Advice and dissent

America’s love affair with the 401(k) was already on the rocks before the Enron Corp. scandal broke. But when the biggest bankruptcy filing in U.S. history caused the energy company’s pension plan to implode, it exposed a fatal flaw of many 401(k)s: They are plainly overloaded with company stock.

America’s love affair with the 401(k) was already on the rocks before the Enron Corp. scandal broke. Two years of back-to-back asset declines was bad enough. But when the biggest bankruptcy filing in U.S. history caused the energy company’s pension plan to implode, it exposed a fatal flaw of many 401(k)s: They are plainly overloaded with company stock.

Now workers and voters are clamoring for more government regulation of retirement plans, and Congress will probably enact some kind of reform before the end of the year. A Senate bill sponsored by Democrats Barbara Boxer of California and Jon Corzine of New Jersey would cap at 20 percent the amount of company stock that a 401(k) account could own; a similar bill in the House proposes a 10 percent limit. President George Bush is pushing for more-modest reform, reflected in Republican-sponsored bills in both the House and Senate that would impose no cap but would allow workers to sell their company’s stock after three years. Enron, like many corporations, had prevented 401(k) participants younger than 50 from selling company shares.

No longer the private domain of policy wonks, retirement security has suddenly become a hot-button political issue. In office cubicles and company boardrooms, on college campuses and most decidedly on Capitol Hill, Americans are scrutinizing the nation’s $1.7 trillion 401(k) system. At issue is whether the do-it-yourself model that defined the 401(k) revolution of the 1990s - in which employees take charge of their retirement planning and assume the investment risk - requires a major overhaul. And if employees need greater protection in their 401(k)s, what form should it take? Increasingly, some are proposing what the financial services industry has been pushing for years: that what investors need most is advice, offered directly by plan providers. Under current law, participants in 401(k)s may only receive advice from independent third-party firms.

“The Enron fiasco clearly reinvigorates the idea of investment advice,” says Stuart Brahs, lead lobbyist for Principal Financial Group, a Des Moines, Iowa-based financial services company. “Employees not only want advice, they need advice,” asserts William Quinn, head of the in-house unit that runs American Airlines’ pension fund and president of a trade organization for the 140 biggest companies’ pension plans. And the word employees most urgently need to hear is “diversify.”

Questions about the role of fiduciaries lie at the heart of the 401(k) debate - and at the center of the collapse of the Enron plan. As defined by ERISA and amplified over the years in various Labor Department rulings, employers are required to oversee their employees’ retirement plans in a “responsible” manner, even as employees make specific choices about their own asset allocation and fund selection. Would-be reformers like Senator Corzine argue that responsible management should include company-stock caps, to encourage the kinds of diversification that experts recommend for all investors. A recent study by Greenwich Associates reports that among employees enrolled in corporate retirement plans with $5 billion-plus in assets, more than half have at least 25 percent of their defined contribution assets invested in their own company’s stock.

“Without a cap, you’ve created an unsound level of concentration,” says Corzine, formerly chairman of Goldman, Sachs & Co. He notes that ERISA prevents a defined benefit plan from holding more than 10 percent of its assets in company stock - why shouldn’t 401(k)s be held to a similar standard? Says Corzine, “There are real limits on sophisticated administrators of defined benefit plans. It strikes me as odd that for the unsophisticated investor, we’re just going to leave it at financial advice.”

Opponents of company-stock caps - a group that includes most employer organizations, corporate trade groups like the Business Roundtable and President Bush - insist that such limits would unfairly restrain investors’ free choice. “I don’t think the government is smart enough to decide that 20 percent, or any cap, is the right number,” says Representative Rob Portman, the Ohio Republican who helped push through a package of retirement reforms last year. He and others argue that the caps would ultimately harm employees by encouraging companies to reduce or eliminate their 401(k) matching contributions. Corporations receive a tax break for matching employee contributions in stock, but they receive no such benefit if they make the contribution in cash.

The debate about investment advice is inextricably linked to the company-stock controversy. Politicians like Corzine would in effect legislate diversification; plan providers like Fidelity Investments and Principal want the freedom to advise employees about that and other investment strategies.

A cause célèbre of the financial services industry for several years, the Retirement Security Advice Act, sponsored by Representative John Boehner, an Ohio Republican, and passed by the House in November, would give providers new powers in offering advice. The Senate now must decide whether allowing providers to extend advice would serve the best interests of plan participants. As the collapse of the Enron 401(k) was inspiring widespread outrage, the White House made Boehner’s bill a central plank of its response to the scandal. White House staffers are aggressively promoting expanded 401(k) investment advice - along with Bush’s proposal to allow all plan participants to sell company stock after three years - as a more palatable alternative to limits on company stock.

In an appearance last month before the House Committee on Education and the Workforce, Labor Secretary Elaine Chao repeatedly said that rather than impose an arbitrary cap on employee investments in company stock, Congress would better serve employees by giving them greater access to investment advice. “What we need to do is help equip and empower workers with the right information,” Chao told lawmakers. “Restricting workers’ choices won’t necessarily make them safer.”

Congress is already clogged with proposed 401(k) reforms. In the House, Boehner has introduced a new version of his advice bill that incorporates the president’s three-year provision; a bill cosponsored by Portman and Maryland Democrat Benjamin Cardin includes Bush’s three-year provision but does not address advice. Meanwhile, a Senate bill cosponsored by Republicans Trent Lott of Mississippi and Kay Bailey Hutchison of Texas allows providers to give advice and contains Bush’s three-year proposal. Another Senate bill, sponsored by New Mexico Democrat Jeff Bingaman, would create a “safe harbor” for plan sponsors that wish to offer advice to their 401(k) participants, but the proposal would not represent much of a change from the status quo.

But who should give investment advice? Advocates of Boehner’s bill argue that plan providers are best qualified to provide the service. “People are starved for personalized advice appropriate to their circumstances,” says Scott Sleyster, president of the retirement services division at Prudential Insurance Co. of America. “This kind of advice is best delivered by professional investment managers - people who have a close relationship with the plan and its participants.”

In Boehner’s bill, a plan sponsor would have to authorize the plan provider to take on the role of investment adviser. Opponents of the bill argue that providers cannot offer disinterested advice if they stand to earn management fees as a result of the specific advice they give: The advice will be tainted. Moreover, providers would have an incentive, they say, to steer investors to their own products. “It’s a fundamental consumer safeguard to ensure that those offering advice do not have a financial interest in it,” says David Certner, director of federal affairs at the powerful American Association of Retired Persons.

“I’m not sure that disclosure of conflicts is enough, especially in light of Enron,” says Representative Thomas Petri, a Wisconsin Republican who sits on the education subcommittee that worked on Boehner’s bill. Adds Boston-based ERISA attorney Marcia Wagner, “Allowing providers to offer advice would be letting the fox into the chicken coop.”

Certainly, mutual fund companies and other 401(k) providers have a strong inducement to win new freedom to offer investment advice: They would like to cement the relationship they have with the 42 million 401(k) investors whose assets they manage. Currently, providers handle their portfolios at arm’s length, because ERISA prevents them from recommending any services or products. But providers could attract a rash of new assets, or steer customers toward products that generate higher fees, if the law allowed them direct access to employees.

The stakes will only grow bigger. Boston-based consulting firm Cerulli Associates estimates that the $1.7 trillion in today’s 401(k)s could grow to $3.4 trillion in the next five years. Targeting 401(k) account holders becomes even more critical when the employees are about to retire or change jobs, shifting their 401(k)s into rollover IRAs. As baby boomers near retirement, that will happen more often - and with more money on the move. On average, only 17 percent of assets remain with the existing plan provider when 401(k)s are rolled over. One reason for this, industry executives believe, is that providers are restricted from communicating with participants.

Because 401(k)s are often employees’ second most valuable assets after their homes, the financial services industry sees the account as an important portal to becoming their chief money manager. “The 401(k) plan can provide the key to the consumer’s entire wallet,” explains Mark Jones, national sales director for Invesco Retirement, which currently administers about $30 billion in defined contribution assets. Third-party advice firms like Financial Engines (which has 1.9 million participants) and MPower Advisors (which has 1.3 million) are allowed to advise individuals on their other holdings, an opportunity that is whetting the appetites of investment managers and recordkeepers. For the better part of a decade, financial services companies have fought to loosen restrictions on giving advice to plan participants. ERISA allows providers to offer general investment education but prohibits them from giving advice on transactions that could benefit themselves.

Currently, a plan sponsor or an employee can contract with an independent advice firm like Financial Engines or MPower to get an analysis of a particular fund or a comparison to its peers. These advisers can suggest an asset allocation model for the individual participant and recommend a group of funds.

Even without new legislation, a Labor Department advisory opinion issued in December, which followed a request from Los Angeles-based insurance company SunAmerica, will make it easier for some 401(k) investors to get more specific investment advice. The ruling allows financial institutions to make advice available but stipulates that the advice must come from an independent firm. What is more, the ruling allows 401(k) investors to turn over all the investment decisions for their account to that independent adviser.

Boehner’s bill, by contrast, enables providers to offer advice themselves as long as they disclose any potential conflicts of interest. For that reason, financial services companies argue that the Labor Department ruling does not go far enough. “We’re not really interested in the DoL advisory opinion,” says James Spellman, a spokesman for the Securities Industry Association. “But we are very much interested in the Boehner bill.”

Considerable uncertainty surrounds both the DoL’s SunAmerica ruling and the advice bill. The key unanswered questions: To what extent are corporations responsible for the investment advice that is offered to their 401(k) participants? How can companies feel confident that they are acting as responsible fiduciaries and not making themselves vulnerable to a lawsuit? Section 404(c) regulations issued by the Labor Department in 1992 stipulate that plan sponsors cannot be held responsible for their participants’ investment choices, though they remain responsible for the selection of the plan’s investment managers.

Inevitably, several class-action lawsuits by Enron employees against Enron management over its handling of the 401(k) plan revolve around the concept of fiduciary liability. Did the energy company act responsibly to protect the interests of its employees? Or, knowing its troubled financial condition, did the company urge workers to buy stock, for both their 401(k)s and their brokerage accounts, to help prop up its price? Several other high-profile lawsuits, against Global Crossing, Ikon Office Solutions, Lucent Technologies and Nortel Networks Corp., argue that fiduciary responsibility was compromised by 401(k) plans overloaded with company stock.

The Profit-Sharing/401(k) Council of America recently surveyed 141 large plans and found that only 22 percent offer their participants some form of investment advice. Of the rest, 93 percent avoid advice because of concerns about fiduciary liabilities.

“At American Airlines we’re offering education but not advice,” says pension chief Quinn. “The problem with advice is that there’s always the risk of a jury trial finding that you are liable.”

Says Brian Graff, executive director of the American Society of Pension Actuaries, a Washington trade group that represents plan sponsors, pension administrators and actuaries: “Why are people not getting advice when it’s certainly accessible? There’s one explanation: fear.”

The ERISA statute that former president Gerald Ford signed into law in 1974 made no mention of investment advice. At the time, almost all retirement assets were held in defined benefit plans, invested at the direction of plan trustees or sponsors. A decade after the 1981 debut of the 401(k) - named after the section of the Internal Revenue Code that authorized the tax deductibility of plan contributions - most defined-contribution-plan assets were still invested at the discretion of the employer. But by the end of the 1990s, more and more companies were allowing their employees to choose their investment funds.

In the industry jargon, defined contribution plans became more “self-directed.” That was, after all, a central argument for the shift from defined benefit to defined contribution plans - to move the responsibility for the investment risk from the employer to the employee. Employers endorsed and encouraged the trend - in part because defined contribution plans generally impose less of a financial burden on employers than defined benefit plans - but they knew that it carried another risk: They were still on the hook as plan fiduciaries. To clarify the scope of their fiduciary obligations, they requested and received from the Labor Department several clarifications of, and exemptions from, ERISA. In 1992, 404(c) regulations clarified that employers could offer investment education and defined their obligations - offering at least three kinds of funds in their plan, for example.

What constitutes investment education, and how does it differ from investment advice? Several Labor Department regulations have sought to address this critical question. A 1996 interpretive bulletin made it possible for providers to explain the ABCs of asset allocation to their participants and to recommend the general shape of a portfolio. In addition, the regulation pointedly required providers to identify alternative investments with similar risk-and-return profiles to fill out an asset allocation plan.

Then Trust Co. of the West, under the leadership of senior vice president Brian Tarbox, asked the Labor Department for permission to offer advice to its clients’ plan participants. Plan provider TCW proposed that Chicago-based Ibbotson Associates act as the independent third-party adviser; Ibbotson would choose from a group of funds selected by TCW to create model portfolios. In 1997 the Labor Department gave its blessing, but TCW did not act on its own proposal, in part because of problematic computer software.

“It’s the greatest exemption that ever wasn’t,” quips Ray Martin, president of CitiStreet, the retirement services joint venture between Citigroup and State Street Corp. Tarbox, as it happened, moved on to become the consultant who helped SunAmerica craft its request for a Labor Department advisory opinion.

Over the next several years, other plan providers requested and received exemptions that allowed them to offer advice through independent third parties. These providers included Prudential, S&P Retirement Services, Smith Barney and Wells Fargo & Co. Then in the late 1990s, companies like MPower and Financial Engines staked out their market niche, partnering with plan providers or delivering their services directly to plan sponsors and offering independent third-party advice. Financial Engines linked up with CitiStreet, Principal, Charles Schwab Corp. and Vanguard Group; MPower aligned with Putnam Investments and Hewitt Associates, among others.

Plan provider SunAmerica jumped into the fray last June, requesting approval to offer advice. The Bush administration Labor Department had already proved more sympathetic to industry concerns than had the Clinton administration, and the SunAmerica request moved quickly though the system, winning approval on December 14.

Although it stops short of allowing providers to offer direct advice, the ruling represents an important shift in the management of 401(k)s. Most importantly, the Labor Department made its case as an advisory opinion, not as a specific exemption in response to a specific request, as it had in the past. This means that other companies can follow SunAmerica’s lead without requesting special dispensation from the government. Though the SIA disparages the significance of the ruling, David Wray, president of the Profit-Sharing/401(k) Council, offers a different perspective. “Some people believe the impact could be revolutionary,” he says.

Washington-based ERISA attorney Linda Shore explains that the SunAmerica ruling paves the way for readier access to investment advice, largely because providers will be able to roll the charges for advice into their fees. “It’s just easier [to get employers to pay for advice] if it comes as part of bundled services,” says Shore.

SunAmerica proposed two scenarios for offering investment advice to its clients’ plan participants; both involved independent third-party firms, and both were approved by the Labor Department. In one model, participants receive investment choices that they can accept or reject. In the second, SunAmerica’s chosen investment advisory service, Ibbotson, essentially takes over the management of an individual’s 401(k) account. The participant receives and approves an asset allocation model and then meets once each quarter, in person or by phone, with an Ibbotson representative to rebalance the portfolio as needed.

In affirming that arrangement the Labor Department clarified what makes a third-party adviser truly independent. The regulators accepted SunAmerica’s proposal that no more than 5 percent of an advisory firm’s revenues can come from a “related source.” In other words, Ibbotson can receive no more than 5 percent of its revenues from SunAmerica.

SunAmerica’s request presented one novel twist, which opens the door for plan providers to have direct contact for the first time with 401(k) account holders. The insurer proposed that a so-called facilitator - a SunAmerica employee or an unaffiliated broker - collect personal and financial information from plan participants and pass that information along to Ibbotson. The facilitator would follow up with the participants each quarter to check on whether the investors’ circumstances had changed and relay the news to Ibbotson. In so doing, the facilitator would give the provider direct access to 401(k) account holders and a valuable opportunity to make a pitch to manage more of their household assets.

“This removes some of the handcuffs on having a simple dialogue with participants,” says John Doyle, who heads T. Rowe Price Group’s marketing of retirement plan services.

Shortly after issuing this advisory opinion, the Labor Department’s assistant secretary for pension and welfare benefits administration, Ann Combs, took the unusual step of issuing a press release. “While this opinion is an important precedent and will facilitate the provision of investment advice,” the release said, “the Department looks forward to the Senate passing the Retirement Security Advice Act. The legislation would provide participants with access to a broad array of advice services and remove barriers to employers offering advice services.”

Combs had made a preemptive strike. Worried that Boehner’s opponents would argue that advice legislation was unnecessary in the wake of the SunAmerica opinion, she made it clear that the department remains squarely behind the legislative initiative. Only the Boehner bill frees providers to offer advice.

But should that freedom be qualified? Even supporters of the advice bill suggest that Boehner’s proposal may now need to be modified. “We need a higher level of disclosure [of potential conflicts of interest] for 401(k) investors than we have for retail investors,” says the PSCA’s Wray. “It has to be more vivid and repeated more often.” The trade association plans to propose amendments to the Boehner bill, but Wray will not offer any specifics.

If the Democratic-controlled Senate rallies around the Corzine-Boxer proposal for a company-stock cap while the House supports advice and a three-year holding period, the myriad 401(k) provisions would end up in a joint conference committee. Then the real wrangling would begin. In that case, some lobbyists suggest, the Democrats might accept the core of Boehner’s advice bill if Republicans agree to some kind of cap on company stock. No one doubts that the debate will be fierce, especially with midterm elections looming. Says lobbyist Wray, “Emotion levels are so high. Everything is up in the air because of Enron.”

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