President Obama has recently turned his attention to retirement plans, as outlined in the The Wall Street Journal. One area of focus is the so-called fiduciary rule that would impose stricter regulations on advisors and force them to act in the best interests of those they advise, rather than taking actions to make more money at the expense of those they are advising.
I don’t think this is a bad idea, but there has been a lot of pushback from the financial industry (who wants to be able to continue to overcharge captive investors) and Republicans.
Indeed, companies and individuals who manage and advise employer-sponsored retirement plans often charge high fees, and many employees complain about this. I’ll give you one point of reference:
My employer uses Nationwide (who is most definitely not on my side) to manage our 401k. One example (that is more favorable to Nationwide than most of the other options) is the S&P 500 Index Fund. Nationwide’s expense ratio is 0.57%, whereas this same index costs me 0.17% in my Vanguard account (it actually costs .05%, because I have Admiral shares, but I’m trying to be fair) – the Nationwide one costs over 3 times as much for the exact same thing.
How significant is this difference? Assume a monthly contribution of $1,000, an average annual return of 7%, and a time period of 30 years – my fund at Nationwide would be worth $1,058,896, while the similar one at Vanguard would be worth $1,139,708 ($1,165,240 for the cheaper Admiral fund). That is a difference of over $80,000 – a really nice car! Keep in mind, this was one of the comparisons most favorable to Nationwide (many of the funds have a difference of 5 or 6x) and many 401Ks are even worse.
Why do 401K providers and advisors charge so much? Because they can. Employers setup plans and most fees are usually passed along to employees who have no say in which provider is used. Many employers setup plans when they are small and have little negotiating power, and as they grow, finding a better provider is never a high priority.
The Labor Department’s proposed rules would aim to alleviate this problem, by making it so providers have a fiduciary duty to plan participants but, as mentioned before, there is a lot of pushback on this. It still remains to be seen whether or not this rule will become law, and if it does, how effective it would be. Personally, I would prefer to see solutions to this problem that involve increasing competition. Specifically, I have two ideas:
1) Allow funds to go directly to an employee-specified qualified retirement account
In this scenario, employers can deposit retirement funds (including matching funds) directly into an IRA. The benefits to the employee are that they can choose their provider, and their retirement account is unlinked from their employer. The benefit to the employer is reduced complexity, reduced compliance costs, and reduced overhead in managing the program.
It would require a little more work in employee onboarding, but ultimately would benefit companies by sparing them the expense and effort involved in maintaining compliance, record keeping, and dealing with audits.
By allowing employees to choose where their funds are managed, they can shop around for the best management and lowest fees. If they want personalized advice for retirement, they can hire fee-based financial planners or go with a firm that advises them as part of their service, but they aren’t forced to pay for advisor services they aren’t using. This would encourage more financial service providers to offer competitive rates and service.
There are two downsides to this plan: Loans from your retirement account are no longer possible (at least under current rules), and dealing with matching funds that aren’t immediately vested is tricky.
The first problem – loans that are currently possible in some 401K accounts – doesn’t seem like that big of a deal to me. Most financial experts agree that this isn’t a great idea in the first place, so losing this ability isn’t the worst thing in the world. Alternatively, current rules around IRAs could be changed to allow for loans, but this could cause other problems.
The second problem – employer matches that don’t vest immediately – is a bit harder to solve. One solution is to simply say this option only applies to employers with no vesting schedule for matching funds. Another would be to allow the employer contribution to sit in another account and be eligible for transfer once the vesting period ends, but this adds additional complexity that doesn’t seem worth it. Ultimately, I think employers should be incentivized to provide plans with immediate vesting and provide alternative solutions for ones that choose not to.
Finally, what do you do about employees with no existing retirement accounts to contribute to? Employers could contract with a financial services company to provide default IRAs for employees, but employees would still be free to change providers at a later date, and the cost to an employer to change the default provider would be minimal (whereas changing 401K providers now involves a substantial amount of effort).
2) Allow annual in-service rollovers to IRAs
Another option (that could be used in addition to my first proposal) would be to make it so 401K participants can perform one in-service rollover to an IRA per year. Currently, participants can only do this when they terminate their employment, but allowing it to be done while they are still employed would let employees move their money to a more competitive provider.
This option is a little more complicated, and affords somewhat less cost savings to employees, but it requires fewer changes to the system as a whole. It also deals with the problem of partially-vested accounts – you can only roll over the vested portion of your account.
If providers knew participants could easily move their money elsewhere, they would be likely to offer better service and lower fees. If not, participants would be free to choose a better provider.
Ultimately, I think both of these proposals would be good for 401K participants and don’t significantly harm the goals of the 401K program. Plan providers and advisors accustomed to large, easy commissions may not like them, but they are good for everyone else involved.
I’d love to hear what other people think about these proposals? Are their better ones? Are there holes in these ideas that I’ve missed?