Back to the Future? Advisory M&A and Monetization of the Participant Relationship
By Rick Rodgers, AIFA® and Wendy Dominguez, MBA
The defined contribution (DC) retirement plan is now more than 40 years old. There have been many material changes throughout its evolution, most of which have been beneficial to 401(a), 401(k), 403(b) and 457 plan participants. Sadly, several recent developments related to the DC plan industry appear to be headed back to a practice that plan fiduciaries and their independent consultants fought hard to escape – monetization of plan assets and participants.
Most DC plans are administered by insurance and mutual fund companies that maintain recordkeeping platforms in conjunction with managing and distributing proprietary investment products. That was the case many years ago and it largely remains that way today. During the 1980s and 1990s – rather formative years for DC plans and providers – revenue sharing and other forms of indirect compensation were often hidden or misunderstood. Many plan sponsors thought of recordkeeping and administrative services as “free” due to that lack of fee transparency. It was also commonplace to find investment menus limited to proprietary investment products, often with high fees and poor performance relative to peers in similar asset classes.
These arrangements provided substantial sources of revenue to the providers, but raise questions about the objectivity of the investment selection process. Many fiduciary advisors and consulting firms have since emerged to address these conflicts.
During the past 20 or so years, spurred by the rollout of newly-required fee disclosures, the industry has moved to an open architecture format that has largely diminished the utilization of proprietary investment products. Open architecture supports thorough due diligence, best-in-class investment selection, and much lower fee and expense profiles. For plan sponsors and the participants they support, this has been a positive change. But the resulting fee compression led many recordkeeping providers to seek other avenues to monetize plan assets, the most prominent being managed account services.
Managed accounts are essentially administered by robo-advisors – investment advice derived by an algorithm applied to a set of input data, typically focused on time horizon and risk tolerance. While data may also allow for inclusion of assets outside of the participant’s retirement plan – perhaps a spouse’s savings and investment information, as an example – this data is rarely input by the participants using these services. The algorithm delivers an asset allocation model and fund recommendations utilizing funds available in the plan’s core investment menu, typically for a fee of 0.35% - 1.00% added to the investment management fees charged by the underlying mutual fund companies.
Managed account services are often sold to participants as a professionally managed portfolio solution that is superior to target date funds. The asset allocation advice, however, is frequently similar to that of the median glide path of target date funds with much lower expense.
This cost/benefit disparity is garnering the attention of plaintiff’s attorneys – managed account services are being challenged in the Guyes v. Nestle USA lawsuit (1) as one noteworthy example. We have also reviewed several prospective client fee disclosures and compliance forms where the vendor’s income from managed accounts out-paced their income from recordkeeping fees. The necessity for this service and the reasonableness of fees is being contested in several fiduciary breach cases, including Reichert v. Juniper (2).
There seemed, briefly, to be a consensus among fiduciary consultants to push back on managed account solicitation and question the reasonableness of the fees…at least, until recently. Despite many fiduciary advisors rightfully criticizing opaque and unfair arrangements related to revenue sharing and the recent push to distribute managed account services, several of these same advisors are now recommending “advisor-managed” account services. These are similar to traditional managed accounts, except the portfolios are created by the consultant rather than a computer algorithm. Many recordkeeping providers have created platforms allowing the consultant to receive asset-based compensation, thereby granting both the consultant and the recordkeeper an opportunity to monetize participant assets. Here again, such conflicted advice can be lucrative – compensation to the “fiduciary advisory” for managed accounts can surpass their consulting fee revenue from the plan.
Not coincidentally, the retirement plan advisor/consultant industry is seeing a dramatic increase in merger and acquisition of these firms. Large aggregator advisory firms, wire houses, and insurance companies have been acquiring firms of all sizes at an alarming rate. Some are backed by private equity capital and the multiples being paid for firms have been quite substantial. The profitability potential of these new arrangements will be dependent upon the ability to monetize participant assets. Firms are already beginning to engage in a series of sales and marketing practices to ensure they meet their investors’ expectations.
Some consulting firms have also created proprietary investment products and wealth management services to market to participants, creating further opportunities to monetize participant assets. Fiduciary investment consultants creating proprietary investment products and recommending them to their clients seems to be a clear conflict of interest and, potentially, self-dealing.
Fiduciary breach lawsuits have already been filed asserting these accusations, as well. In Lauderdale v. NFP Retirement (3), plaintiffs allege that the consultant breached its fiduciary duties in the provision of advice concerning flexPATH target date funds, offered through a related company.
Likewise, in Reetz v. Lowes (4), the plan’s consultant (Aon) recommended its own proprietary equity fund. Lowes settled for a reported $12.5 million even as Aon continued to fight the complaint. Earlier this year, a judge dismissed the charges against Aon, explaining that it did not violate ERISA in cross-selling its proprietary investment products, instead asserting that Lowes is a large, sophisticated corporation and is responsible for independently deciding to engage. The outcome seems extremely unfair and unfortunate for the plan sponsor, who not only paid a large settlement but had ostensibly trusted their fiduciary advisor for objective guidance and advice.
In light of these developments, it does feel like we’re taking a step backward. Back to arrangements fraught with conflicts of interest and the potential for increased liability for plan sponsors. Given the recently settled and outstanding litigation related to advisor cross-selling, it seems imprudent for plan sponsors to engage in practices that may increase liability.
Innovest is different. We are committed to serving as a steward to our clients – advocating on their behalf and always delivering objective, conflict-free advice. We have not engaged in the distribution of proprietary investment products or advisor managed accounts, nor will we. We see these practices as being in direct conflict with our commitment to serving the best interests of our clients.