The biggest obstacle for states looking to launch auto-IRAs

In mid-July, President Barack Obama issued a new pension rule directive to the Department of Labor that has likely escaped the attention of advisers focused on the agency’s controversial conflicts-of-interest rule. The July 13 directive ordered the DOL to assist the growing number of states that want to mandate private-sector IRAs or 401(k)-type plans for workers who lack access to an employer-sponsored retirement plan.

Roughly one-third of workers work for companies that do not offer a retirement program. This not only threatens their future financial outlook, it also portends adverse tax-base and social service implications for governments. The Obama administration has unsuccessfully proposed federal legislation to mandate automatic IRA enrollment for these workers.

In the absence of a federal mandate or bipartisan support on Capitol Hill for auto-IRAs, the prospects for passing a new default retirement program in Washington are bleak. As a result, the states are anxious to move forward on their own.

At least 20 states have considered programs or studied the issue, but none have progressed all the way to implementation. A handful have approved programs pending federal clearance: California, Illinois, Oregon and Washington State are awaiting tax and fiduciary guidance from Washington, D.C.

(Opinion: The case for automatic IRAs)

The biggest obstacle for states is the question of whether ERISA would preempt their efforts, given federal responsibility for ERISA-regulated employee benefit plans. While there is a safe harbor regulation in place stating certain conditions that would allow payroll-deduction individual retirement accounts to steer clear of ERISA, aspects of the state plans under consideration call into question whether the existing safe harbor is safe enough for them to move forward. In a nutshell, the states need assurances that their plans would receive preferential tax treatment at the federal level, like 401(k) plans and IRAs.

In addition, some but not all of the states have conditioned approval of their plans on an exemption for participating companies from ERISA’s strict fiduciary standard. As is true under the proposed conflicts-of-interest rule that is currently moving toward implementation, the DOL has consistently asserted its authority to apply prohibited transaction rules under both ERISA and tax laws such as those governing IRAs.

As a result, the president’s new directive may pose a special challenge for policymakers. On the one hand, the DOL requires service providers to ERISA plans, including investment advisers, to fully disclose investment and other costs to plan sponsors and plan participants and avoid conflicts of interest. Plan fiduciaries are obliged to review service agreements to ensure that costs are reasonable and that they serve the best interests of plan participants and beneficiaries.

(Related read: Plan sponsor advocate pushes for exemption in DOL fiduciary rule)

On the other hand, under the White House directive, the DOL is being asked to provide an easy path for states to implement retirement coverage for those who have no ERISA plan available to them. ERISA’s fiduciary standard is tough — often touted as the highest standard under the law — and does not allow plan providers to speed by fiduciary protections for investors.

If the DOL steps aside when it comes to oversight of fiduciary responsibilities for state programs, who will take ultimate responsibility for protecting these worker assets from the perspective of overseeing plan governance? The answer is important because most of the focus at this stage seems to be on eliminating DOL oversight of fiduciary obligations for state plans, not on vesting that oversight role in some other party — whoever that may be — that is ultimately responsible for a state program.

While the fiduciary standard has been criticized as an impediment to potential plan sponsors, the fact is that someone must be held accountable for the rules governing retirement assets, whether it is a state-run IRA program or a modified 401(k) plan outsourced by the state to third-party managers.

Even if the DOL eases or stands clear of fiduciary oversight of state plans, it’s still possible that workers would seek enforcement of ERISA rights in federal court. While the DOL has clout, it doesn’t have the last word on fiduciary status. In 1974, Congress stated that its intent in approving ERISA was to protect participants in employee benefit plans and to establish standards of conduct for fiduciaries of those plans.

A 2007 report by a State of Maryland task force on state liability seemed to bear out this concern, concluding that “it is not legally possible to eliminate the risk of state liability which could occur because of administrative and fiduciary mistakes” in managing a voluntary employee accounts program. However, the report noted that “the risk could be reduced through prudent practices and certain elements of program design.”

In fact, Washington and the states will be exploring entirely new legal territory if they agree on rules reducing fiduciary conduct. This could result in an unfortunate two-tier system where some American workers saving for retirement are afforded fiduciary protection and others are not. The Department of Labor has proven to be a staunch defender of fiduciary protections and may yet be in this instance. Ultimately, it could be the courts that have the last say in the matter.

Blaine F. Aikin is president and chief executive of fi360 Inc.