Invest Retirement

Watch Out for These 3 401(k) Rule Changes

Dayana Yochim  |  August 27, 2020

While you weren’t looking, the DOL proposed some 401(k) rule changes that could expose you to more risk and deny access to certain investments.

While the market was going bonkers and you were doing your best to ignore what was happening in your workplace retirement account, the Department of Labor was busy coming up with new 401(k) rules.

The DOL has proposed 401(k) rule changes to address 1.) whether risky investment products like managed equity are suitable for average retirement savers (the Secretary of Labor believes so), 2.) if plan advisors should be allowed to accept kick-backs from third-party providers (sure!), and 3.) how to determine if socially-responsible mutual funds should be allowed as an investment choice (only based on their financials, not their guiding principles). 

Here’s a closer look at the DOL’s proposals and how they may affect the way you save for retirement. 

Opening up 401(k)s to private equity

First, an explainer. A private equity fund is a type of mutual fund that invests in or outright purchases mainly privately held companies (ones not listed on the stock exchange), or buys a large controlling stake in a publicly traded company. Often the fund’s holdings are highly concentrated in a few companies that may be extremely small, unproven or is a business in financial distress. Then there are the fees, which are typically 2% annually for management, and giving up 20% of gross profits when a company is sold. 

“Private equity is illiquid, opaque and not as regulated as the traditional mutual fund or even a collective investment trust (CIT),” says Jeanne Fisher, managing director of the retirement plan consulting firm, Strategic Retirement Partners (SRP). In other words it’s complex and risky. 

Because of the high-risk, high-fee nature of these funds, private equity is usually only open to wealthy investors or institutions (like pension funds). But soon individual investors may be invited behind the red velvet rope. 

The DOL proposes tweaking the rules about what types of investments are allowed in 401(k) plans as dictated by the Employee Retirement Income Security Act (ERISA). (ERISA protects retirement plan investors from misuse of plan assets.) 

It started paving the way for private equity to enter the 401(k) plan market in an “Information Letter” in early June. The press release announcing the proposed rule change pitches it as a way to “… help Americans saving for retirement gain access to alternative investments that often provide strong returns.”

The proposal has gotten a lot of heat, partly because of the appearance of favoritism toward private equity, says Jeff Cullen, managing partner at SRP. “It’s possible that part of the outcry is due to private equity getting a proverbial ‘seat at the table’ of defined contribution plans when many other alternative type investments — physical real estate, hedge funds, etc. — didn’t.”

Another concern is exposing less sophisticated investors to an alternative investment choice that that may be inappropriate.  

However, if this new 401(k) rule goes through, workers won’t be allowed to invest directly in a private equity fund in a 401(k). Instead you’ll be offered indirect ownership “as part of a professionally managed multi-asset class vehicle structured as a target date, target risk, or balanced fund.” In other words, you’d invest in a target date fund that holds a private equity fund along with a bunch of other investments.

There is precedent for including private equity in retirement accounts — specifically defined benefit plans (aka pensions), says Jim Robison, managing director of Strategic Retirement Partners. And while it could add a layer of diversification and value to a managed portfolio, Robison emphasizes the need for caution and an experienced manager: “Theoretically, the offering itself should go through many levels of review before even being an option to a retirement plan participant.”

The onus for vetting the appropriateness of the investment vehicle falls on the retirement plan consultant and committee, he says. But ultimately, the onus for deciding if it’s an appropriate investment for your retirement portfolio is on you. 

Relaxing the fiduciary rule

There’s a law against giving knowingly crappy financial advice. It’s the fiduciary rule, and it legally requires financial advisors to provide advice that puts the clients’ best interests first. 

Companies that manage 401(k)s have a fiduciary duty to make sure that an employer’s retirement plan offers the best possible investments (lowest fees, best-in-class for investment objective) for participants. They can’t, for example, choose an inferior investment for the plan for the kick-back being offered when another investment at better terms is available. 

The DOL proposal walks back some of the rules about what constitutes sound, unbiased advice under the original fiduciary standard. The new 401(k) rule would subject investment advice providers to “Impartial Conduct Standards” instead. These standards include a “best interest standard, a reasonable compensation standard, and a requirement to make no materially misleading statements” — all of which are open to a wide range of interpretations. 

Some argue that the rule change is an attempt to water down investor protections and leaves the door open for retirement advisors to get kick-backs for recommending certain investment products to clients. Fisher believes that loosening the restrictions will help create balance and give more consumers access to advice. “Ultimately, the average American needs access to financial advice that is 1) as conflict-free as possible and 2) affordable. The original DOL rule was very aggressive towards creating conflict free advice. In doing so, it had the potential to severely limit the number of advisors who could provide that advice,” Fisher says. 

After getting pushback on the proposal, the DOL’s Employee Benefits Security Administration (EBSA) scheduled a public hearing on the fiduciary rule for September 3. 

Adding roadblocks for socially conscious investment options

ESG funds invest with an eye toward supporting companies with an environmental, social and governance mission. And, according to the Secretary of Labor, Eugene Scalia, they should be subject to special scrutiny before being allowed in employer-sponsored retirement plans. “Private employer-sponsored retirement plans are not vehicles for furthering social goals or policy objectives that are not in the financial interest of the plan,” he said in the DOL announcement.

At issue is how ESG funds are evaluated for inclusion in a 401(k) plan. ERISA requires that each investment a plan chooses is appropriate for the risk-adjusted economic (as in bottom line financial) value of serving a specific investment objective. The new 401(k) rule proposal acknowledges that the rules let plan administrators scrutinize the financial factors of ESG funds. But it wants that to be the only criteria used. 

It’s saying that a fund’s non-financial objectives — applying a socially conscientious filter to investment choices — should play no role in the decision whether to include it as a choice in a 401(k). 

That’s a huge blow to retirement savers for whom purpose and profit are equally important. But it tracks. “Ultimately – when constructing the lineup and the funds offered to their employees – they [plan sponsors and consultants] must choose investments based on their quality, not political statements,” Cullen says.

If passed, the new 401(k) rule might not only limit the number of ESG funds being added to the plan, but also remove those that are currently offered in retirement plans. Based on inflows into ESG funds, that’s the exact opposite of what investors want. In 2019, inflows into sustainable funds were four times what they were the previous calendar year, according to fund-tracker Morningstar. In the first half of this year, investors poured another $20.9 billion into ESG managed funds and indexes.

Ultimately, ESG companies may naturally find their way into mutual funds included in 401(k) plans. Environmentally-friendly, sustainable, and governance are becoming the key to future success for many companies, Cullen says. “We are already seeing these key principals naturally woven themselves into existing funds, as portfolio managers recognize how important they are for the long-term success of a company.”

Want to learn more about ESG? We talk all about it on the HerMoney Podcast, in episode 226: How Your Investments Can Impact Change, and episode 175: Investing For Good

Until then, you can choose the mutual funds that align with your personal and financial priorities by using your 401(k) plan has a brokerage window (which gives you access to a wider array of investments). And if your plan doesn’t have a brokerage window, invest how you want in a self-directed IRA.

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