IMPORTANT NEW RULES THAT WILL AFFECT YOUR IRA AND 401-K
By MARY LYNNE DAHL, CFP®
May 09, 2016
Overall, the change is very good for the public. It requires that any financial advisor for an IRA or 401-k account will now have to be a “fiduciary”. A fiduciary is held to the highest standards when giving financial advice and must always act in the best interest of the client. This is good, of course, but not all advisors do this. Some give “advice” that is more in their own interests than in the interest of the client. Usually, this advice involves the advisor getting a fat commission on the sale of the investment produce that he or she recommends. Under the new law, however, commissions, fees and costs will have to be disclosed in writing and will require proof as to why they are in the best interest of the client. If the fees and commissions are reasonable (not high or above market rates), this will not be a problem, but if not, this will be hard to justify, since there are plenty of low fee, low cost, no commission investments available.
The issue that prompted this new rule is that Congress, the Department of Labor and administrators of ERISA (Employee Retirement Income Security Act of 1974) believed that the American public was paying too much in fees for their retirement accounts and were not being given unbiased advice about how to invest their retirement money. In many cases, they were correct in this belief.
Studies were conducted to determine what fees and costs had been routinely charged to ordinary Americans in their IRA and 401-k accounts. The results indicated that while some fees and costs were, in fact, reasonable and fair, they were unreasonable in too many cases, and additionally, the advisors with the higher fees often did not adequately disclose those fees and costs to the IRA or 401-k plan participant. The studies concluded that, too often, the fees and costs were unfair, the investments recommended had conflicts of interest that were not disclosed and the investments were not in the best interest of the investor.
The end result of these studies was that a law was passed to change the way IRA and 401k retirement plans were serviced by the investment industry. The US Department of Labor estimates that the savings to the public will be about $17 billion per year. This is money that will be kept by the IRA and 401-k accounts instead of being paid out as sales commissions and fees to financial advisors and their firms who charge high fees and commissions.
In the past, someone with an IRA or a 401-k plan at work would open their retirement account online or with a financial advisor who helped him or her set up the account and recommended the investments for that account. That advisor might be a registered investment advisor/firm, a stock broker or an insurance agent. Each of these types of financial advisors has provided services in very different ways in the past, but now they will be forced to conduct their business in more similar ways, providing financial advice as fiduciaries, all of them putting the best interests of the client first. It will change how many of them get paid and what kind of investments they can recommend to clients. It should reduce the costs to investors, by reducing many of the fees and commissions that are charged on investments.
So, how do financial advisors get paid? A registered investment advisor (RIA) generally charges a fee for advice and is always required to be fiduciaries on behalf of their clients whom they advise. RIA firms often employ Certified Financial Planners™, who are also held to a strict fiduciary standard of care, putting the interests of the client first, as part of their ethics rules and general obligations as professionals. Many RIA firms are fee-only firms who do not accept commissions for investments that they recommend. Typical fees for RIA firms are 1.0% - 1.5% per year, based on the value of the account. Some simply charge by the hour. Many offer comprehensive financial planning, retirement, business, estate and investment planning and advice as part of the services paid for by the fee that they charge. Based on the requirements of normal fiduciary standards, most RIA firms are already compliant with the new law and will not be impacted very much.
On the other hand, a registered representative of a broker/dealer firm (a stock broker) or insurance agent is paid a commission for selling investment products to an IRA or 401-k investor. Sometimes those products are “proprietary”, meaning that they are owned by the firm, such as ABC mutual funds, owned by ABC Company or ABC Insurance. Most of the time, they are investments that charge commissions which are used to pay the sales person (the stock broker or insurance agent). Another issue is that a salesperson being paid a commission may or may not be giving unbiased advice about the investments being recommended and this is not in the best interest of the investor.
The usual commission range paid to a stock broker or insurance agent has been broader, ranging from about 4% on average up to as much as 8% in some cases, charged up front with every addition to the account (called “front loaded”) or when the account is closed (called “back loaded”). However, investments with front or back loaded commissions also frequently have ongoing commissions of ¼ of 1%, called 12-b-1 fees which are charged continuously as long as the investment is owned. There are a number of variables that affect how much the commission will be, such as the dollar amount of the investment; the smaller the amount, the higher the commission percentage rate, in most cases. Most of these commissions are charged on mutual funds and insurance products, such as annuities of all kinds. In addition, most annuities have other fees in the range of 1.0% - 1.5% in addition to the sales commissions charged. Some of those fees are one-time only while others are ongoing. It is a complex system of fees and charges, and has been strongly criticized as not being too confusing to investors and not in the best interest of the investing public, particularly for retirement plan investors trying to save for their golden years.
So, the new law, which is commonly referred to as the “Fiduciary Rule”, has changed the rules dramatically. Under the new law, a written contract, called a Best Interest Contract (BIC) will be required, signed by the investor and the advisor, specifically addressing all of these costs, conflicts, investments recommended and the requirement of the advisor to act as a fiduciary in the best interest of the investor client. It will be required whenever the advisor recommends an investment that costs more in fees and commissions than what the law considers reasonable or if the fees and commissions will be more than the investor has been paying in the past.
This requirement for a Best Interest Contract is new. In the past, stock brokers and insurance agents were not required to have a signed advisory contract with investor clients. They only had to recommend investments that were “suitable”, which is vague, broad and does not address the issue of what those suitable recommendations will cost the client. Now, under the much higher fiduciary standard, a “suitable” recommendation is not good enough. Obviously, being held to the fiduciary standard does take those costs into consideration, and now requires that costs be reasonable, disclosed and level. In the past, costs were unreasonable, undisclosed and variable, depending on the investments recommended by the broker or agent, and/or the dollar amount being invested. In addition, conflicts of interest that the advisor may not have previously disclosed must now be disclosed. All of this must now be put in writing, into the Best Interest Contract (BIC) that the client and advisor must sign, making certain that the investing public now knows much more about what he or she is doing, what it will cost, whether or not it is in his/her best interest and what to expect from the advisor. The investing public has been confused by and often unaware of these costs and variables for years, but the new rule aims to make this less confusing, more fair and fully transparent to ordinary Americans who are just trying to accumulate enough to be able to retire in security someday.
Many brokerage firms and insurance companies who have been active in the retirement and investment industry for years will need time to change how they do business, how they price their services and products and how they pay their employees, the stock brokers and insurance agents who have relied on the commissions from these products for decades. As a result, they have until 2017 to implement the changes in their IRA and 401-k business accounts.
Congress, ERISA and the US Department of Labor have been concerned about the costs to the public, the loss of dollars in fees and commissions charged on high-cost investment products and the lack of disclosure and transparency that has plagued this industry for years. The passage of the “Fiduciary Rule” will change all of this and be a benefit to the American public. No doubt the new law is not perfect and may require some further tweaking, but it is a pretty good start to creation of a better way for Americans to save and invest for their future. Over the course of 20-30 years of saving and investing for retirement, the increase in contributions from money not spent on high fees and commissions will benefit the American public by a staggering amount. Supporters of the new law estimate that the savings to the American public will be equal to an increased return of at least 1% per year, possibly more. That 1% more will dramatically increase the income at retirement for retirement accounts of 20-35 year durations.
For example, $500 per month or $6,000 per year in IRA or 401-k contributions that earn 5% per year (on average) for 35 years will be worth a future value of about $569,018, but if you increase that average return to 6% per year, the future value would be $708,725. This is $139,707 more in accumulated value, which can provide almost $5,600 more per year in retirement income (at a payout rate of 4%) than if the account earned the lesser average return of 5%. This income projection assumes the retired person does not spend any of the principal of the IRA or 401-k plan, but if the retiree wanted to take out of principal as well as earnings, he or she could do so and increase the amount of income they would receive. This is generally how an annuity works, using up the earnings and principal over time. However, many people like to preserve some or all of the principal, in case they need a lump sum at any point, or to leave a legacy to their heirs.
There may be some legal challenges to this Fiduciary Rule from the brokerage and insurance industries that have not overwhelmingly supported it, but it is unlikely that this new law will be softened in a way that would not benefit the public. It is long overdue, welcomed and heralded by the professional community of certified financial planners, the majority of registered investment advisor firms nationwide and the regulators who oversee the financial services industry. It would be hard to demonstrate how it is not in the best interests of the public to get unbiased, lower cost, fully disclosed investment advice and recommendations, so we think this new “Fiduciary Rule” law is here to stay.
©2016 Mary Lynne Dahl, CFP® is a Certified Financial Planner ™ and partner in Otter Creek Partners, a fee-only registered investment advisor firm in Ketchikan, Alaska. These articles are generic in nature, are accepted general guidelines for investment or financial planning and are for educational purposes only.
Mary Lynne Dahl©2016
Mary Lynn Dahl can be reached at firstname.lastname@example.org
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