How Advisors Can Meet 401(k) Rollover Regulations

Today, 401(k) rollovers to individual retirement accounts serve as the main source of new assets under advisory. Advisors now face greater scrutiny to show they are acting in the best interest of their clients.

Against this backdrop, we argue that the dreaded D-word—documentation—should actually be embraced.

With a well-documented process for evaluating alternatives against an investor profile, advisors can go a long way in communicating and executing best-interest advice.

At year-end 2023, Americans had about $13.6 trillion in IRAs This represented 35% of total US retirement assets, according to the Investment Company Institute [PDF]. 401(k)s followed with about $7.4 trillion in assets, or 19% of the pie.

Both of these account types have grown over time, in absolute terms and as a percentage of the overall market. In 2005, IRAs comprised 23% of U.S. retirement assets, while 401(k)s made up about 17%.

Meanwhile, the use of defined benefit plans, or company-run pensions, has declined over the years. Pension plans placed the onus of investment decisions on professionals, but with this shift, individuals have to manage on their own or seek help.

This worries regulators.

Regulations now require advisors to show they’re meeting best-interest standard of care when they recommend rollovers from 401(k)s to IRAs.

The most recent catalyst for this higher standard was a Department of Labor rule that took effect in 2020. The guidance addresses fiduciary requirements for professionals who recommend investments to employer-sponsored plan participants and IRA holders.

The regulation is controversial in that it allows fiduciary advisors to take compensation from mutual fund companies.

But the DOL rule also requires policies and procedures are “prudently designed to ensure compliance with the impartial conduct standards” and “mitigate conflicts of interest.” Advisors must also provide investors with written disclosures explaining why rollover recommendations were in their best interests.

The DOL guidance comes after the Securities and Exchange Commission’s 2019 rule, or Regulation Best Interest. This in turn followed the Department of Labor’s original Fiduciary Rule, which a federal court vacated in 2018.

The regulations aim to solve a long-standing problem. They aim to ensure advisors make recommendations in their clients' best interests without placing the broker-dealer's interests first.

Financial advisors now must substantiate rollover recommendations. This involves some key areas of due diligence:

• Understand the investment options and services associated with a client’s ERISA-covered defined contribution plan, including the plan lineup.
• Evaluate plan fees versus rollover fees.
• Assess the risk-fit and investment quality of the client’s current 401(k), as well as the potential risk-fit and quality of a rollover.
• Compare investment fit, quality and services available in the plan to the proposed fit, quality and services of a rollover.
• Document the value of an advisor's advice in a rollover.

While Regulation Best Interest is not explicit about documentation requirements, most firms will want processes in place to show compliance.

Ultimately, advisors need tools to evaluate the cost, services, and investment options of the employer plan.

They need to show how the rollover may offer more features, flexibility, or potential for advice in order to justify any higher costs.

And for each investment they recommend, advisors also need to consider other investments, or “reasonably available alternatives.”

Broker-dealers shouldn't see new regulations as a burden. Instead, they should consider how the new rules could help them systematize and document investor-first recommendations.

Far beyond checking a compliance box, data and digital innovation can empower financial representatives to personalize client engagements. This is where advisors can build trust and strengthen their competitive advantage by surpassing client expectations.

With Morningstar, advisors can easily document and store each of the steps along the path of the rollover, and more importantly, show the enhanced steps of the process as a value-add for the client.

Here's how it works.

1. Look up a client’s 401(k) or 403(b) plan in Morningstar’s Defined Contribution plan database. Using Morningstar ratings, a professional can assess the investment options available and save the DC plan lineup as part of a client proposal.
2. Make an informed fee assessment across all platforms. When fee data is unavailable, as may be the case for smaller DC plans, Morningstar provides fee-level benchmarks by plan size. Advisors can input more detailed annual and plan-level fees for the current portfolio, as well as any investment-level fees and charges.

Here's a potential talking point for your clients.

3. Measure a client’s risk tolerance and adjust risk profiles as needed.The Morningstar Risk Profiler includes a research-backed risk tolerance questionnaire. Its 20-plus years of history and nearly 2 million completions provide a rigorous statistical basis for verifying the assessment validity.

4. Make an investment proposal that can fit a client’s needs better than current investments or reallocating to other plan options. Morningstar’s investment proposal tool makes it easy to allocate against targets by “looking through” managed investment products to show the real underlying asset allocation and risk level.

4. Check investment recommendations within a portfolio against firm-suggested criteria. In the platform, advisors can consider reasonably available alternatives in context and add notes for investment recommendations.

Here's how to talk about it with clients.

5. Demonstrate the potential value of a rollover with the Best Interest Scorecard. Using bar graphs and charts, it assesses each in terms of investment quality, fee amounts, client fit, and service value. It also provides a quantifiable assessment of the value provided by the rollover versus the 401(k) or hypothetical reallocation within the qualified plan.

6. Substantiate the rollover proposal with detailed, FINRA-reviewed reports. In Advisor Workstation, advisors can quickly create including fee disclosure reports, DC plan details, and portfolio comparisons.

One last potential talking point.

Forward-thinking advisors and institutions will understand that all of these financial tools at their disposal give them an opportunity to demonstrate the value that they're bringing to the relationship.

This is especially true for 401(k) rollovers, a critical source of new assets.

Yes, Reg BI and the new DOL rule layered on new formalized regulatory requirements to ensure rollovers are in a client’s best interests.

But with the right tool set, approach, and process, these changes can be something you can pitch as benefits, and building trust with clients along the way.