Outside voices and views for advisers

401(k) advisers under pressure to keep up with due diligence of investment products

Fiduciary concerns under ERISA include cost compression, product development and regulatory pressures

Oct 24, 2017 @ 3:34 pm

By Blaine Aikin

Regulation and market forces are driving rapid evolution of investment products. Costs are coming down, conflicts are coming under closer scrutiny, and competitive pressures – along with shifting investor objectives – are reshaping new product creation.

As a result, pressure is on advisers to keep current with the changing investment product landscape and adjust their due diligence processes to appropriately screen investment options. Retirement advisers are particularly pressured due to fiduciary obligations under the Employee Retirement Income Security Act of 1974 to incur only reasonable costs, avoid or mitigate conflicts of interest, and prudently select investments that serve clients' best interests.

What is considered "reasonable" cost can be a moving target as conditions evolve. Currently, we are in a prolonged period of rapid and sustained cost compression in the mutual fund space. Fund expense ratios have fallen dramatically across the "big three" major asset classes — between 1996 and 2016, the average fund expense ratio for both stock and bond funds fell by over 39%, according to data from the Investment Company Institute. Money-fund expense ratios declined by a whopping 65%.


Cost compression has been particularly intense for index funds. The average equity index fund expense ratio has fallen by two-thirds, from 0.27% in 1996 to just 0.09% in 2016. Exchange-traded funds are comparably priced or even less expensive.

Reasons for the fall in fund prices include improved cost transparency, rising consumer demand for lower-cost funds, and what ICI refers to as the "growing trend [for] investors [to pay] intermediaries for advice and assistance directly out of their pockets rather than indirectly through funds."

The Department of Labor fiduciary rule has been cited as driving or accelerating cost compression. Given how long the decline has been underway, the rule's role seems to be overstated. However, the rule has overtly cited new types and classes of mutual fund shares that levelize (e.g., T shares) or remove ("clean" shares) compensation to advisers as potentially effective methods of managing conflicts of interest.


The market seems more receptive to "clean" versus T shares, most likely due to the trend in investor preferences for direct over indirect forms of compensation, in addition to simplified compliance with fiduciary rules.

While expense ratios of hybrid funds such as target-date funds, which hold a combination of asset classes, also have fallen, they have declined less than has been true of the big three asset classes over the past 20 years.

(More: How to select the right TDF for a 401(k) plan)

Asset flows to TDFs have been booming thanks to their preeminent position as the default fund of choice in defined contribution plans. Retirement advisers should not be complacent in their TDF due diligence. Not only must due diligence address costs, but also conflicts associated with underlying holdings proprietary to the fund provider, the efficacy of a guidepath's assumptions, and the relative merits of TDFs versus other types of default funds.

(More: Fidelity, American Century adopting new TDF fee tactic as cost pressures grow)

Interesting new lifetime income products are becoming available as marketplace demand is shifting with the rising tide of baby boomers hitting retirement age. The DOL is pivoting from what has largely been viewed as a position of ambivalence or hostility to lifetime income products to one of support for innovation in this area.


An August 2015 Government Accountability Office report titled "401(k) Plans: Clearer Regulations Could Help Plan Sponsors Choose Investments for Participants" included a call for the DOL to clarify the use of lifetime income solutions in default investment products, which the DOL has subsequently done. Annuity providers are responding by providing fee-based indexed and variable annuities and fixed-rate deferred annuities with income riders.

In the rapidly expanding and evolving universe of investment products, the traditional steps in performing product due diligence still apply:

• Understand the applicable regulatory and plan governance obligations;

• Periodically evaluate plan and participant needs and objectives;

• Perform objective due diligence on leading product alternatives that are most likely to serve investors' best interests;

• Document the decision-making process; and

• Monitor to make sure the products being used are performing as expected and continue to serve investors' best interests relative to available alternatives.

The current pace and scope of innovation requires fiduciary advisers to be more proactive and flexible about understanding what new products are available and the key attributes that need to be assessed in the decision-making process.

Blaine F. Aikin is executive chairman of fi360 Inc.


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