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Rollover Regulation and How Advisors Can Serve Their Clients’ Best Interest

Read Time: 6 Minutes

Rollovers are the lifeblood of growing assets for any financial advisor—and regulators have taken notice. With 401(k) rollovers to individual retirement accounts serving as the main source of new assets, advisors now face greater scrutiny to show they are acting in the best interest of their clients.

IRAs are getting increasing attention by regulators given the rapid growth in IRA assets over the years. About $12.2 trillion of U.S. retirement assets were in IRAs at year-end 2020, representing 35% of the $34.9 trillion in U.S. retirement assets, according to the Investment Company Institute. 401(k)s ranked second, with about $6.7 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. Fifteen years ago, IRAs comprised 23% of U.S. retirement assets, while 401(k)s made up about 17%.

Meanwhile, over the years, the use of defined benefit plans—or company-run pensions—has declined. Pension plans left the onus of investment decisions to professionals, but with this shift toward IRAs and 401(k)s, it’s up to the individual to manage on their own or proactively seek help.

This worries regulators. Regulations now require advisors to show they are meeting best-interest standard of care for recommendations of rollovers from 401(k)s and other retirement plans to an IRA. The most recent catalyst for this higher standard was a Department of Labor’s rule that took effect in February. The guidance, “Prohibited Transaction Exemption 2020-02—Improving Investment Advice for Workers & Retirees,” addresses fiduciary requirements under the Employee Retirement Income Security Act (ERISA) for professionals who recommend investments to participants in 401(k) or other employer sponsored plans 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 include written disclosure to retirement investors of the reasons that a rollover recommendation was in their best interest.

The DOL guidance comes after the Securities and Exchange Commission’s 2019 rule, “Regulation Best Interest: The Broker-Dealer Standard of Conduct,” or Reg BI, which took effect on June 30, 2020. (This in turn was a follow-up to the Department of Labor’s original Fiduciary Rule, which was vacated by a federal court in 2018.)

The regulations aim to solve a long-standing problem for policymakers as DB plans phase out: ensuring Main Street investors have access to unbiased and effective advice for their retirement savings. Their intent is to ensure advisors are acting in the best interest of the retail customers when a recommendation is made, without placing the financial or other interests of the broker-dealer ahead of the interest of that customer.

With respect to rollovers, financial professionals must evaluate how they advise customers and demonstrate that a particular transfer of assets is in the best interest of the client. They must show how the benefit of a rollover may in part be due to the value of advice or asset-allocation recommendations that match a client’s goals. For the DOL rule, proof of this value must explicitly lie in the documentation, and while Regulation Best Interest is not explicit about documentation requirements, most firms will want documentation processes in place to demonstrate compliance.

Strong Technology Platforms Can Help Brokers Gain an Edge

Ultimately, advisors need tools to help evaluate the cost, services and investment options of the employer plan against the value of putting the assets into an IRA. Or how a variable annuity would be more appropriate. They need to show how the rollover may offer more features or flexibility and potential for advice in order to justify any higher costs. And for each investment they recommend, advisors also need to consider other investments they could recommend (known in Reg BI as “reasonably available alternatives”).

Against this backdrop, we argue that the dreaded D-word, short for documentation, should actually be embraced. With a technology-enabled, well-documented process for the evaluation of alternatives and consideration against the investor profile, advisors can go a long way in communicating and executing best interest advice. In fact, finding technology solution providers that are investor-centric and tailored to support the DOL rule’s obligations is crucial to setting themselves up for success.

But rather than seeing this as a regulatory check-the-box burden, brokers should instead consider how the new rules could help them systematize and document investor-first recommendations and empower their financial representatives to lean into more personalized client engagements. Data and digital innovation are an effective way to do this, far beyond the enforcement of regulations. This is where advisors can build trust and strengthen their competitive advantage by surpassing client expectations.

With rollovers, financial advisors now must substantiate a recommendation to roll over funds from an employer-sponsored plan to an IRA. 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 not only the risk-fit and investment quality of the client’s current 401(k), but also the potential risk -it and quality that could be achieved by reallocating the 401(k)
  • Comparing investment fit, quality and services available in the plan to the proposed fit, quality and services of a rollover

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

For example, advisors can look up a client’s 401(k) or 403(b) plan from Morningstar’s DC plan database. Using Morningstar ratings, a professional can assess the investment options available, and save the DC plan lineup as part of a proposal to the client. The advisor can then use the software to 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 and further allows the advisor to input more detailed annual and plan-level fees for the current portfolio, as well as any investment-level fees and charges.Advisor’s talking point: “As part of my rollover proposal, I’ve studied your 401(k), including the quality of the other options available in the plan and the fees they charge you.”

Morningstar Profiler

Along the way, financial software should make it easy to demonstrate and document how a proposal fits a client’s needs. For example, the Morningstar Profiler, which includes a psychometric risk tolerance assessment—FinaMetrica—helps advisors measure a client’s risk tolerance, adjust risk profiles as needed, and set a compatible target allocation for the proposal. In fact, the FinaMetrica assessment has been ranked as the most defensible risk-profiling solution by independent fintech expert and Inside Information publisher Bob Veres because its 20-plus years of history and nearly 2 million completions provide a rigorous statistical basis for verifying the assessment validity.

Advisor’s talking point: “I’m including a psychometric risk-tolerance assessment so we both can better understand the level of risk you’d be comfortable taking to reach your goal. This will help me make a proposal that is more personalized to you.”Advisors must then 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, and further allows advisors to check investment recommendations within a portfolio against firm-suggested criteria, consider reasonably available alternatives in context, and add notes for any or all investment recommendations as needed.

Morningstar Portfolio Risk Score

In Fall 2021, Morningstar will be adding the Morningstar Portfolio Risk Score to its proposal tool, further allowing advisors to demonstrate portfolio compatibility with client needs. Backed by the Morningstar Target Allocation index family, the Portfolio Risk Score helps advisors see where a current or proposed portfolio lands relative to category benchmarks across the risk profile spectrum from conservative to aggressive. When paired with the Morningstar Profiler’s FinaMetrica risk tolerance test, the Portfolio Risk Score also outputs a Risk Comfort range for the client, serving as another effective tool for meeting the care obligation for rollovers.

Advisor’s talking point: “I’m able to see how your 401(k) is currently positioned, and whether it’s a good fit for you based on your risk tolerance test. In making a proposed portfolio for you, I’m not only looking at risk fit, but also finding the best individual investments I can.”

Software should also be able to easily capture the services offered by a DC plan and compare them with the proposed rollover-related package. Morningstar’s software allows for easy comparison of advice services being offered under the proposed plan versus the DC plan, and further can quantify the value of each service for the life stage of the client.

Advisor’s talking point: “We want to ensure you get everything you need for your life stage by rolling over. I will consider and quantify what services you are or could be taking advantage of in your 401(k) and comparing that with what we can offer you.”

Best Interest Scorecard

The advisor can then use Morningstar’s Best Interest Scorecard to demonstrate the potential value of a rollover. The scorecard includes the current 401(k), a quantitatively derived hypothetical portfolio that could be constructed with plan options, and the proposed portfolio. 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.

Advisor’s talking point: “A rollover is a big decision. Before we move any money, I run an independent scorecard to make sure it’s the right thing to do for you. That scorecard looks not only at your current 401(k) and the plan services you’re currently using, but also considers other services and investments you could be using in your plan.”

Each step of the way, advisors can substantiate the rollover proposal with detailed, FINRA-reviewed reports, including fee disclosure reports, DC plan details, and portfolio comparisons.

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.