Why Is the FPA Backing This Bill?

By Staff Writer

January 13, 2002 at 07:00 PM

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The Financial Planning Associ-ation is backing an ERISA reform bill that is derided by many as anti-consumer, and by supporting the legislation the trade group is helping financial services giants compete more effectively for financial planning clients.

In backing H.R. 2269, the Retirement Security Advice Act of 2001, the FPA says it is reluctantly backing a law that will permit mutual fund companies to give advice to consumers that is tainted by a potential conflict of interest. But because the change in the law would also permit advisors to "double dip"–get paid a 12(b)-1 fee for advising a fund sponsor on which funds to include in its plan and another fee for advising plan participants on which funds are best for their individual financial plans–FPA is backing the legislation.

A trade association must first and foremost protect the interest of its members. If the FPA is doing things right, however, the interests of advisor members should be aligned with the investing public. However, by throwing its support behind a bill that would permit advice dripping with conflicts of interest, the FPA is letting down consumers. It's opposing AARP, AFL-CIO, the Consumer Federation of America, and other groups who have the best interests of plan participants at heart. And for what? To allow independent advisors to give advice to a customer one time and get paid a 12(b)-1 fee in perpetuity, or to allow advisors to get paid a finder's fee for selecting funds for the plan as well as the ongoing 12(b)-1 fee. The group is backing a law that is very likely to encourage advisors to gouge their customers.

It gets worse. The giants of the financial services industry are pushing H.R. 2269 because they want to get their hands on IRA rollovers. They can't do that now. But if this bill becomes law, the fund complexes, insurance companies, wirehouses, and banks will suddenly be able to provide retail advice to plan participants as well as be the advisor to the plan sponsor. That's bad for independent financial planners.

In other words, the FPA is supporting legislation that is bad for consumers so that its members can double dip along with the rest of the industry. But in doing so the FPA is making it easier for the financial services giants to compete with its members by backing a law that will let the Prudentials of the world convert plan participants into financial planning clients.

H.R. 2269 basically rewrites the "prohibited transaction" section of ERISA that prohibits fund companies from giving "particularized" advice; i.e., advice to individuals.

Under current law, T. Rowe Price, Fidelity, Vanguard, Merrill Lynch, Prudential, and the other companies that are providers of the funds in 401(k) plans at large- and mid-sized companies cannot also give advice to individuals. That's a prohibited transaction. Under H.R. 2269, the prohibited transaction rules would no longer be an obstacle and the giants would be allowed to tell plan participants which funds to buy.

"2269 would allow people with an inherent conflict of interest to profit by rendering advice," says Marcia Wagner, who heads an ERISA and employee benefits boutique law firm in Boston. "This will be bad for plan participants."

Duane Thompson, director of government relations at FPA, says the entire financial services industry has been pushing to get H.R. 2269 through Congress.

Thompson, who spent over an hour on the phone explaining the law and the FPA's position, concedes that H.R. 2269 is not perfect, and he points out that the FPA's support for the bill is conditional.

In a letter posted on the FPA Web site supporting the legislation, Thompson says the FPA would like the exemption from the prohibited transaction rule to extend only to Registered Investment Advisers. The letter notes that the agents at banks, brokerages, and insurance companies are not subject to a competency exam, which is required of those who act as IA representatives. The bill, by the way, would bestow a new title on agents offering individual advice to plan participants, Fiduciary Advisor, a credential with no educational or competency standards. But the FPA, you can safely assume, knows that is it unrealistic to believe that the legislation would be altered precisely to suit its members, who typically are RIA reps, or RIA reps affiliated with broker/dealers. This is so especially since the backers come from the big fund companies, banks, and insurance companies that contribute mightily to political campaigns and stand to benefit the most from the bill.

"We support it very reluctantly because we have members in a situation where they are prohibited from taking 12(b)-1 fees," says Thompson. He says that supporting a bill that would enable collection of those fees for independent advisors makes sense because advisors currently collect 12(b)-1 fees on non-ERISA assets.

"Getting 12(b)-1 fees, as long as they're disclosed, is legal now," says Thompson. "So what's wrong with doing it on ERISA assets? There are two different standards in federal law for providing advice on identical portfolios."

12(b)-1 Fees and ERISA

To understand the rules on 12(b)-1 fees in ERISA plans, I turned to Lowell Smith, president of Service Provider Solutions of Pittsburgh, an ERISA consultant to plan providers such as Invesmart. Here's what I learned from Smith and other experts.

Some independent financial planners work as consultants to plans, typically a plan put together for a group of doctors or other professionals. The planners get paid a 12(b)-1 fee for selecting a group of funds to be included in the plan. The plan sponsor remains the fiduciary responsible for selecting the funds and the planner acts as the broker of record, which allows for collection of the 12(b)-1 fee.

This isn't a great deal for the plan sponsor, who essentially relies on the planner to pick the funds but is still liable for the investment selection process as a fiduciary. Worse still, 12(b)-1 fees do not oblige a rep to provide any ongoing advice beyond making the initial recommendation, allowing the planner to get paid a 12(b)-1 fee in perpetuity for a one-time recommendation.

The other way a rep can get a 12(b)-1 fee is when guiding (but not advising) a participant in a self-directed 401(k) account.

What is not allowed under current law is getting 12(b)-1 fees for advising the plan sponsor on which funds to include and at the same time getting paid for advising an individual plan participant. You can either decline to receive the 12(b)-1 fee for advising the plan or offset the individual advice fee with the 12(b)-1 fee. Offsetting a 30- to 100-basis- point advice fee to plan participants with a 20- or 25-basis-point 12(b)-1 fee for advising the plan sponsor on fund selection, for instance, is permissible and common. But you cannot receive both fees under the prohibited transaction rule.

H.R. 2269, sponsored by Rep. John Boehner (R-Ohio), chairman of the House Committee on Education and the Workforce, is thus a good way for an independent planner to collect embedded 12(b)-1 fees as well as an advice fee for assisting plan participants. The trouble is that it will tempt a planner to direct plan participants toward more expensive funds, funds that pay higher 12(b)-1 fees, and leave the planner open to compensation influences that ERISA has so far kept out. It will also deal a competitive blow to independent advisors.

FPA Foulup

Brian Tarbox, a former executive at Trust Company of the West who now consults to senior policy makers at the Department of Labor, which enforces the ERISA rules, says the FPA is making a bad business decision as well as an ethical misstep.

"The FPA should know better," says Tarbox. "What should differentiate a trade association from the financial services industry at large is the ethical manner in which it operates."

Beyond the ethics, there is the practical business issue that needs to be considered. The big financial services companies are pushing to see this bill get adopted because their business model is in trouble, say Tarbox, Smith, and other consultants. They have learned that managing fund assets is not the best business plan. The name of the game now is managing the money when individual plan participants roll it out of their plan to an IRA. There is more money now in IRAs in aggregate than in 401(k)s as a result of such rollovers, says Smith.

Tarbox says that companies providing plans to corporate America are capturing somewhere between just 5% and 30% of plan assets when they're rolled over. The rest is going to a trusted personal advisor–brokers and financial planners with whom a participant has an existing relationship.

"Plan providers have been ineffective in capturing the majority of rollovers," says Tarbox. "Instead of having a great franchise, they have a dwindling asset." Under the proposed law, "the plan providers would be in an optimal position to capture rollovers," says Tarbox. And the FPA is playing along.

Once the large financial services firms get the legal right to provide individual advice to plan participants, they will become much better at keeping the assets under their management. If the Boehner bill becomes law, the giant plan providers will probably forego the fee for providing advice to individuals. They'll bundle it in their record-keeping fees or in their fund fees.

They'll bring in a Web-based platform with a call-in center to provide plan participants individual advice to keep costs low. They'll build a relationship with plan participants during their working career. When it comes time for the rollover, that's when the real money can be made and the plan providers will be right there to help create a financial plan that can take each participant through retirement. Plus, they'll be there to help with college planning, estate planning, and everything else. Why would a plan participant need to look any further?

Passage Likely in 2002

James Delaplane of the American Benefits Council, an association for large ERISA plan sponsors and providers, says it's likely that a version of H.R. 2269 will pass in 2002. He says that the prohibition on acting as a fund provider and as an advisor to individual plan participants is very likely to disappear. While he conceded that changing the prohibited transaction rules would present the possibility of a conflict of interest, he insists that the rules making advisors fiduciaries would deter abuse.

An alternative to the Boehner bill that originated in the Senate, sponsored by Senator Jeff Bingaman (D-New Mexico), would keep the prohibited transaction rule in place. Like the Boehner bill, it would take plan sponsors off the legal hook if they choose an advice giver that gives bad advice. The Bingaman bill in its current form would seem to make sense for FPA members.

Right now, plan sponsors are responsible for selecting and monitoring funds for their plans, and have a fiduciary responsibility to do this. When the sponsor picks an advice giver for their individual participants, it's unclear whether they're also responsible legally for that advisor. Both bills say they are not. The Boehner bill goes a step further and says sponsors can also advise individuals. Bingaman simply says that sponsors are not legally liable when the individual advice giver makes a recommendation, although the individual advice giver is liable as a fiduciary.

The Bingaman bill would make it easier for plan sponsors to bring in independent advisors without fearing they will get sued by participants when the advisor makes a bad recommendation.

The FPA supports the Bingaman bill but wants a safe harbor from the prohibited transaction rule for RIAs. This would allow RIAs–but not banks or insurance company agents–to act as advice givers to plan participants as well as to plan sponsors. Asking for this safe harbor is probably a bad idea because it would allow any firm to create an RIA or use an existing RIA to give conflicted advice. It would also allow the financial services giants to use an RIA to compete with independent planners.

Arguing for pro-consumer legislation in a trade publication may not be a popular stand. But the independent planning business should lobby for advice to be delivered in ways that will encourage long-term relationships between planners and clients. When the business issues also support such a stand, it makes you wonder why the industry would do otherwise. I have a feeling this won't be the last you hear about this issue.

A Chat With Bill Sharpe

The Nobel laureate and brains behind Financial Engines weighs in on timely topics

I am no financial genius. Fact is, I break complex financial ideas into little pieces so I can understand them, then string together short sentences to explain them. I live in fear that my inadequacy will one day be laid bare somehow. So it was with great trepidation that I interviewed Bill Sharpe.

Sharpe invented the Sharpe Ratio, a way to evaluate the risk-reward tradeoff on a stock with a single number. Sharpe invented style analysis, a way to use mutual fund returns to explain their behavior and mass-produce diversified fund portfolios in an automated process. Sharpe won the Nobel prize for economics in 1990 for inventing the Capital Asset Pricing Model in the early 1960s, which explained that the volatility of a stock comprises systematic market risk and risk specific to a company, and thus laid the framework for much of Modern Portfolio Theory. For the last few years, the 66-year-old professor of finance at Stanford University has been driving Financial Engines, which aims nobly to make intelligent portfolio advice affordable and understandable to the masses.

Sharpe gave me close to two hours of his time. Sharpe is not at all like other academics I've interviewed in the past who have no sense of humor or patience with people who don't have a Ph.D in finance. He's fun to talk to. The idea running through all of his great work is to make the complex science of finance more accessible to Everyman.

What's it like being a Nobel Prize winner? Do you get free tickets to Knicks games? I can answer that in a couple of ways, after having spent the last 10 days with 175 other Nobel prize winners for the Nobel centennial. All the pre-2001 Nobel winners who could stagger over to Sweden attended. It was very good being among 163 previous winners and 12 new ones because it keeps you from having the slightest bit of a swelled head to be among so many smart people. But to answer your question, being a Nobel prize winner is not different from being anyone else. One thing that changes is that when you get asked to give talks, you're not asked what you will speak about. You get invitations where you can give a keynote address with a subject of your choice. No, I don't get free Knicks tickets, but there was a period where Lufthansa would upgrade you to first class automatically; they stopped that about five years ago.

Do mutual fund managers add value? When you get to the question of can they add value by betting against each other, to the extent you ask: does my guy, who puts me in IBM and Intel, do better than someone else who puts me in HP and Compaq? Ultimately, at the end of day before costs, half will win and half will lose. And after costs, more than half will lose. So the arithmetic tells you that the average fund manager does not add value. What all of us are trying to do is find the managers that win the betting game more than half the time after their costs.

Do financial advisors add value? Do they help people get better financial outcomes? The good ones do. You have individuals with specific needs and circumstances and preferences and fears. Then you have this incredible array of products and strategies. A financial advisor can do a huge amount of good work getting that individual positioned right with regard to products and services and strategies. Then there is the betting game, and the financial advisor can make bets just like the mutual fund manager. And half can turn out to be bad and half good, and it costs money to make the bets.

If you believe advisors add value, then why did you create an advice platform in Financial Engines that initially did not utilize professional advisors? We wanted to help individuals–not just rich individuals–to make decisions and to get the advice and help they need. We could have started with high-net-worth individuals but did not feel our comparative advantage was there and it wasn't what we wanted to do. We could have started with medium-net-worth individuals and built a set of services that professional advisors could use. But one of the things that motivated us was the whole growth of 401(k)s, and the way we were beginning to change the way low-net-worth individuals saved for retirement. And most of them could not economically afford a human being as an advisor. So we figured this hole needed to be filled, and it would also work with people who then need service from human advisors. So we said let's tackle the hardest problem first because it was being serviced not at all or very badly at the time we founded the company. I wouldn't say we've cornered that market but we've made real progress, and now we're going upstream to deliver services with a combination of human beings and technology, which, once you get to the point where the economics work, is clearly the way to go.

Where do you think most people go wrong in making financial decisions? The mistake people make is they don't even acknowledge uncertainty, let alone try to address it. They make simple projections like, "Let's see, if I save this much, and it grows here, I'll have this much at retirement." They have no sense of range or uncertainty.

Once beyond that, I think people fail to internalize the tradeoffs if they don't have a way of assessing tradeoffs, like, "If I save this much, I'll have this range of outcomes. If I save more, I'll have this range of outcomes." They don't have the technology to see range of outcomes, so they're flying blind and won't make good decisions.

As far as specific mistakes, probably the biggest is saving too little. People may get better now that we've had markets going down. We also often see lack of diversification. People put 60% of their money in company stock, or people in the Valley here put all their money in tech stocks–duh.

The equity risk premium is a hot topic these days and it's an important part of your modeling of the future in Financial Engines. What is the current equity risk premium? Have you made some downward revisions to it in the last couple of years? First off, there are various ways of defining the equity risk premium. And often you get long arguments only to find that people were talking about a different measure. So let me define it. It's the spread between a diversified equity portfolio, like the U.S. stock market, and short-term Treasuries. Some people talk about stocks versus bonds, or big stocks and not all stocks. I'm talking about all U.S. stocks versus the 30-day T-bill. The second thing you need to be clear on is whether it's a geometric average or arithmetic. Geometric takes compounding into account. I'm going to talk about arithmetic, which makes for a bigger spread than the geometric. A large discrepancy comes from talking about different measures. Rob Arnott, for instance, talks about stocks versus long-term bonds and that's why he gets a smaller spread. So the argument gets obscure fast. Is the premium lower? Yes. But relative to when? A lot of people still look at the historical record going back to 1926.

You're referring to Roger Ibbotson's estimate? Yes. We believe it is lower than going back that far. There are three reasons for that. One, almost anyone agrees risk is now lower than it was in that long historical period. If there is less risk, people don't need as much reward. So that's one good reason why you have a lower equity risk premium. Two, we're better at spreading risk around. We're better at running the economy than we were in the 1920s and 1930s. We have this whole panoply of financial instruments, swaps and derivatives, and the currency market. We're better able to take risks that exist and allocate them globally to spread them more efficiently. And, lastly, investors are richer than they were 50 or 75 years ago. Richer people require less reward for bearing risk. On pure economic grounds these make the equity risk premium lower than the historical average.

Ibbotson's equity risk premium number is probably in the high 8s and we're typically between 5 and 6, in that range. That's a big difference. Arnott would come in even lower than our number. Gene Fama, too, would probably be in this camp. These people believe that in addition to the big secular changes, there are month-to-month and year-to-year changes, and there is evidence that following a big bull market the premium is lower and this is consistent with the wealth effect. Following a bear market, the argument would also hold that the premium would be higher. We do change our risk premium and reevaluate everything each month. But we don't change the risk premium by huge amounts on this kind of month-to-month basis or quarter to quarter. Once you get into too much short-term movement of your risk premium, you're basically market timing, and we're not advocates of that. Partly, it's a matter of what we're up to: We're helping people make longer-term decisions and don't want to tell them to whip their portfolios around month to month. We don't think that's a good idea.

An advisor who uses Financial Engines has a problem. When a client has a portfolio of funds and you replace a single fund, it upsets the balance of the entire portfolio. Finding a replacement with the same unique mix of asset classes upsets the balance of the rest of the portfolio, and finding a top-rated fund to replace it is almost impossible. Do you wind up having to change the rest of the portfolio just to change a single fund in FE? A fund that seems in a more simplistic sense to be a replacement fund probably is not the same in all dimensions. And if you want the same overall structure and risk, you need to change other things. So, in some sense, we're doing what you should, taking subtleties into account. As a practical matter, you can lock down all the other funds and make the substitution with something that's not identical. There are ways to work with the system to deal with that issue and see if it's a big enough difference to be important. A simple case is to replace a large value fund. It may actually be 60% or 80% large value and the rest in small value or small growth. With crude classifications people use, you think you made a replacement. With our system, you know it's not the same and you can make adjustments accordingly. The right way to do it is our way. If you want to hold risk and return characteristics the same, you need to make the changes in the whole portfolio. We're trying to take the subtleties

into account.

Ten or 12 years ago, a lot of financial advisors became convinced that using an optimizer was the answer to their dreams. But now they rely on this much less and regard it as just another tool. Many see Monte Carlo analysis the same way, as just another tool. You've created a platform that allows for little or no tire kicking and human judgment. Advisors are skeptical of that. What say you? You can use a lot of human judgment. You can lock in changes, and you can experiment with all kinds of alternative portfolios. This is by no means, "Get out of the way and we'll tell you what do to." They can change the decisions.

On the subject of optimizers, part of the reason people don't use them as much is because a large number of people use them with history and then you're finding the best thing you could have done if you knew 70 years ago what would happen. That's not very useful. We don't get those kind of cockamamie results out of our forecasts because they're all constructed with the way financial markets actually work and take into account risk correlations, and recent market values, and it's all made to be consistent. Because they are good inputs, you don't get crazy outputs. Monte Carlo is the only feasible way if you take enough reality into account to make forecasts that take into account the range of things that can happen. I don't know any way to make realistic forecasts in the investment arena other than using Monte Carlo simulation.

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