Industry Evolution

Brace yourself. Rarely have advisers faced so many fundamental shifts simultaneously—and at the same time as national and global economies still slump and the market volatility continues. Consider the U.S. Department of Labor’s (DOL) revisions to its fiduciary-definition proposal; the implementation and aftereffects of the DOL’s new fee-disclosure rules; potential new U.S. Securities and Exchange Commission (SEC) fiduciary rules and a stepped-up adviser-examination program; sponsors’ growing demand for customized and index investment options; and Baby Boomers beginning the transition from the accumulation phase to decumulation. Here, experts talk about how these five key shifts could affect the business of being a plan adviser.

“We are asking the DOL to carefully target its proposal on well-defined and documented problems, and balance the cost and benefits,” says David Bellaire, general counsel and director of government affairs at the Financial Services Institute Inc. (FSI), which represents independent broker/dealers and independent advisers. Most contentiously, the previous proposal suggested that advising people about individual retirement accounts (IRA) crosses the fiduciary line. With the revision, “The question is going to be more about how [the DOL] deals with that IRA issue,” says Dan Barry, director of government relations at the Financial Planning Association (FPA). “Do they provide some sort of exemption, and if so, is it workable from the industry’s perspective?” Expect some shifts. “From what we are hearing, the department has in mind to be responsive to at least some of the public commentary received on the scope of the proposal,” says Mark Smith, a Washington-based partner at law firm Sutherland Asbill & Brennan LLP. Department officials have spoken about considering exemptions, such as with the indirect-compensation methods like revenue sharing, he says. They also have suggested that they will add relief on the sales process of service providers such as advisers, to ensure what they say does not cross the fiduciary line, he adds.

Yet, some sources say the revised proposal still will suggest a broader fiduciary definition. “There is no indication that they have reconsidered their view that a broadening of the definition is justified by the changed circumstances in retirement today—the move to the DC world, the greater complexity of investments in which plans partake and the interrelationships of service providers,” Smith says.

That unquestionably would affect many advisers. “If the definition is broadened, advisers affiliated with wirehouses, other broker/dealers or product manufacturers all potentially face greater challenges in ERISA compliance than they do today,” Smith says. “The department’s view is that if you are a fiduciary and you give advice where you or an affiliate might receive additional revenue as a consequence of that advice, you have a conflict of interest.” Without exemptions, those advisers and companies might have to stay out of some of the retirement business or restructure how they receive fees.

2. Taking next steps after fee disclosure. In February, the DOL’s Employee Benefits Security Administration (EBSA) issued its final rule for 408(b)(2) fee disclosure and announced a three-month extension to the rule’s effective date, meaning service providers must be in compliance by July 1, 2012, for new and existing contracts or arrangements between ERISA-covered plans and service providers.

“For mid-sized plans through megaplans, there is not going to be a lot of new information in those disclosures,” Smith says, especially because many plans already had some of the information disclosed after the revisions to the Form 5500 Schedule C last year. Smaller plans, for which Schedule C does not apply, might learn a lot, though Smith does not anticipate many knee-jerk reactions to go to the cheapest provider. “That is not the requirement of the law,” he says.

Nevertheless, Michael Falcon, J.P. Morgan Asset Management head of retirement, worries about the reaction. “One of the things that concerns me is a myopic focus on fees, as opposed to outcomes and results,” he says. “The overall cost of a plan is important, but the question is, what are you getting for the money you pay?”

Sponsors have to go beyond making sure they receive the disclosures, says Bill McClain, Seattle-based principal at consultancy Mercer. He outlines the steps fiduciaries need to take, and advisers likely will play a crucial role. Most importantly, he says, sponsors must benchmark plan administrative costs and investment fees to ensure they are reasonable for the services provided. Additionally, they must meet disclosure requirements to participants and in the Form 5500 Schedule C. Sponsors also need to consider how they allocate fees to participants, as well as document decisions and action steps in a plan Fee Policy Statement (FPS).

Thinking about the allocation of fees to participants “is the area where most plan sponsors are struggling now, or have not gotten to,” McClain says. Part of the issue is separating investment costs from administrative costs. “Revenue sharing kind of lumps the two together, but they really are two very different animals,” he says.

McClain anticipates more plans shifting to per-head administrative fees—X dollars per participant, instead of X basis points of a participant’s assets. “If someone has 10 times the assets, does it cost 10 times as much to administer that account?” he says. “Fixing cost on a per-head basis makes sense. It ties the allocation of cost more closely to how it is generated, which is on a per-head basis.”

Less reliance on revenue sharing appears likely. “It seems like the trend is toward less revenue sharing and more hard-dollar fees, although I would not say that it is a majority of plans,” McClain says. He sounds doubtful that it will disappear. “A megaplan in the billions of dollars of assets has the option to go to separate accounts and get rid of revenue sharing altogether,” he says. “If it is a couple-hundred-million-dollar plan, it does not have that option, unless the sponsor says it is only going to use funds that have no revenue sharing.”

3. Anticipating SEC changes. The aftermath of SEC studies required by the Dodd-Frank Wall Street Reform and Consumer Protection Act may affect the advisory business in a couple of ways. The first is in regard to work for individual investors: In January 2011, the SEC released a study recommending a uniform fiduciary standard of conduct for broker/dealers and investment advisers when they provide personalized investment advice about securities to retail investors.

A little more than a year later, the SEC apparently continues to work on crafting a proposal to harmonize the fiduciary standard, Bellaire says. “Thus far they have not been that transparent about what the proposal would look like,” he says. “One school of thought is to take the Investment Advisers Act and essentially port that over to the broker/dealer world. We have encouraged the SEC to develop a set of common, core principles of fiduciary behavior, and then develop unique requirements for broker/dealers and investment advisers based on those core principles.”

The FPA’s Barry sees growing broad agreement about the need for a change. “Brokers, for years, under exemptions under the Investment Advisers Act, have been able to give a degree of advice without being [subjected] to the same standard. In many cases, they are providing the same advice, with a different standard,” he says. “For providing the same service and the same advice, they should be held to the same standard.”

Another SEC study prompted by Dodd-Frank looks at how to beef up adviser examinations, and plan advisers would feel a direct impact. The report released in January 2011 suggests Congress pick from three options: 1) impose user fees on SEC-registered investment advisers to pay for more examinations by the SEC’s Office of Compliance Inspections and Examinations (OCIE); 2) authorize one or more self-regulatory organizations (SRO) to examine these advisers, or; 3) authorize the Financial Industry Regulatory Authority (FINRA) to examine dual registrants for Investment Advisers Act (IAA) compliance.

“There is pretty broad consensus that the adviser exam program needs to be ratcheted up,” Barry says. The SEC study found the number of examinations of registered investment advisers (RIA) conducted each year decreased 29.8% between 2004 and 2010. Just 9% of these advisers were examined in 2010, so, at that rate, the average RIA could expect to be examined less than once every 11 years. “We know that they visit some of the larger ones more often, so they visit some of the smaller ones less often,” Barry says.

“The OCIE has been underfunded for years and years, so the growth in the examinations staff has not kept pace with the growth in investment advisers,” says Neil Simon, IAA vice president for government relations. The SEC once performed routine exams regularly, he says, “but these days, almost all exams are based on a risk assessment. Given that resources are precious, the SEC is trying to identify the advisers who pose the greatest risk.”

The logistics remain up in the air, because Congress would have to pass legislation picking one of the options. Draft legislation was floated in fall 2011, Bellaire says, with a revised version expected to surface this year.

4. Gaining expertise in both customized and index funds. Advisers are spending less time helping pick off-the-shelf active funds for plans. Customization appeals to sponsors partly because it breaks the connection between a retail investment brand and participants, J.P. Morgan’s Falcon says, and allows sponsors to make changes more often. Today, committees often hesitate to take a lagging fund out of the lineup because that risks crossing the fiduciary line, he says; if the new fund subsequently does not perform as well as the replaced fund, that sponsor may face participant lawsuits. “When they have fund-of-fund components, they can have multiple managers in some large asset categories,” he says. “So they can move money from vehicle to vehicle, or replace a manager, more frequently. Ultimately, it is going to make it look more like the DB space.”

That thinking has started to spread to target-date funds, at least at the institutional level of plans with more than $1 billion in assets. Many plans initially went with their providers’ target-date fund series. “We are just starting to see committees say, ‘Hey, we are in this target-date product. How is it performing? Does it line up to our needs?’” Falcon says. “We are seeing more target-date replacement and more customization at the larger-plan end.”

Other sponsors view it differently and increasingly gravitate toward target-date series using passive funds. “We have noticed that plan sponsors go down one path or the other: One path is indexed, off-the-shelf funds, and the other is customization,” says Alison Borland, Aon Hewitt vice president of retirement strategy and product development. “Generally when we see plan sponsors move to index funds, a lot of it has to do with fees. A market-based, hands-off solution can be very attractive to some sponsors. There is certainly a perception that it decreases the chance of fee-related lawsuits.”

5. Helping Baby Boomers get decumulation advice. There has not been widespread conversation among sponsors about using traditional annuities in-plan, Borland says, but some feel open to thinking about different ways to help people in retirement. “It is basically organizations that are willing to be trendsetters, to be ahead of the curve,” she says of in-plan options.

Most decumulation will not happen within the plan world, Falcon believes, but he thinks decumulation increasingly will be an adviser-assisted activity. “It is extremely complicated,” he says. “When you are in the accumulation phase, your ability to aggregate accounts and have an overall strategy and decide what to do next is easier.”

But that need butts up against the increasing adviser-specialization trend. A plan adviser who has an alliance with other advisers who focus on the retail side—either within their organization or independent advisers focusing on decumulation business—may be in better shape to compete, Falcon thinks. “We will see more teaming, because there is value in continuity,” he says.

But Falcon does not envision plan advisers shifting focus to specialize in working with retirees. “The way that the industry is currently segmented, I do not see anything that would make a plan-focused adviser suddenly interested in retail accounts,” he says. “Advisers need to continue to focus on their specialties, because the specialties are getting more technical. You cannot dabble in either of these things.”