Posted by Jason Zweig on Apr 7, 2016 

Image credit: Thomas Cole, “The Voyage of Life: Old Age” (1842), National Gallery of Art

By Jason Zweig  | April 4, 2016 5:30 a.m. ET

New rules aimed at stockbrokers will have enormous impacts on the way Americans save for retirement.

The rules aren’t coming from the government’s financial regulatory apparatus but from the Labor Department. This week, it is expected to release final regulations that will require brokers getting paid to provide investment guidance on a retirement account to act solely in the best interest of the investor.

Brokers’ recommendations to this point have only had to be “suitable”—a less rigorous standard that critics say has encouraged some advisers to charge excessive fees, favor investments that offer hidden commissions and recommend securities that can be difficult for investors to sell.

The shift, more than six years in the making, could cut the total costs of investing by billions of dollars annually. But it also will put the federal government deeper into the business of deciding what Americans should do with their own money.

Investors who now pay commissions when they buy stocks or bonds will likely be moved into accounts where brokers collect up to 1% of their assets every year—a change that will compensate brokers for increasing the size of the account, not selling products. A range of popular but controversial offerings like variable annuities, commodity pools and some real estate investment trusts will likely be de-emphasized for retirement accounts. In their place investors increasingly will be offered low-cost index funds that passively mimic market returns. Moving funds from a 401(k) into an individual retirement account could become cheaper, as brokers comply with requirements that the fees are reasonable and the investment strategy is appropriate. And investors who feel they were wronged will find it easier to sue for breach of contract.

The flip side of those changes is that the money-management industry faces its most sweeping overhaul in a generation. Small firms could be heavily pressured by compliance costs, while some large financial firms could be left better off than before.

Mountains of money hang in the balance. Total assets held in IRAs stood at $7.3 trillion at the end of 2015, an amount roughly equal to the combined gross domestic product of Germany and Japan. An additional $6.7 trillion sits in 401(k)s and similar employer-sponsored retirement plans, estimates the Investment Company Institute, a trade group for fund managers.

Changes aimed at how that money is managed could easily spread into the broader market for financial advice.

“This is the $14 trillion tail that has the potential to wag the dog,” said Bradford Campbell, a former assistant secretary of labor who specializes in employee-benefits law at Drinker Biddle & Reath in Washington.

The standards are widely expected to go into effect before President Barack Obama leaves office in January. At their heart is a fact that still surprises many investors: Most brokers are under no obligation to do what is best for clients. Repeated surveys have found that investors believe—incorrectly—that anyone offering investment advice must put a client’s interests first. Instead, as long as they sell products that can pass muster as suitable, they are generally free to push offerings that earn them the highest fees, even if cheaper alternatives would be better for the investor.

The Labor Department has said it aims to protect retirement savers from expensive or inappropriate investments when they “roll over,” or transfer, assets from a 401(k) or other employer-sponsored retirement plan into an IRA.

That’s because savers in a 401(k) typically don’t pay commissions or fees to a financial adviser. But, until now, an adviser who recommended a rollover from a 401(k) to an IRA has generally been free to collect commissions on such a transfer, often up to 10% of the total money at stake.

Rollovers can raise other conflicts whenever an adviser has a financial incentive to sell his or her own firm’s investment offerings or other products that may generate high fees for the adviser. A 2013 report by the Government Accountabilty Office found that retirement investors considering rollovers are “often subject to biased information and aggressive marketing of IRAs.”

Retirees Stephen and Margaret Rodgers, who live near Hartford, Conn., say they learned that the hard way at the end of 2014 when a local broker advised Mr. Rodgers to roll over his 401(k) into investments including a fund that invested in junk bonds as well as a real-estate investment trust and a business-development company—neither of which traded in the public markets.

Mr. Rodgers said the couple paid commissions of up to 10% and lost at least $75,000 on their total investment of about $885,000, with limited access to much of their money. “They promised us a Rolls-Royce and sold us a Yugo,” said his wife.

In most cases under the new rules, any financial adviser being paid for a 401(k) rollover will have to assert that the fees are reasonable and the investment strategy is appropriate. He or she will also need to disclose potential conflicts of interest and provide a contract committing to serve the client’s best interest before any transactions take place.

The Labor Department has estimated that the rule—which may still change from the version released in 2015—could save investors $4 billion a year. Brokerages and other investment firms dispute that. The Securities Industry and Financial Markets Association, a trade group, estimates in a study done with accounting firm Deloitte LLP that brokerages could have to spend up to $4.7 billion complying with the rule in the first year and an additional $1.1 billion annually thereafter.

“The department woefully underestimated the cost,” said Sifma Chief Executive Kenneth Bentsen, “and that will have to be passed on to the client.”

Others agree the rules could trigger some unintended consequences. With these restrictions putting new pressure on advisers to recommend lower-cost products, the direct costs of investments will probably drop. However, many investors with small account balances, say, $50,000 or less, may end up paying higher annual fees for advice over time than the commissions they traditionally incurred only when buying or selling an asset.

Those higher costs are evident in the economics of the other end of the equation. As Wall Street brokerages remove incentives to sell inappropriate products, they are expected to push advisers to manage their clients’ money for a flat annual fee. Those arrangements will yield at least 60% more revenue than traditional commission-based sales, according to research firm Morningstar Inc.

Giants like Morgan Stanley and Bank of America Corp.’s Merrill Lynch are already moving away from commissions, because fee-based revenue is more stable and less tied to market swings. Morgan Stanley’s wealth-management division, for example, already has 40% of client assets in accounts that charge an annual fee. That helped it generate $8.5 billion in fee-based revenue last year, or 70% of its total.

In January, Morgan Stanley projected a 5% to 13% increase in pretax profitability at its wealth unit in 2017, partly as a result of its continuing shift to fee-based accounts.

The new rules could even change the composition of the stock and bond markets themselves. By mandating that advisers who serve retirement investors must put those clients’ interests ahead of their own, the Labor Department is implicitly pushing advisers into recommending the lowest-cost investments available, industry analysts say. That will accelerate the trillion-dollar migration into index-tracking mutual funds and exchange-traded funds that has been under way for years.

Giant asset managers BlackRock Inc. and Vanguard Group will likely benefit as the rules drive more investors into the low-cost index funds these firms already specialize in. Asset-management companies specializing in more-expensive mutual funds that actively bet on individual stocks or bonds could struggle to compete. That would put an ever-growing share of assets in the hands of index-fund managers.

Life insurers with large exposure to variable annuities are expected to be among the hardest hit, according to a March report by Moody’s Investors Service. Variable annuities are a tax-deferred way of investing in stock and bond funds. Many are sold with guarantees of lifetime income even if the funds perform poorly. They are popular with investors who don’t have traditional pensions to draw on—and with insurance agents and other advisers who like selling them because many issuers pay them upfront commissions of 5% to 7% of the total amount invested.

Many financial firms have resisted the initiative, saying it could reduce options for mom-and-pop investors, and some may sue to block it. Those viewed as most vulnerable are smaller firms that won’t be able to absorb the higher compliance costs, brokerages that rely heavily on commissions and sellers of annuities.

Some brokerages and financial-advisory firms warn they may shed investors with smaller nest eggs as they look to cut costs or eliminate client relationships that could bring regulatory scrutiny. Other firms servicing retirement accounts say they are wary of offering educational material to investors because they fear it could be interpreted as advice and lead to penalties.

Patrick Furey, a 26-year-old wedding photographer from Philadelphia, is looking forward to the changes. He said he wished the tighter rules existed when he started saving eight years ago.

Mr. Furey recently dropped his broker after learning how much fees had reduced his returns. “It shouldn’t be OK for someone in a position of financial trust to sell you something that’s only helping their bonus at the end of the year,” he said.

Source: The Wall Street Journal

http://www.wsj.com/articles/new-government-rule-rewrites-retirement-savings-1459762202