More Worries for Defined Contribution Plan Fiduciaries and Participants
Helpful Hints for Vanguard
We’re big supporters of the Vanguard mutual funds and have even gone so far as to recommend the funds on Wall Street Week and in speeches before institutional investors. But a recent experience involving advising a defined contribution plan moving its assets to Vanguard has left us with an uneasy feeling.
Initially we were disappointed that Vanguard, if hired as administrator and record-keeper to the plan, would not agree to fiduciary status in its contract. We weren’t surprised that the variable annuity insurance companies bidding on the contract refused; insurance companies have demonstrated a remarkable lack of concern for and awareness of pension issues. Were it not for the huge commissions (and secret payments for endorsements) related to their products, they would have no presence in this market. However, we expected Vanguard to willingly agree to being held to a higher standard of care. After all, an honest firm that puts the interests of its clients first and has no hidden financial dealings should have no fear of being considered a fiduciary. The only explanation for Vanguard’s unwillingness to be a fiduciary that we were provided came from an in-house attorney. Apparently Vanguard believes that since the Department of Labor generally doesn’t consider administrators and recordkeepers to be fiduciaries, why should they agree they are? Our answer to this is: (1) because the prospective client has asked you; and (2) because it separates you from the pack. If you’re cleaner than the rest (and we believe Vanguard is) why not expressly acknowledge it?
Now there is an exception to this fiduciary aversion. Vanguard will agree to be a fiduciary if the plan agrees to use “managed” accounts. In managed accounts, the participants hand over discretion to Vanguard to make investment decisions for them. There is a heavy cost for this advisory service-- approximately 40 basis points. Ironically this pricing structure may result in the participants paying more for the managed account advice than they pay Vanguard for actually managing their money in mutual funds. Once you factor in the additional costs related to managed accounts, Vanguard is not such a low cost provider anymore. But we have additional concerns.
Some portion of the 40 basis points charged by Vanguard for managed accounts is paid to a firm named Financial Engines for independent portfolio optimization. Vanguard refused to tell us how much of the fee went to Financial Engines. It’s a secret and Vanguard doesn’t disclose fees paid to service providers, we were told. However, we pointed out that Vanguard discloses all the investment advisory fees it pays and that such fees are at the very core of its business. Why should Vanguard be so shy about fee-splitting with Financial Engines? And how can we, as fiduciaries responsible for monitoring plan costs, agree to such an arrangement absent full disclosure?
Rest assured, we were told, the fee splitting arrangement with Financial Engines met the guidelines for independent advice the Department of Labor had established in their SunAmerica advisory opinion.
The fact that the Department of Labor says a given practice is okay may be comforting to some but has never been to us. While the DOL knows a great deal about ERISA, its knowledge of investment management practices and related conflicts of interest is severely limited. (We are currently working with the Government Accountability Office in connection with an investigation into why the DOL has been so inept at ferreting-out pension wrongdoing.) Further, how are we supposed to verify that the fee splitting arrangement complies with the SunAmerica guidelines unless it is fully disclosed to us? Am we supposed to simply trust Vanguard?
We called Bill Sharpe, the Nobel Prize winning founder of Financial Engines, for an explanation regarding this lack of transparency. We left a message but got no return call. Weeks later we called Financial Engines’ Director of Marketing and left another message. Weeks later we e-mailed the firm. When we finally got a return call, we were told that Sharpe doesn’t return calls and that any disclosure regarding the Vanguard relationship would have to come from Vanguard. We had come full circle. A conspiracy of silence. We were told again that the advice provided was independent and therefore we shouldn’t be concerned that there might be any financial incentives built into the model.
Who says the advice is independent, we asked? Had anyone verified the independence of the computer generated advice? The fellow we were talking to said he would have to get back to us on that point. He hasn’t to date. He also advised us that, contrary to what Vanguard representatives had said, Financial Engines would not agree to be a fiduciary if we went with the Vanguard/Financial Engines managed account program. (It appears that under the new legislation, the creators of computer driven investment advice provided to defined contribution plan participants can themselves serve as the “experts” certifying the independence of their product.)
Let’s talk more about “managed” accounts. In case you haven’t heard, Congress has found a solution to poor defined contribution plan participant decision- making and participant account performance. Congress has fixed 401ks. The answer is– get this– independent advice provided by Wall Street! If we allow Wall Street stockbrokers to guide plan participants, then they will make better decisions and have more money in their retirement accounts to live on in their golden years. More Wall Street advice is the key, Congress says; the brokerage and investment management industries couldn’t be happier.
Didn’t the nation learn anything from the research analyst and mutual fund scandals? Wall Street is not in the business of providing independent, unconflicted advice. The clients’ best interests always will always be sacrificed in the pursuit of corporate profits.
What is “independent” advice anyway? If a computer picks funds into which participants’ assets should be allocated from a defined universe sold to an employer by an investment firm, is that independent advice? Will the computer tell you that better funds are available elsewhere? Maybe, maybe not. In most or many cases what investors will receive is not really independent advice: it’s the illusion of independent advice. There may be models available that will provide access to a greater number of fund families, but at what cost? Here’s the deal we envision investors will be offered: really good (independent) advice for a high fee; mediocre (tainted) advice for a moderate fee; totally conflicted (i.e., Conflicted Really Awful Portfolio (“CRAP”) advice for free. Guess what? That’s the deal investors have today. Which scheme do investors almost universally choose? Bad advice for free!
Should pension fiduciaries be comforted that Congress has approved pension legislation that expressly permits providing independent advice to defined contribution plan participants? Well, this action certainly reduces the likelihood of being sued in the near term. However, those of us who investigate pension wrongdoing will eventually uncover that much of the so-called independent advice provided participants was corrupted. While some in the brokerage community may rush deeper into this new market, most of these firms have already been giving such advice, only pretending that they weren’t. Other more thoughtful firms have rightfully indicated some nervousness about the potential liability. These firms recognize their brokers lack expertise in pension matters.
Another solution Vanguard and other mutual fund companies offer to retirement plans is target retirement funds. These funds achieve their objectives by providing broad exposure across the major asset classes through investments in carefully selected portfolios of certain Vanguard funds. The portfolios become more conservative as investors approach their retirement date, by automatically adjusting the allocation to each asset class. These funds are designed to meet the needs of investors seeking “a simple turnkey solution for investing for their retirement.” The big surprise to us here was the asset allocations the Vanguard target retirement funds utilized. The Vanguard 2005 Target Retirement fund has, we were told, a 47% allocation to equities. That is the most conservative target retirement fund Vanguard offers. (Vanguard does, however, offer an income fund that invests 30% in equities.) Did we hear that right, we asked? Vanguard recommends that persons who retired in 2005 should be almost 50% in stocks? What about the old maxim “Don’t put into the stock market any money you’re not prepared to lose?” Is Vanguard saying that these retired investors are prepared to live off of 50% of their retirement assets in the event of an extreme downturn? They must be really, really wealthy. We bet if you asked the retired investors in that fund, you’d find their risk profile is not consistent with the fund’s asset allocation. The Vanguard target retirement funds invest between 47%-90% in equities for funds dated from 2005 to 2050.
According to an article by George Daniels Jr. and James Lauder entitled “Benchmarking a Moving Target: Target Retirement Funds Come of Age” in the September/October Journal of Indexes , “Different providers have different views on how much risk (as defined by equity exposure) is appropriate at a specific point on an investor's timeline. A survey of existing offerings shows that total equity allocations, domestic and foreign, in longer-term target date funds (i.e., those currently targeting 2040 and 2045) range from 76 percent to 95 percent, with the mean being approximately 88 percent. On the more conservative end of the timeline, "today" or "income" funds feature equity allocations ranging from 19 percent to 45 percent, with a mean of approximately 32 percent. In the middle years, total equity allocations for 2025 funds ranged from 48 to 84 percent. Taken together, there's certainly a wide enough range to give all investors and fiduciaries reason to closely examine their own attitudes toward risk before choosing a particular target date series.”
In conclusion, no matter which firm you’re dealing with, as a fiduciary to a defined contribution plan, you are going to have to do some digging. A host of new concerns is arising and the new legislation creates as many questions as it answers. We still believe that Vanguard is among the best mutual fund companies offering defined contribution plan investment management, recordkeeping and administrative services. Could Vanguard improve its services? You bet. Here’s to hoping they do.
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New Pension Legislation
By John Churchill Aug 2, 2006 11:38 AM
Brokerage firms have long managed assets in employer-sponsored retirement accounts, but offering specific investment advice to individual plan participants has always been off-limits to reps. That could change soon. According to the rules of the Pension Protection Act (PPA), which passed the House of Representatives last Friday, brokers would have access to this heretofore-unreachable pool of assets in defined-contribution plans, worth an estimated $2 trillion.
The PPA is chiefly designed to shore up the $313 billion funding gap in employer-sponsored pension plans by encouraging firms to not only keep their plans but to also increase their contributions and use automatic enrollment. Plus, the PPA contains an investment-advice proposal. Pushed for by Senator John Boehner (R-OH) for seven years now, the statute will allow financial advisors to offer specific investment advice to individual retirement-plan participants.
With access to plan participants, advisors would be able to cultivate new relationships and, perhaps, boost the size of their books. Financial-services industry lobbying organizations certainly see a benefit: Both the Securities Industry Association (SIA) and the Investment Company Institute (ICI) have heaped praise on Boehner’s proposal. Meanwhile, critics, like Edward Siedle, a former SEC attorney and founder of Benchmark Financial Services, which investigates money managers, say the pension and 401(k) industries have enough problems without allowing more interested parties into the mix. “For example, there is no way for a 401 (k) plan participant to verify the accuracy of their statements,” Siedle says. As for the Department of Labor, he says the pension industry’s enforcer is inept and routinely playing catch-up with problems. Says Siedle: “Now you’re going to let people with even less professional skill into the mix?”
While the bill’s fate is uncertain, so is the interest of brokers. So far, many advisors seem clueless about the opportunities presented in Boehner’s proposal, or they are simply disinterested—most accounts are viewed as being too small. “It’s nice for me that all of my 401(k) clients can ask me to come in and give them advice,” says one Robert W. Baird advisor, tongue firmly in cheek. He says the problem for most brokers will be the time commitment to what amounts to a lot of below-average accounts. “Twenty percent of the company is likely to have 80 percent of the assets, those are the clients brokers want,” he says. “But as a fiduciary, you can’t discriminate within a plan.”
Indeed, there will be a lot of things reps won’t be able to do. Here’s a quick summary of the specifics of Boehner’s investment-advice provision in the PPA:
Who’s eligible:<br> Only qualified fiduciary advisors may offer investment advice. A Series 7-holder, who operates under a “suitability” standard, can qualify if he agrees to act as a fiduciary (like a registered investment advisor does under the Investment Adviser Act of 1940).
Fiduciary safeguards:
Advice must be prudent, objective and for the “exclusive purpose” of providing benefits to plan participants and beneficiaries.
Employers are responsible for selecting and reviewing advice providers.
Advisors will be personally liable for the advice they give. That means they will be subject to any civil and criminal penalties by the Labor Department, civil lawsuits from the aggrieved worker and additional excise tax from the Internal Revenue Service.
In regard to specific advice, the provision requires that:
Any purchase or sale occurs solely at the discretion of the advice recipient;
Compensation of the fiduciary advisor is reasonable; and The terms of any purchase or sale of a security must be at least as favorable to the plan as an arm’s- length transaction would be.
Additionally, fiduciary advisors to both non-employer- sponsored plans and employer-sponsored plans must first use a certified and audited independent computer model to tailor investment advice for participants. If the participant then wishes to seek advice directly from the advisor, he can do so.
Sound like a long walk for a short day at the beach? The Baird broker thinks so. His plan is to keep doing what he does now—offering occasional free informational seminars to the employees of his executive clients as a favor. His advice to other brokers: “Give away custodial service to 401(k) clients so that when they leave the company—with a much larger 401(k)—you have the potential to take over management of that money.”
Some securities specialists say that unearthing complete information about any broker's background is difficult and that most consumers don't realize that the industry is largely self-regulated.
"We believe there is a conflict of interest inherent in self-regulation, and as long as the brokerage industry is allowed to control that data, the system will always understate the amount of wrongdoing and the risks involved in doing business with a brokerage firm," said Edward Siedle, a former attorney for the federal Securities and Exchange Commission who now investigates pension fraud and money management abuses through his own Florida-based company.
The National Association of Securities Dealers defends its system, saying in a statment that the information it releases to the public meets ``federally approved parameters." However, the statement also said that it would be ``a good idea" for investors to check with their state's securities regulators, because state regulators may disclose more information.
Brokers are required to report complaints against them to the Central Registration Depository, a nationwide computerized database. State regulators say they rely on brokers to accurately report complaints to the depository. However, the North American Securities Administrators Association, the organization that represents state regulators, is pushing for new rules that would close a loophole in the reporting system and provide consumers with more critical information, said Melanie Lubin, Maryland's securities commissioner. Lubin said regulators are working on changes that would require the identities of brokers who are involved -- but not officially named in a complaint -- to also be listed in the nationwide depository report that details the arbitration. The current system does not include brokers' names in these reports.
Lubin said lawyers often use a strategy of not naming the brokers in complaints, and instead list their employers, to win faster settlements for their clients. She said current industry rules do not require brokerage firms that are named in complaints to disclose those cases in the same way brokers are required to report them.
"If somebody is going to do due diligence in getting information from state regulators, they should also ask a broker, `Have you had any information expunged from your [file]? Has your firm been sued, based on accounts you have handled?' " advised Lubin, who is also chairwoman of a steering committee on disclosure and licensing issues for the North American Securities Administrators Association.
"A lot of people spend more time figuring out what their next toaster or washing machine will be," Lubin said, ``rather than whether they will have the money for a toaster or washing machine when they retire."
To request a report on a broker's background, consumers can call the Securities Division in Massachusetts Secretary of State William Galvin's office: 617-727-3548. The fee is 30 cents a page, plus mailing costs. The office will fax reports that are fewer than 10 pages.
"Secretary of State Galvin's goal is to give every bit of information that is available to the public. This is crucial for investors to have before they decide who they want to manage their money," said Bryan Lantagne, director of the Massachusetts Securities Division.
Teacher retirement fund consultant facing lawsuit By Michael Higgins.
A former top consultant to the state's teacher retirement fund took in millions of dollars in fees from money managers, including managers that the consultant later recommended for lucrative state work, a retired school official alleges in a lawsuit.
By taking the fees, Callan Associates, based in San Francisco, violated its duty to serve only the interests of the state's school teachers, who depended on Callan to provide fair and objective recommendations, contends Patrick Patt, a retired school superintendent from Lake Forest.
"The Illinois Pension Code is clear," said Brian McTigue of Washington, an attorney representing Patt. "You cannot have an investment manager with a conflict of interest. ... Callan should pay for any losses that result from the conflict." Patt is seeking class-action status of the suit, filed last week in Cook County Circuit Court. Officials at Callan, which faces similar allegations in a lawsuit by city officials in San Diego, declined to comment. Officials at the Teachers' Retirement System of the State of Illinois said this week that Callan disclosed the potential conflict, as required under its state contract, and that no investor money was lost.
With Callan as adviser, the pension fund ranked in the top 10 percent among funds of similar size, said Jon Bauman, executive director of Teachers' Retirement System. The performance "was excellent and does not indicate any substandard managers," Bauman said. But officials at Teachers' Retirement System, which is not named as a defendant in the suit, also acknowledge that they downsized Callan's consulting role in March and that the outside fees were "a consideration" in making that decision. Callan was a primary investment consultant to the retirement fund from December 2001 to March 2006.
The state paid Callan about $2.8 million in fees from fiscal 2002 to 2006, state officials said. At the same time, Callan was receiving fees from money managers, who paid to attend Callan seminars, such as its Callan College and Callan Investments Institute, the suit alleges. Teachers' Retirement System officials said they studied the matter in 2004 and found that various state consultants had collected combined fees of $6 million to $7 million per year from money managers from 2001 to 2003, and that Callan's share of that was millions of dollars.
State officials said they could not determine on Wednesday how many of the money managers that paid fees to Callan received the consultant's recommendation or how many the state ultimately hired. Patt is seeking to force Callan to return its fees from Teachers' Retirement System to the state fund. Patt's attorneys said that as part of the litigation, they also will investigate whether Callan's influence regarding the choice of investment managers caused the retirement fund to lose money.
Setting Standards For The Investment Management Industry
