Washington next week to fight on behalf of RIAs in Bachus bill showdown.

Schweiss adds that his firm supports increased transparency but says that the Department of Labor isn’t giving the industry enough time to respond.

“We will continue to engage with service providers and trade associations on this issue and look forward to receiving additional clarity from the DOL on this important issue,” Schweiss adds. See: Which three of DOL’s new 401(k) rules represent the biggest land mines for financial advisors and plan sponsors.

Informed participants

Department of Labor spokesman Michael Trupo says that the main objective in the fee disclosure mission is to ensure that participants and beneficiaries in retirement plans receive the information they need to make informed decisions about investing.

“Designating a manageable number of investment options is a critical part of making these retirement plans work for America’s workers,” he says.

Terrence Morgan: It’s lunacy to consider
that self-directed brokerage accounts should be
supervised by advisors.

Open to input

“Unless participants and beneficiaries are financially sophisticated, many of them may need guidance when choosing their own investments from among a large number of alternatives. Designating specific investment alternatives also enables participants and beneficiaries, who often lack sufficient resources to screen investment alternatives, to compare the cost and return information for the designated investment alternatives when they are selecting and evaluating alternatives for their accounts.”

Evaluating the brokerage windows is also critical, Trupo adds. “The Department has been and will continue to be open to input from employers, financial service companies, record keepers and other industry groups as we all move forward to implement these important information disclosure requirements,” he says.

For its part, the DOL has said that it won’t treat brokerage accounts with more than 25 fund options as designated investment alternatives if the plan sponsor offers disclosures on funds in which at least five employees have invested. For plans with more than 500 participants, the threshold changes to 1% of participants.

Bad call?

But Borzi and the DOL have some very valid points, says Craig Watanabe, an advisor with Penniall & Associates Inc. in Pasadena, Calif. He doesn’t like brokerage accounts in 401(k) plans and prefers the structure, continuity and control of a traditional 401(k) fund lineup.

“Self-directed brokerage accounts create more variability and increase the possibility of bad outcomes for the participant,” Watanabe says. “We have all heard stories of the participant that wants to be 100% into gold or some other undiversified investment.”

Watanabe’s firm traditionally includes a lineup of 20 funds with a wide range of asset allocations — ample choice for participants to create their own portfolio, he adds.

Rick Meigs: [Plan sponsors will] have
an uproar.

Playing with dynamite

While RIA Terrence Morgan of Ok401k Inc. isn’t a huge fan of self-directed brokerage accounts, he can’t imagine monitoring all of them in a 401(k) plan. He includes self-directed accounts in a number of 401(k) plans but has participants sign a statement saying that they won’t hold their company or his firm responsible for bad investments.

“We preach against them, but unfortunately they’re insisted upon by white-collar groups who think they know how to play the market,” Morgan says. See: Report of a possible delay in DOL’s fee disclosure rule sparks apprehension among advisors and industry observers.

“We’ll let these kids play with dynamite and blow themselves up. But we insist they sign the waiver saying they won’t hold their employer or OK401k responsible for any meltdowns in their accounts. These guys get in there and they all think they’re Warren Buffett. I’ve seen doctors and attorneys destroy their results.”

While Morgan understands that participants clearly want these accounts, he says there’s no way advisors can be expected to monitor all of them.

“It’s lunacy to consider that self-directed brokerage accounts should be supervised by advisors,” Morgan says.

Closing window

Craig Hoffman, the general counsel for the American Society of Pension Professionals & Actuaries, says his group is concerned about the eleventh-hour notice, fearing that smaller employers may choose to discontinue their 401(k) plans.

“There are a large number of plans that offer a brokerage window,” he says. “Small businesses want these brokerage windows, and we’re concerned that if they take them away these small firms will be less inclined to start new plans or maintain an existing plan.”

Craig Hoffman: This seems to be
taking a bazooka when a fly-swatter
would have been more appropriate to
address the concerns.

Hoffman understands there may be concerns about some employers trying to bypass the DOL’s rules, but says overall he believes that if employers do include a lineup of selectively monitored funds then they should also be able to include brokerage accounts as an option for some select investors.

“This seems to be taking a bazooka when a fly-swatter would have been more appropriate to address the concerns,” he says.

Giving more opportunities

The whole purpose of the self-directed brokerage accounts is to give participants who aren’t happy with the investment lineup an opportunity to pick their own, says Rick Meigs, chief executive officer of Portland, Ore-based consulting firm 401khelpcenter.com.

“These self-directed accounts are big in 401(k) plans and the plan sponsor will have a tough time closing them,” he says. “They’ll have an uproar.” See: Schwab to make long-awaited move in 401(k) market with an all-indexed mutual fund and ETF strategy.

A bright side

Jason Roberts, founder and chief executive of Pension Resource Institute LLC, says he thinks Borzi is feeling “overly sensitive” to industry pushback.

He points out that the DOL’s interpretation was a surprise to many in the industry and may affect some service providers negatively. There was no opportunity for comment or testimony, he says.

However, Roberts is already in the past few weeks seeing some advisors who are focusing on small law firms and doctors’ groups or dental groups, which likely include self-directed brokerage accounts in their plans.

“The advisors are opening doors by saying, “'Did you know that you, as a business owner, now have a fiduciary duty under ERISA to monitor the accounts of plan participants to see how they are investing and, if you don’t make the required disclosures, you can be held personally liable?’”

Then, he says advisors are trying to drum up new business by offering these small businesses new 401(k) plans with a specific lineup of funds rather than a 401(k) plan with only self-directed brokerage accounts.

“They go on to say, 'Why don’t you hire me, and I will set you up with a more traditional plan,’” Roberts says.