The Best Interest Standard for Retirement Products

Armed with data that suggests Americans lose $17 billion a year from bad advice from financial advisors, brokers and brokerage houses, President Obama is again asking for new laws to protect the people from poor suggestions about retirement investments.

The rules include a so-called best interest standard that brokers must meet before they sell IRAs and 401(k)s. The standard would act as a safeguard, preventing brokers from giving bad advice.

Anyone familiar with the secondary annuity market knows that a “best interest” standard is already in place for the industry – and it works. Although free-market lovers argue that the raised bar for structured settlement and annuity transfers – that is, court approval for most deals – prevents people from doing what they want with their money when they want to do it, there’s no groundswell to change the standard.

When it comes to applying a similar standard to retirement investment, Obama faces a task with multiple hurdles. First, there’s no internal pressure to make any changes to the way business is now conducted. The Labor Department, at whose request Obama appeared before the AARP last week to push the new laws, believes change is needed. But brokers of all sizes are against the change, as are Republicans in both the House and Senate.

Obama’s first effort to get similar regulations through Congress failed in 2010, and critics are already lining up to block his charge again.

Obama Suggests Strict Guidelines to AARP

Obama told AARP last week about his support for the Labor Department’s plan, one that says it will protect retirees from fraud by adding rules for selling retirement products. Specifically, the proposal aims to halt the $17 billion annual bleeding cited by the Council of Economic Advisers by adding stringent guidelines for IRA and 401(k) transactions.

The rules involve oversight on practices that pressure investors to put money in products with higher fees and lower returns, saving money for the more than 40 million families with retirement savings accounts.

“Right now, there are no uniform rules of the road that require retirement advisers to act in the best interests of their clients, and that’s hurting millions of working and middle class families,” Obama said.

Brokers currently have to meet what is known as a suitability standard. This means products must be suitable for consumer needs. The problem arises when a broker has, for example, two suitable products but recommends the one that provides a higher commission. This offering meets the suitability standard, but works to the advantage of the broker.

The Department of Labor’s “best interest standard” provides stricter guidelines for broker recommendations. Specifically, brokers would be required to offer a product based on consumer needs and not on commissions.

For example, brokers motivated by large compensations can mislead people seeking advice about rolling over 401(k)s into IRAs when leaving a job or retiring. They convince investors to take money from low cost retirement savings to high-cost accounts.

The proposal outlines rules reducing conflicts of interest and hidden fees. It suggests a fiduciary standard that would determine services brokers can – and cannot – offer clients.

“It’s a very simple principle: You want to give financial advice, you’ve got to put your client’s interests first,” Obama said. “You can’t have a conflict of interest.”

Critics of the Proposal

Obama’s plan brings plenty of critics to the front. Congressional Republicans and brokerage firms of all sizes fear increased regulation will make financial advice too costly and will push brokers from assisting clients with small portfolios.

“Anyone with less than $50,000 we just wouldn’t be able to serve,” said Dean Harman, managing director of Harman Wealth Management, a private and independent Texas-based advisory firm and a member of the board of the Financial Services Institute. He is only able to serve some limited-asset clients today because they’re young-adult children of current big-portfolio clients.

Fidelity, Wells Fargo, Raymond James and small brokerage houses are among those who would feel the brunt of the proposed changes.

Sen. Orrin G. Hatch (R-Utah), who chairs the Finance Committee, said he plans to work with congressional Republicans to develop legislation preventing these changes. He contends that any proposed changes demand greater evaluation from tax leaders because they involve IRAs, a tax-preferred savings account. He wants the Treasury Department, which is responsible for enforcing tax code, to help shape any proposals.

Critics also worry new rules will conflict with current developments from the Securities and Exchange Commission.

“While concerns about improper actions by investment advisers should certainly be addressed, an overly broad proposal could price professional financial advice beyond the reach of many modest income families,” Financial Services Roundtable President and CEO Tim Pawlenty told The New York Times. “A sledgehammer is not needed where a regular hammer would fix the problem without causing unintended damage.”

The Best Interest Standard in the Secondary Market

A best interest standard already exists for one segment of the financial market – the secondary market for annuities and structured settlements. This unique market – one in which people sell annuities and structured settlements for cash advances – has its own safeguard. In almost every purchase (or transfer) a judge must sign off that the transaction is in the seller’s best interest.

The Structured Settlement Protection Acts and Internal Revenue Code section 5891 require courts to make an assessment of whether a transfer is in a payee’s best interest. If the transfer proceeds without approval, the funding company gets hit with a 40-percent tax.

Generally, this involves the payee appearing in court. (There are some courts that don’t require an appearance to gain approval.) The court then determines if the transfer is appropriate and evaluates the funding company and payee’s claims about the deal. In most states, courts require payees to get advice from an independent financial professional.

Transfers pass the best-interest test if they’re deemed reasonable after the court ponders all relevant circumstances. What circumstances? The court looks at family situations, including number of dependents, income and typical financial demands.

A court can – and will – deny any transfer to protect the payee. Some judges say no to prevent payees from depleting all funds in annuity or structured settlement accounts and turning to public assistance.

Regulations for the Financial Market

These regulations can limit how consumers use and leverage their money, but they also provide a bit of security. Lawmakers developed both standards as a way to reduce the risk of fraud, helping prevent consumers from facing unnecessary financial ruin.

While the secondary market standard reduces instances where consumers complete financially detrimental transactions, it also prevents some consumers from accessing financial assets they already own. The Labor Department’s proposal may limit consumer access to brokers, as it would put a higher price on financial advice and de-incentivize brokers from selling low-commission retirement plans.

These controversial standards have the potential to restrict some investors, preventing them from getting advice or moving forward with the purchase of retirement and investment products.

The White House proposed similar changes to broker regulations in 2010 but was met with strong opposition. It will be months before the Labor Department finalizes its latest proposal.

5 Cited Research Articles

  1. Davis, J. (2015, Feb. 23). Obama seeks new protections for retirement savings in speech to AARP. New York Times. Retrieved from http://www.nytimes.com/2015/02/24/us/with-congress-stalled-obama-seeks-governors-help-to-aid-middle-class.html?_r=0
  2. Walla, G. (2015, Feb. 23). Obama pushes protections for retirement accounts. CNN Money. Retrieved from http://money.cnn.com/2015/02/23/retirement/obama-retirement/
  3. Mason, J. & Lynch, S. (2015, Feb. 23). Obama takes aim at brokers' fees on U.S. retirement accounts. Retrieved from http://www.reuters.com/article/2015/02/23/us-usa-fiduciary-idUSKBN0LR0XR20150223
  4. Ackerman, A. & Damato, K. (2015, Feb. 23). Obama backs new rules for brokers on retirement accounts. Retrieved from http://www.wsj.com/articles/obama-to-back-new-rules-for-brokers-on-retirement-accounts-1424689201
  5. Hindert, D., & Ulman, C. (2005, Spring).Transfers of Structured Settlement Payment Rights. Judge's Journal. Retrieved from http://www.jmwsettlements.com/structured_settlements/Article%20Reprints/JudgesJournalUlmanHindert0605.pdf
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