401(K) Plans: Improved Regulation Could Better Protect Participants from Conflicts of Interest
Released: 2011-02-28T00:00:00

Letter

Background

In contrast to workers in a traditional defined benefit (DB) plan, workers in a 401(k) plan, the predominant type of defined contribution (DC) plan in the United States, have more control over their retirement assets, but also bear greater responsibility and risk in the investment of assets. In a typical 401(k) plan, workers decide whether or not to make contributions into an individual account. Contributions may also be made by their employer. Participants direct these contributions to mutual funds and other financial market investments to accumulate pension benefits, dependent on investment returns net of fees. As we reported in 2006, investment fees are usually paid by participants and administrative fees are often paid by employers, but participants bear them in a growing number of plans. Depending on contributions and net investment returns, participants accumulate an account balance that will then be withdrawn at or after retirement. Over the last decade, participation in DC plans among all private industry employees has increased from 36 percent in 1999 to 43 percent in 2008. In 2008, about 49.8 million workers actively participated in a 401(k) plan.

The degree of responsibility and risk borne by workers in 401(k) plans underscores the need for prudent investment decisions if these plans are to provide an adequate source of income in retirement. Poor investment decisions—either by the plan sponsors when they decide which investment options to offer in the plans, or by participants when, given these options, they decide where to invest their assets—can result in lower returns and correspondingly less retirement savings. Several studies have found that, from 1988 to 2006, DC plans underperformed DB plans by 1 percentage point or more, which may be explained by higher fees in 401(k) plans and a lack of diversification in participants’ investment allocations. Numerous studies on financial literacy have also pointed to the need to educate participants to improve their investment decision-making and savings outcomes. For example, one study found that a large percentage of American workers have not conducted meaningful retirement planning, even when retirement is in the near future. Another study found that most workers acknowledge they do not know as much as they should about retirement planning and that many workers actually guessed at their retirement savings needs.

To address the challenges of investment risk in 401(k) plans, both plan sponsors and participants may seek assistance from service providers in selecting investment options. At the plan sponsor level, many plans rely heavily on the expertise and guidance of their advisers when making investment decisions. The service providers that offer these advisory services to plan sponsors can vary considerably in their business arrangements. While some service providers operate as independent, “fee- only” advisers, who are compensated solely by their clients and do not receive additional compensation contingent on the purchase or sale of a financial product, other service providers offer affiliated services, including brokerage and money management, in addition to advisory services. As shown in figure 1, service providers can be used to provide a number of services necessary to operate a 401(k) plan, which can be bundled or unbundled with investment management services or advisory services. Under a bundled service arrangement, the plan sponsor hires a company that provides multiple services directly or through subcontracts.

At the participant level, advisory services can also be provided through a variety of methods, including call centers or help desks, group seminars, one-on-one sessions, computer models (e.g., software that estimates future retirement income needs or asset allocation models), or brochures and other printed materials provided by plan service providers. When providing this assistance to participants, a service provider may furnish either investment education or investment advice. As specified by EBSA, investment education consists of general investment information, including general information about the plan and asset allocation models that is not tailored to the needs or interests of an individual plan participant (see table 1). Investment advice, on the other hand, consists of one or more individualized investment recommendations tailored to a participant’s particular investment needs.

While plan sponsors and participants may rely on service providers for assistance in making investment decisions, concerns have been raised about the independence of the advice provided in some cases. A 2005 SEC report noted that its examination of investment advisers providing pension consultant services found that many such consultants provide services to both plans and money managers, a situation that has the potential to compromise the objectivity of the consultant’s recommendations to the plan. Namely, the report states that concerns exist that consultants may steer plans to hire certain money managers or other vendors based on the consultant’s (or an affiliate’s) other business relationships and receipt of fees from these firms, rather than because the money manager is best suited to the plan’s needs. As we reported in 2007, no complete information exists about the presence of conflicts of interest at pension plan service providers. However, the 2005 SEC examination of the activities of 24 pension consultants from 2002 through 2003 revealed that 13 out of 24 of the service providers examined failed to disclose significant ongoing conflicts of interest, such as affiliated businesses or compensation received from money managers.

Regulation of Investment Advice

Investment advice provided to plan sponsors and participants and any related conflicts of interest are regulated under ERISA. ERISA states that a person who renders investment advice for a fee or other compensation, direct or indirect, with respect to any moneys or property of a plan or has any authority or responsibility to do so is a fiduciary and thus is subject to fiduciary standards outlined in the law and regulations. This statutory definition of fiduciary for investment advice is currently subject to a five- part test, set forth in regulations, each element of which must be met for an individual to be considered a fiduciary. Specifically, under this test, a consultant or adviser is determined to be providing investment advice only if the advice was provided for a fee either direct or indirect, and the advice was provided 1. as to the value of securities or other property or as to the advisability of investing in, purchasing, or selling securities or other property; 2. on a regular basis; 3. pursuant to a mutual agreement, arrangement, or understanding; 4. as a primary basis for investment decisions; and 5. based on the particular needs of the plan.

Although plan sponsors often rely on consultants and other service providers to assist them in asset management, which includes selecting money managers and monitoring money managers’ performance and brokerage transactions, not all of these consultants and service providers are at all times fiduciaries under ERISA based on the application of the five-part test.

For plan sponsors and other service providers who are fiduciaries, ERISA requires they discharge duties solely in the interest of the participants and beneficiaries with care, skill, prudence, and diligence. Although ERISA generally prohibits fiduciaries from acting on conflicts of interest, certain transactions are strictly precluded under prohibited transaction rules, regardless of whether or not participants are harmed. In particular, prohibited transaction rules preclude fiduciaries from “self-dealing,” which includes an individual dealing with plan assets for his or her own benefit. In addition, EBSA has explained that ERISA obligates fiduciaries to obtain and consider information relating to the cost of plan services and potential conflicts of interest presented by such service arrangements.

EBSA is responsible for enforcing these provisions of Title I of ERISA, as well as educating and assisting plan participants, beneficiaries, and plan sponsors. Fiduciaries that breach their plan duties are personally liable for making up losses to the plan and restoring any profits made through the use of plan assets. In addition, they may face removal as plan fiduciaries. Participants may also seek recovery against nonfiduciaries in certain circumstances. In addition to carrying out its enforcement responsibilities, EBSA assists regulated parties in complying with ERISA by issuing technical guidance, including advisory opinions and interpretive bulletins, and educating plan participants, beneficiaries, and plan sponsors.

Securities Laws

In addition to being regulated by ERISA, investment advice and conflicts of interest are also regulated under securities laws. SEC regulates certain money managers and pension consultants under the Investment Advisers Act of 1940 (Advisers Act), which requires those firms meeting certain criteria to register with the commission as investment advisers. For these registered investment advisers, SEC requires that they disclose information about affiliations, business interests, and compensation arrangements to their advisory clients, primarily by providing a brochure that meets the requirements of Part 2 of SEC’s Form ADV to new and prospective clients. In addition, registered investment advisers must annually deliver either an updated brochure with a summary of material changes or a summary of material changes and offer to provide an updated copy of the brochure. According to SEC, all investment advisers— whether registered with SEC or not—have a fiduciary obligation under the Advisers Act to avoid conflicts of interest and, at a minimum, make full disclosure of material conflicts of interest to their clients. When an adviser fails to disclose information regarding material conflicts of interest, clients are unable to make informed decisions about entering into or continuing the advisory relationship. Failure to act in accordance with requirements under the Advisers Act may constitute a violation. If SEC becomes aware of conflicts of interest that are inadequately disclosed or pose harm to investors, it can take enforcement action against the service provider.

SEC also regulates broker-dealers under the Securities Exchange Act of 1934 (Exchange Act), which requires that broker-dealers register with SEC, unless an exception or exemption applies. In addition, broker-dealers that deal with the public must become members of the Financial Industry Regulatory Authority, Inc. (FINRA). Under the anti-fraud provisions of the federal securities laws, including just and equitable principles of trade, broker-dealers are required to deal fairly with their customers. Salespersons of broker-dealers are subject to licensing requirements, including examinations. Broker-dealers are held to a suitability standard when rendering investment recommendations. When a broker-dealer makes a recommendation to buy, exchange, or sell a security to a retail investor, that broker-dealer must recommend only those securities that the broker reasonably believes are suitable for the customer. In addition, a broker-dealer must disclose all material information regarding the security and the recommendation, including, among other things, any material adverse facts or material conflicts of interest. However, according to FINRA staff, up-front general disclosure of a broker-dealer’s business activities and relationships that may cause conflicts of interest with retail customers is not required. SEC staff has noted that, in practice, with broker-dealers, required disclosures of conflicts have been more limited than with investment advisers and apply at different points in the relationship. Table 2 provides a comparison of the standards of conduct required by ERISA, and those required of investment advisers and broker- dealers.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd- Frank), signed into law on July 21, 2010, includes provisions that amend the Advisers Act and the Exchange Act that affect investment advisers and broker-dealers. Under these provisions, SEC, among other things, conducted a 6-month study on the effectiveness of existing standards of care for broker-dealers and investment advisers and examined whether there are legal and regulatory gaps, shortcomings, or overlaps in legal or regulatory standards in the protection of retail customers. Based on its review, SEC staff recommended that SEC propose rules that apply a uniform standard of conduct which requires broker-dealers and investment advisers, when providing personalized investment advice to retail customers, to act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser. SEC staff also recommended that SEC should facilitate the provision of uniform, simple and clear disclosures to retail customers about the terms of their relationships with broker-dealers and investment advisers, including any material conflicts of interest.

Service Providers May Have Conflicts of Interest in Providing Investment Assistance to Plan Sponsors because of Third- Party Payments and Other Business Arrangements

Service Providers’ Business Arrangements May Create Conflicts of Interest in Investment Assistance Provided to Plan Sponsors

Several industry experts we spoke with cited third-party payments, also known as revenue sharing, as a potential conflict of interest for service providers involved in the fund selection process for a 401(k) plan. Revenue sharing, in the pension plan industry, generally refers to indirect payments made from one service provider, such as the investment fund provider, to another service provider in connection with services provided to the plan, rather than payments made directly by the plan sponsor for plan services. According to industry experts, revenue sharing is a widespread practice among 401(k) service providers. As we have previously reported, revenue-sharing payments can be used to offset expenses the plan has agreed to pay and thus be cost-neutral to the plan. However, as shown in figure 2, revenue sharing may, depending on the circumstances, also create a conflict of interest if it is not structured to be cost-neutral to the plan and may result in increased compensation to service providers. Industry experts we spoke with explained that this situation creates an incentive for the service provider to suggest funds with higher revenue-sharing payments. Because of these conflicts of interest, the service provider may suggest funds that have poorer performance or higher costs for participants compared with other available funds. The amount of revenue-sharing payments can vary considerably, both across investment funds and within a fund through different share classes. Documentation we obtained showed revenue- sharing payments from hundreds of share classes of different investment funds that ranged from 5 to 125 basis points (bps). Given this variation, EBSA field investigators told us that a service provider might only recommend or include fund share classes that pay higher revenue sharing and exclude other fund share classes that pay lower or no revenue sharing.

As described in table 3, revenue sharing can include various forms of payments, such as 12b-1 fees, that may create conflicts of interest for service providers assisting with the selection of investment options for a 401(k) plan.

Besides creating a potential conflict of interest, using revenue sharing to reimburse for record-keeping expenses can have other adverse effects on the plan and participants. Service providers told us these payments are often not clearly disclosed to the plan. As shown in figure 3, this could result in participants paying a greater or lesser share of record-keeping expenses depending on which funds they choose to invest their assets. Further, because subtransfer agent fees are based on the amount of assets under management, the record-keeping costs increase as the fund grows and may get quite large if not revised. According to one service provider we interviewed, these fees can result in the plan continuing to pay more for record-keeping services as assets grow, although the cost of providing record-keeping services tends to remain the same.

In addition to revenue-sharing payments from fund companies, payments from brokerage firms, which execute trades for participants’ investment funds, to other service providers can also create conflicts of interest related to a 401(k) plan’s investments. For example, in a 2007 SEC case, an investment adviser was alleged to have advised its pension plan clients, including 401(k) plans, to use a specific brokerage firm under certain circumstances. The brokerage firm allegedly paid the service provider annual compensation based in part on the amount of commissions generated, which the adviser failed to disclose to its pension plan clients although the adviser was required to do so. The contingent compensation from the brokerage firm to the investment adviser created an incentive for the service provider to steer plans to use that particular brokerage firm.

In other cases, industry experts told us that, at the request of an investment adviser, brokerage firms can use commission revenues from trading shares to make payments to other service providers that can create conflicts of interests if not handled properly. Under the Securities Exchange Act of 1934, investment advisers are permitted to pay broker- dealers more than the lowest available commission rate for trading shares under certain circumstances. The investment adviser can direct the broker-dealer to use the commission revenues to pay the fees of other service providers or to purchase services of value to investors, such as investment research to improve the management of the fund. However, if the commission revenues are not used for the benefit of the plan, it could create a conflict of interest. A 2005 SEC report concerning examinations of pension consultants identifies several areas of concern and examples of poorly managed conflicts of interest. For example, Using commission revenues to pay for another service provider’s fees, (i.e., a “commission recapture” arrangement) such as for a pension consultant, can result in greater compensation to that service provider, because such arrangements may not be capped to terminate when fees due to the service provider have been paid in full, resulting in the plan overpaying for services.

These arrangements are not always well documented and raise concerns that plans may not receive “best execution,” meaning that the plan’s service provider may recommend that the plan use a broker-dealer with whom it has such an arrangement even if the broker-dealer does not offer the most favorable terms for the plan.

These arrangements can also create the incentive for the service provider to recommend a more active trading strategy to increase the number of transactions and, consequently, the amount of commissions.

Other Business Arrangements That May Create Conflicts of Interest

In addition to payments among service providers, other types of business arrangements can also create conflicts of interest. As shown in table 4, service providers may have affiliated businesses, such as proprietary investment funds or a brokerage arm, that can profit from the investment of plan assets. For example, a service provider that offers its own investment funds has the incentive to steer plan sponsors to select these proprietary funds even if other funds are available from different providers that better suit the needs of the plan.

Many Service Providers Are Reported to Arrange Their Association with Plan Sponsors in a Manner That Avoids ERISA Fiduciary Responsibility

Although service providers that are subject to ERISA fiduciary standards are prohibited from benefiting from the investment of plan assets, many service providers that assist in selecting investment options are reported to structure their relationships with plans to avoid being subject to these standards. Under ERISA, a person who provides investment advice for direct or indirect compensation is a fiduciary; however, the EBSA regulations currently in effect establish a five-part test, each part of which must be met, to determine if a service provider is a fiduciary for purposes of providing investment advice. Many industry experts we spoke with said that service providers often do not meet one or more parts of the test and thus avoid being subject to ERISA fiduciary standards. Consequently, these service providers may have a conflict of interest by increasing their compensation based on the funds selected by the plan without violating ERISA. Service providers may structure their association with a 401(k) plan to avoid meeting one or more parts of the current five-part test, as shown in figure 4. For example, an ERISA attorney said that although service providers give investment recommendations, they will include a provision in their contract that states that the investment recommendations provided are not intended to be the primary basis for decision making. A recent report by Labor’s OIG found that some service providers included in their review and identified to have significant undisclosed conflicts of interest attempted to avoid meeting the criteria for ERISA fiduciary status under the current five-part test by simply stating in their investment adviser contract that they were not fiduciaries. The 2010 report examined EBSA’s handling of certain service providers, acting as pension consultants, that were determined by SEC in a 2005 staff report to have significant undisclosed conflicts of interest. According to the SEC report, many plan sponsors rely heavily on these pension consultants in making investment decisions. Other industry experts said that a service provider can avoid meeting the criteria of the five-part test if it offers investment recommendations as part of setting up the plan, rather than on a regular, recurring basis (see table 5). According to EBSA officials, it can easily be asserted by a service provider that advice given on a onetime basis does not meet the five-part test.

When selecting investment options for the plan, plan sponsors can work with various types of service providers subject to different regulations, some of which may not be required to provide advice in the best interest of the plan or disclose conflicts of interest. Several industry experts we interviewed said that while some plan sponsors hire registered investment advisers (RIA) who are subject to SEC regulations and often acknowledge ERISA fiduciary responsibility, many other plan sponsors work with broker-dealer or insurance company representatives who are not subject to ERISA fiduciary responsibility and may also not be subject to SEC regulations. Under the Advisers Act, RIAs must seek to avoid conflicts of interest and, at a minimum, make full disclosure of material conflicts of interest. However, other service providers, such as insurance company representatives, may not be subject to ERISA fiduciary duty or certain SEC regulations and thus may not be required to make recommendations in the best interest of their clients, or to disclose all conflicts of interest. Furthermore, plan sponsors may contract directly with a bundled service provider that offers its own investment funds and does not provide formal investment advice subject to ERISA or SEC regulations.

No comprehensive data are available to determine how many service providers are ERISA fiduciaries for purposes of providing investment advice. Although plan sponsors are required to provide certain information about the plan and service providers in annual filings to EBSA, this information does not include which service providers are acting as ERISA fiduciaries. As we previously reported, ERISA requires that at least one fiduciary be named in the plan documents provided to participants, although others may be identified voluntarily. Consequently, determinations as to ERISA fiduciary status of service providers may not be made unless an investigation by EBSA is initiated or a lawsuit is filed claiming that the plan has been harmed. Misunderstanding can also occur because many large providers offer a range of services that a sponsor can choose from, including some that involve fiduciary duties and others that may not.

Despite reports indicating that many service providers are not acting as ERISA fiduciaries in providing investment assistance, industry experts and EBSA field investigators told us that plan sponsors are often not aware when a service provider is not an ERISA fiduciary and often assume the advice they receive from them is subject to these standards. Consequently, plan sponsors may not be aware that service providers can have a financial incentive to recommend certain funds that would be prohibited if they were ERISA fiduciaries. As we previously reported, plan sponsors may also assume they have delegated all of their fiduciary duties to an outside professional hired to run the plan, even though the sponsor always retains some fiduciary obligation. Several industry experts we spoke with, including EBSA field investigators, indicated that there is a considerable amount of confusion among plan sponsors about whether or not they are receiving investment advice subject to ERISA fiduciary standards. For example, unless disclosed on the schedule A of the annual form 5500, they noted that, in their opinion, plan sponsors are generally not aware, when dealing with service providers who are broker-dealers or insurance company representatives, that the providers are not giving formal investment advice subject to ERISA fiduciary standards and thus may be earning sales-based compensation on fund sales. Contributing to the confusion, broker-dealers or insurance company representatives can refer to themselves as advisers even though they are not providing advice as ERISA fiduciaries and are receiving sales-based compensation. A service provider representative said that, from the plan sponsor’s perspective, investment assistance provided by a nonfiduciary service provider that may have conflicts of interest often looks very similar to investment advice provided by an independent service provider with no ties to investment funds.

Smaller plans may be more exposed to conflicts of interest on the part of service providers because they are less likely than larger plans to receive investment assistance from a service provider that is acting as a fiduciary. Several industry experts we spoke with said that larger plans are much more likely to employ RIAs who are subject to fiduciary standards under the Advisers Act in providing investment advice. Larger plans may also have sufficient resources and in-house expertise to make investment decisions without assistance. Smaller plans, on the other hand, often lack the resources to perform these tasks in-house or to hire an independent adviser who will act as an ERISA fiduciary. Smaller plans also often receive investment assistance from insurance brokers or broker-dealers, who are not acting as ERISA fiduciaries and also may not be subject to fiduciary standards under the Advisers Act, which requires the adviser to act solely in the best interests of the client.

Conflicts of Interest in the Selection of Investment Options May Cause Problems for Plan Sponsors and Reduce Participants’ Savings for Retirement

The potential conflicts of interest described by industry experts we interviewed could cause problems for plan sponsors if appropriate action is not taken. Under ERISA, plan sponsors are obligated to take steps to identify and address service providers’ potential conflicts of interest and ensure that the plan is run in the best interest of participants. For example, an advisory opinion issued by EBSA describes conditions under which revenue-sharing payments received by a fiduciary are permissible under ERISA. Specifically, the advisory opinion states that, in order for a fiduciary to avoid a prohibited transaction, revenue-sharing payments should be fully disclosed to the plan and used either to offset fees the plan is obligated to pay, on a dollar-for-dollar basis, or else be rebated to the plan. In addition, EBSA and SEC developed a list of questions to assist plan sponsors with identifying and assessing service providers’ potential conflicts of interest that is available on SEC’s Web site. The questions include inquiries about a service provider’s compensation, affiliations, or other business relationships with money managers, and ERISA fiduciary status. Representatives of service providers and ERISA attorneys we spoke with also described steps plan sponsors could take to address service providers’ potential conflicts of interest. For example, plan sponsors could examine a service provider’s direct and indirect compensation, ensure that the investment options offered are diversified and not entirely composed of the service provider’s proprietary funds, negotiate for institutional fund share classes which do not have revenue- sharing payments so that fees are paid through direct charges to the plan, or specify in their contract that the service provider will not receive any compensation other than what is allowed for in the contract.

Although plan sponsors may take steps to address potential conflicts of interest, several industry experts we spoke with said that the complexity of service providers’ business arrangements and insufficient disclosures pose challenges to plan sponsors who want to obtain information regarding potential conflicts. Some of these conflicts might rise to the level of a prohibited transaction, such as self-dealing. Even though revenue sharing is reported to be a widespread practice among 401(k) service providers, several industry experts we spoke with said that plan sponsors, especially of smaller plans, may not fully understand or even be aware of these payments. Further, some industry experts said that even if disclosures are provided, they are very complicated and difficult to understand.

If not addressed, conflicts of interest could lead to 401(k) plans offering investment funds with higher fees or mediocre performance, which can substantially reduce the amount of savings available for retirement. A service provider with a conflict of interest may steer plan sponsors toward investment funds that increase the service provider’s compensation even if other funds with better performance are available at equal or lower cost. Several industry experts we interviewed said that the financial impact of conflicts of interest can be considerable. For example, representatives from one service provider we interviewed said fees for plans that have been managed by service providers with conflicts of interest can be reduced by 30 percent or more. Similarly, a representative from an advisory firm that does not accept payments from investment funds said that, in some cases, fees for the firm’s 401(k) plan clients are reduced by 180 bps or more. As we previously reported, however, a detailed financial audit would be necessary to precisely estimate the financial impact of a conflict of interest in a specific situation. While the financial harm from conflicted investment advice is difficult to estimate, several studies provide a general sense of the magnitude of the effect of an increase in fees for retirement savings over a worker’s career. Based on a 1 percentage point increase in fees, projections from EBSA, a prior GAO report, and an industry study range from a 17 to 28 percent decline in final account balances. The size of the impact varies based on the time horizon, the projected rate of return, and other assumptions made in the projection.

Participants May Receive Conflicted Investment Education and Advice from Service Providers in Certain Circumstances, but Enhanced Disclosure Could Help Mitigate Such Conflicts

Participants May Perceive Investment Education as Advice and May Be Unaware of Situations when Service Providers Have Conflicts of Interest

Participants may be unaware that service providers, when furnishing education, may have financial interests in the investment options available to participants. For example, investment education, which may be provided to participants in brochures, other written materials, and computer models, can include asset allocation models that highlight specific investment options as examples of investments available under an asset class. In particular, funds in which the service provider has a financial interest can be highlighted and participants may perceive this information as investment advice. In one case, representatives from a service provider for many large 401(k) plans told us that because the company can highlight its own funds as examples of investment options under each asset class through investor education, it has no plans to offer investment advice. While investment advice is subject to ERISA fiduciary standards, which require that the advice must be in the participant’s best interest and prohibit the adviser from having a financial interest in the investment options recommended, investment education is not subject to these standards. Thus, a provider furnishing education may do so despite a conflict of interest, such as a financial stake in the outcome of participants’ investment decisions. EBSA requires providers who highlight proprietary funds as part of an asset allocation model to provide a statement that other investment options may be available under a plan; however, this statement may not sufficiently prevent participants from construing information on investment alternatives as advice. For example, the statement is not required to explain that the service provider is not providing advice as an ERISA fiduciary who is required to act in the participants’ best interests, and the provider may stand to profit from participants’ investment decisions. Consequently, without the benefit of an enhanced disclaimer that explicitly states that the highlighted funds are not advice and that the service provider may have a financial interest in the funds, participants may believe that providers are giving investment advice that is in participants’ best interests, even in situations where this may not be the case. In addition to furnishing asset allocation models, some service providers may highlight specific investment funds in communications with participants, as part of providing investment education, by using language such as “you may wish to consider [this investment fund]” instead of “I recommend,” which makes a subtle differentiation between investment education and advice that most participants will not understand. Moreover, agency field investigators said that service providers who avoid rendering formal investment advice subject to ERISA fiduciary standards may, nonetheless, refer to themselves as investment advisers to participants. Participants who confuse investment education for impartial advice may choose investments that do not meet their needs, pay higher fees than with other investment options, and have lower savings available for retirement.

Although several industry professionals said that providing investment advice to participants through computer models, subject to ERISA standards, has advantages in addressing potential conflicts of interest, others said that these models could have biases that are difficult to detect. While investment advice—through a direct service arrangement—can be provided to participants through a computer model from a service provider that does not have any affiliations with the investment options offered, two other computer model arrangements are permitted, the SunAmerica and the Pension Protection Act (PPA) eligible investment advice arrangements, in cases where the service provider may have a conflict of interest (see table 6). See appendix II for more information regarding the common formats providers use to deliver investment education and advice.

Several industry professionals we interviewed said these models ensure consistency in the content of the advice rendered to multiple participants.

In addition, unlike a one-on-one consultation or group presentation, a computer model may be audited to determine whether it is generating impartial information. Despite these advantages of computer model- based advice, other industry professionals said that it is possible to build biases into these models that may be difficult to detect. For example, a computer model may be designed to exclude certain types of investment options, which results in situations in which participants are receiving advice that does not include all investment options available to participants. In particular, representatives from one service provider told us that a computer model’s exclusion of target date funds could allow a provider to steer participants toward investment options that charge higher fees, such as managed accounts.

Although a number of studies have been conducted about the availability of investment assistance for participants, these studies do not always discern whether participants are provided investment education or advice. According to a poll of 401(k) plan sponsors and service providers that we conducted in coordination with the Society of Human Resource Management and the Society of Professional Asset-Managers and Record Keepers, investment education is more commonly offered to participants than investment advice, although many respondents offered both. Among respondents, brochures or other written materials were one of the most commonly used formats for delivering education and advice. Computer modeling, including Web-based tools, was also one of the most common methods of delivery reported.

Conflicts of Interest May Arise from Compensation to Service Providers for Cross-Selling Financial Products outside of Retirement Plans to Participants

Several industry experts we spoke with said that conflicts of interest also arise for 401(k) service providers who sell nonplan products and services, such as IRA rollovers, to participants outside their 401(k) plan, a practice known as cross-selling, which can considerably increase the service provider’s compensation. While IRAs may serve participants’ retirement needs by assisting them in saving for retirement, industry professionals we spoke to had concerns about the manner in which providers cross-sell IRA rollovers and other products to participants. Cross-selling products outside of a plan to participants can substantially increase a service provider’s compensation, which creates an incentive for the service provider to steer participants toward the purchase of these products even though such purchases may not serve the participants’ best interests. For example, products offered outside a plan may not be well suited to participants’ needs or participants may be able to secure lower fees by choosing investment funds within their plans comparable with products offered outside their plans. Industry professionals we spoke with said that cross-selling IRA rollovers to participants, in particular, is an important source of income for service providers. For example, according to an industry professional, a service provider could earn $6,000 to $9,000 in fees from a participant’s purchase of an IRA, compared with $50 to $100 in fees if the same participant were to invest in a fund within a plan.

Plan sponsors can take steps to preclude service providers from cross- selling nonplan products and services to plan participants. For example, some plan sponsors require their plans’ service providers to sign nonsolicitation agreements that prevent the service providers from marketing nonplan products and services to participants, but such agreements may not be widely used among plan sponsors. In addition, some service providers do not directly cross-sell products and services outside of a 401(k) plan to participants unless the service providers obtain permission from plan sponsors to do so, or unless participants initiate the discussion with service providers and inquire about products and services that are outside of their plans’ investment offerings. According to our poll of 401(k) plan sponsors and service providers, of the 475 SHRM respondents who sponsored a 401(k) plan, 30 respondents explicitly allowed providers to market, or cross-sell, nonplan products to participants. Among the 30 respondents who allowed providers to engage in cross-selling, IRA rollovers were the most common product marketed to participants. However, the extent of cross-selling may be greater than reflected by the poll responses because service providers may do so without explicit permission. An industry professional told us that many sponsors of small and midsized plans may not be aware that their providers are cross-selling nonplan products and services to plan participants; hence, sponsors would not know to ask their providers to stop cross-selling nonplan products to participants.

Available data on IRA rollovers indicate that many participants choose to roll their assets into an IRA rather than keep their assets in an existing plan or roll them into a new employer’s plan. As shown in figure 5, from 1998 to 2007, more than 80 percent of funds flowing into IRAs came from rollovers of lump-sum payments or account balances from defined benefit and defined contribution plans.

According to data collected in 2006 from the Survey of Income and Program Participation, a survey relating to income and related information conducted by the U.S. Census Bureau, approximately 69 percent—or approximately 4.87 million—survey respondents who received a lump-sum distribution from their retirement plans rolled their distributed funds into IRAs. Additionally, as shown in table 7, data from three large service providers indicate that, among participants who terminated their DC plan, between 42 and 48 percent of participants’ plan assets were rolled into IRAs in the observed time periods.

An advisory opinion issued by EBSA states that ERISA fiduciary standards do not apply to a service provider cross-selling an IRA rollover to a participant unless the service provider is already servicing the plan as an ERISA fiduciary. Consequently, unless the service provider is already an ERISA fiduciary, the service provider may advise a participant to roll his or her account funds into an IRA, even if such a transaction may not be in a participant’s best interest. Without disclosures that indicate whether the service provider’s assistance is subject to ERISA fiduciary standards and whether the service provider has a financial interest in the investment products, participants may mistakenly assume that service providers are required to act in the participant’s best interest. Furthermore, while final regulations may require a service provider to furnish IRA fee disclosures—such as a disclosure statement or a fee schedule—to participants, ERISA does not impose similar disclosure requirements for IRAs. In particular, service providers are not required to provide fee disclosures that specifically alert participants to the difference in fees between comparable funds available in their plan and funds offered by the plan’s service provider. As we reported in 2009, owners of IRAs generally pay higher fees than participants in 401(k) plans because an individual IRA’s account balance is usually not big enough to purchase an amount of investments large enough to qualify for volume discounts on fees. Representatives from a 401(k) record- keeping firm said that, typically, IRA owners pay higher fees in the range of 25 to 30 bps and, in some cases, as high as 65 bps, which can be two to three times higher than fees paid by plan participants for in-plan investments. As a result of the lack of disclosure requirements on fees associated with IRAs, participants may be unaware of the higher fees associated with IRAs’ rollovers and may not understand that paying these higher fees can reduce their retirement savings over time.

In March 2010, EBSA proposed a regulation that may improve fee disclosure to participants by requiring ERISA fiduciary advisers to disclose all fees or other compensation that they or their affiliates might receive in connection with an IRA rollover before providing investment advice on investment options for rollovers. However, the requirements would not apply to nonfiduciaries that are providing advice to participants about IRA rollovers or inform participants that fees for IRAs may actually be higher than fees for investments in a plan. The U.S. Department of the Treasury (Treasury) has proposed a separate regulation to require advisers to provide notice to plan participants about the consequences of taking money out of a retirement plan. Specifically, the disclosure would state that, among other things, investment options available in a plan may not be available for the same costs outside of a plan. However, without more explicit disclosure that IRAs typically have higher fees than investments in a plan, participants may not understand the difference in fees between IRAs and investments in a plan or the implication of higher fees on retirement savings over time.

EBSA’s Enforcement Program and Recent Regulatory Actions Take Steps to Address the Potential for Conflicted Investment Advice, but Further Changes Could Better Address Conflicts of Interest

EBSA’s Enforcement Efforts Do Not Address Potential Conflicts of Interest of Nonfiduciary Service Providers Involving the Selection of Investment Options

EBSA’s enforcement efforts regarding potential conflicts of interest related to investment advice have not addressed potential violations by non-ERISA fiduciary service providers. As we have previously reported, EBSA’s ability to recover losses related to conflicts of interest by a service provider through its enforcement program is largely limited by the extent to which the service provider functions as a fiduciary under ERISA. For EBSA to take action against an individual or entity, there generally must be a breach of that fiduciary duty. This can be an obstacle for EBSA given that many service providers structure their contracts with plans to attempt to avoid meeting one or more of the five parts of the current EBSA officials ERISA fiduciary definition reflected in EBSA regulations.noted that it was rare to find a pension consultant to an employee benefit plan who acknowledged ERISA fiduciary status. Moreover, EBSA officials told us that proving ERISA fiduciary status under the five-part test tends to be a difficult and complex task because it depends on the facts an circumstances of each case. These cases are usually very resource- intensive and involve interviewing plan sponsors and service providers and reviewing a significant amount of documentation, which may need to d be subpoenaed. If EBSA is unable to determine that the service provider was an ERISA fiduciary pursuant to the five-part test currently in effect, or was otherwise an ERISA fiduciary, EBSA officials told us that they have the authority to cite plan sponsors or other plan fiduciaries to take corrective action for not prudently selecting and monitoring their service providers. However, according to Labor’s OIG officials, EBSA does not focus its enforcement activities on plan sponsors or other plan fiduciaries that fail to detect conflicts of interest on the part of nonfiduciaries.

Indeed, although EBSA has taken steps to address conflicted investment advice provided to plan sponsors or other plan fiduciaries by establishing the Consultant/Adviser Project (CAP), this effort is constrained by the current definition of an ERISA fiduciary investment adviser in its regulations. EBSA launched CAP, a national enforcement effort, at the beginning of fiscal year 2007 to investigate situations where ERISA fiduciary pension consultants or advisers may have used positions of trust with pension plans to generate improper, undisclosed fees for themselves or their affiliates. Since its launch, EBSA has designated 40 CAP cases and, as of August 2010, closed 16. Of these 16 cases, only 5 yielded results, including restoration of plan assets and actions taken by ERISA fiduciaries to ensure that the conflicts of interest did not occur again. However, EBSA was unable to take action in other closed cases because it was unable to prove that service providers were ERISA fiduciaries under the five-part test or acted otherwise as fiduciaries. For example, EBSA investigated 12 of the 13 pension consultants identified in a 2005 SEC staff report for failing to disclose significant ongoing conflicts of interest to their pension fund clients—all 13 of which were considered fiduciaries under the Advisers Act, which was used as a criterion in the SEC review—but EBSA told us that many of the 13 pension consultants were adept at avoiding fiduciary status under EBSA’s five-part test. As a result, Labor’s OIG recently reported that EBSA was only able to take action on 2 of these 13 consultants because only those 2 consultants were determined to be ERISA fiduciaries and were engaged in prohibited transactions. The OIG report noted that without establishing ERISA fiduciary status, EBSA was unable to enforce conflict of interest issues and did not take any further action on these cases.

EBSA’s Approach for Initiating Enforcement Cases May Also Fail to Detect Some Conflict of Interest Violations by ERISA Fiduciaries

EBSA’s enforcement efforts through CAP may also miss violations by some ERISA fiduciaries because EBSA’s approach for detecting violations does not currently include routine compliance examinations, which could help identify these violations. We reported in 2007 that EBSA does not conduct routine compliance examinations to focus its enforcement efforts the way other agencies do, and as a result, EBSA is not positioned to focus its resources on key areas of noncompliance or have adequate measurable performance goals to evaluate its impact on improving industry compliance. For example, EBSA officials told us that they do not assess overall service provider compliance with the SunAmerica advisory opinion, which describes an appropriate method for providing one form of advice to participants, and that they do not plan to assess compliance with the Pension Protection Act’s eligible investment advice arrangement provisions after they are finalized. Instead of routine compliance examinations, CAP cases have been initiated based on a variety of sources, including referrals from other agencies, spin-offs from regular enforcement cases, tips, and media reports. According to EBSA, 18 of the 40 initiated CAP cases were based on referrals from external sources, including the SEC staff report. While these leads may be specific and detailed, EBSA may not be able to rely on consistent referrals from these external sources because they may not always review the same topics. For example, many of SEC’s referrals to EBSA, which resulted in CAP cases, stemmed from a onetime review by SEC of pension consultants in 2005. In addition, 9 CAP cases were initiated by EBSA investigators based on leads from the media and participant complaints. While these sources are important, such methods may not reveal violations that are more complex or hidden. For example, it may be difficult for participants to detect conflict of interest violations and submit complaints to EBSA, since service providers’ business arrangements may be complicated and their disclosures may be insufficient or difficult to understand. Finally, Labor’s OIG told us that EBSA does not have a formal process for looking at conflicts of interest regarding nonfiduciary service providers during EBSA’s regular enforcement investigations—neither at the front end, when a plan hires a service provider, nor later on during transactions of plan assets. If EBSA’s investigators come across a potential conflict of interest violation during their regular enforcement efforts, EBSA officials told us that the investigators refer the conflict of interest portion of the investigation to the CAP program. However, officials from Labor’s OIG told us that, even though there have been numerous cases referred to the CAP program in this manner, as of July 2010, none had progressed to a CAP case in which EBSA took action against a service provider.

To address such limitations, we previously recommended EBSA consider conducting routine compliance examinations. Specifically, we recommended that EBSA evaluate the extent to which it could supplement its current enforcement practices with strategies used by similar agencies, such as routine compliance examinations and dedicating staff for risk management. EBSA officials told us that, starting in fiscal year 2011, they will implement routine compliance examinations.

Labor’s Recent and Proposed Regulations Address Some of the Potential for Conflicts of Interest in Investment Advice and Lack of Disclosure

In addition to its enforcement efforts, EBSA has recently announced several regulatory initiatives that would address some potential conflicts of interest on the part of service providers. These efforts include (1) revising the definition of an ERISA fiduciary, (2) requiring enhanced disclosure of providers’ direct or indirect compensation and fiduciary status, and (3) establishing safeguards for PPA investment advice arrangements. If the requirements specified in these regulations are implemented as they are currently written, they may help EBSA and plan sponsors detect and deter conflicted investment advice, but plan sponsors and participants still would not have sufficient and comparable information to identify potential conflicts of interest because disclosures are not required to be provided in a consistent and summary format.

Fiduciary Definition Regulations

Proposed regulations by EBSA to amend the definition of an ERISA fiduciary for purposes of investment advice, if implemented, would help address potential conflicts of interest on the part of service providers by encompassing a greater number of advisory relationships in which the plan sponsor relies on the service provider when making investment decisions. Existing regulations have been in effect for 35 years, and EBSA officials told us they need to be revised based on knowledge and experience EBSA has gained through its enforcement efforts, as well as the evolution of the 401(k) industry.

In the preamble to the proposed regulations, EBSA acknowledges that the five-part test takes a narrow approach to fiduciary status that “sharply limits” its ability to protect plans and their participants and beneficiaries from conflicts of interest that may arise from the diverse and complex fee practices existing in today’s retirement plan services market and to devise effective remedies for misconduct when it occurs. Accordingly, the new proposed regulations are intended to more broadly define the circumstances under which a person is considered a fiduciary by reason of giving investment advice to a plan or its participants. 75 Fed. Reg. 65,263, 65,271.

OIG noted that the five-part test is narrow and hampers EBSA’s enforcement efforts. In place of the five-part test, the proposed regulation would establish ERISA fiduciary status based on a broader standard. In particular, the proposed regulation makes the following key changes, among others: Acknowledgment or representation as an ERISA fiduciary is sufficient to result in ERISA fiduciary status.

Advice does not need to be provided on a regular basis to be considered a fiduciary act.

The parties do not need to have a mutual understanding that the advice will serve as a primary basis for plan investment decisions.

Fulfilling any of the independent and alternative conditions specified in the proposal would be sufficient to result in ERISA fiduciary status for purposes of investment advice. By reducing the number of conditions that need to be met to be deemed an ERISA fiduciary, the proposed regulation would encompass a greater number of service providers assisting plan sponsors with selecting investment options. In addition, the revised standards more closely align with advisory relationships that industry experts and service providers told us plan sponsors rely on to make investment decisions. As a result, the proposed regulations should help reduce confusion on the part of plan sponsors, many of whom are reported to currently believe they are receiving impartial advice subject to ERISA fiduciary standards when this is not the case. Moreover, the regulation may aid EBSA’s enforcement efforts regarding conflicted investment advice by simplifying the method EBSA uses to determine who is an ERISA fiduciary. In addition to amending the five-part test, the proposed regulations also state that selling or marketing investment options to a plan sponsor does not constitute investment advice if it is disclosed in writing that the person is not undertaking to provide impartial investment advice. However, the proposed regulation does not specify the format for this disclosure. Given that industry experts told us there is a considerable amount of confusion among plan sponsors about whether or not they are receiving investment advice subject to ERISA fiduciary standards, some plan sponsors may continue to be unaware of the distinction between ERISA fiduciary advice and sales or marketing activities without a requirement that this disclosure be made in a consistent and prominent manner. While the proposed regulations should result in a greater number of advisory relationships being subject to ERISA fiduciary standards, the regulation has yet to be finalized. If EBSA does not finalize this regulation and replace the five-part test, many service providers may continue to act outside of ERISA fiduciary standards and EBSA’s enforcement efforts will remain limited.

Service Provider Disclosure Regulations

Interim final regulations released by EBSA in July 2010 require enhanced service provider disclosure of compensation and ERISA fiduciary status. These regulations, effective on July 16, 2011, for both new and existing arrangements between service providers and ERISA plans, specify that a contract between a covered plan and a covered service provider is not reasonable unless certain disclosures are made to the responsible plan fiduciary. Required disclosures include descriptions of the services to be provided to the plan and the compensation the provider expects to receive for those services. In addition, if service providers expect to provide ERISA fiduciary services to plans, they are required to make a statement to such effect. Industry experts indicated that this regulation should help plan sponsors identify conflicts of interest and assess whether they are causing harm to participants’ balances. In addition the new disclosure requirements will allow EBSA to exercise enforcement authority over service providers who refuse to disclose direct and indirect compensation. As shown in table 8, disclosures required by this regulation would provide plan sponsors with valuable information and could enhance their ability to evaluate compensation arrangements and potential conflicts of interest.

While these disclosures may help plan sponsors and EBSA detect and deter conflicted investment advice, they may leave out important information that could help plan sponsors compare compensation arrangements and assess the potential for conflicts of interest. Specifically, the interim final regulations do not specify that these disclosures be made in any particular manner or format. As a result, the disclosures may be made through multiple documents, which could reduce their usefulness for plan sponsors and EBSA in detecting conflicts of interest given that, as industry experts told us, such disclosures can be very complicated and difficult to understand. As part of the comment process on these interim final regulations, EBSA solicited comments about the feasibility of requiring the disclosures to be reported in a consistent and summary format, such as taking the form of a summary document, limited to one or two pages, that would include key information intended to provide an overview for the responsible plan fiduciary of the information required to be disclosed. The summary also would be required to include a road map for the plan fiduciary describing where to find the more detailed elements of the disclosures required by the regulation. EBSA plans to examine the comments received before it includes this kind of requirement in the final regulations. Without being presented in a consistent summary format, the disclosure regulations may not be as effective as intended.

Another limitation of these interim final regulations is that they do not require that service providers specifically disclose whether they have conflicts of interest. Since many conflicts result from the payment of money or other items of monetary value, EBSA and others have argued that the direct and indirect compensation disclosures required by this interim regulation will reveal some conflicts of interest. But, while these regulations may provide more compensation information to plan sponsors, Labor’s OIG told us that the regulations do not necessarily ensure that plan sponsors understand how the compensation translates into business arrangements with potential conflicts of interest. In a recent report, Labor’s OIG found that the disclosures required by EBSA’s interim final regulation would not require that conflicts from two of the cases identified in the 2005 SEC study be disclosed. They pointed to these two cases as examples to show how conflicts of interest could go undetected under the interim final regulations. As a result, OIG recommended that EBSA require the disclosure of all conflicts of interest. In response, EBSA stated that it felt that the interim final regulation may already provide this requirement through the detailed disclosures of direct and indirect compensation and that it was in the process of providing clarifying interpretations. Given that plan sponsors must assess conflicts of interest when selecting service providers, it is important that such conflicts be clearly disclosed.

In addition, the interim final regulation requires service providers to disclose information to plan sponsors, but not participants. While some of these disclosures may make it to participants through various communications by plan sponsors, complete information on service provider compensation is not readily available to participants. As an attempt to remedy this, EBSA also published final regulations on October 20, 2010, designed to improve participant-level fee disclosure by requiring that plan sponsors provide participants core information about investments available under the plan, including performance and fee information, in a chart or similar format designed to facilitate investment comparisons.

PPA Eligible Investment Advice Arrangement Regulations

Many industry experts we interviewed said that investment advice arrangements permitted under the PPA should make investment advice more widely available to participants; however, some industry experts said the established safeguards may not sufficiently address potential conflicts of interests on the part of service providers. ERISA generally precludes service providers with conflicts of interest from furnishing investment advice. However, in an effort to expand the availability of investment advice to more participants, the PPA created two eligible investment advice arrangements that allow service providers who have a conflict of interest to furnish advice to plan participants. Specifically, under the PPA, an otherwise conflicted service provider may furnish investment advice using either a computer model arrangement or a level fee arrangement.

EBSA proposed regulations in March 2010 to administer these requirements of the PPA and received comments from industry professionals and other interested parties. Several industry professionals and service providers submitted comments in support of EBSA’s efforts to increase participants’ access to unbiased investment advice and minimize the effects of service providers’ potential conflicts of interests. However, some industry professionals we interviewed expressed concerns about whether the PPA advice arrangements sufficiently minimize the risks posed by service providers’ conflicts of interest since it is possible to embed investment biases into computer models, which may be difficult to detect even when computer models are audited. For example, an industry representative said that adequate monitoring and auditing of computer models may be costly and that auditors may not be aware of the various ways in which computer models could be manipulated. In addition, computer models may be designed to exclude certain types of investment options, such as target date funds. If basic investment options offered in a plan are excluded from the computer model, the advice provided will be based on an incomplete analysis of investment options or holdings the participant may have in his or her 401(k) account. The exclusion of certain investment options from computer models may have the effect of steering participants toward options that may involve higher fees. Furthermore, even in the situation where a service provider’s profits do not vary depending on participants’ investment decisions, the service provider may nonetheless exhibit a natural bias toward its proprietary funds when furnishing fund recommendations to participants.

Conclusions

While there are no comprehensive data on the prevalence or impact of service providers’ conflicts of interest, available evidence suggests that there are a broad range of potential conflicts of interests that may harm participants and beneficiaries. Numerous industry experts we spoke with identified a wide variety of arrangements, often, but not always, complex, where conflicts of interest can occur to the possible detriment of plans and their participants. The arrangements are often designed in a way that makes it difficult for conscientious plan sponsors to detect them. Participants rely on the plan and its fiduciaries to review the investment options and services provided through the plan. Given the potential for financial harm to participants, it is important to ensure that plan sponsors, as fiduciaries, are aware of whether a conflict of interest exists and that the actions of service providers are appropriate. Conflicts of interest related to the plan’s investment options can negatively affect 401(k) participants through higher fees and lower investment returns, which, ultimately, reduce their income in retirement. When service providers stand to gain from a plan sponsor or participant’s selection of investment options, it is important to ensure that those providers do not have an undue influence over the plan sponsor or participant’s selection process— or participants’ balances could suffer. However, the complexity of business arrangements with service providers presents significant challenges for plan sponsors to fulfill their obligation to identify and mitigate potential conflicts of interest and ensure that the plan is operated in the best interest of participants. This may be particularly problematic for smaller plans, which do not have the resources to hire an independent adviser to review their options. The presence of conflicts of interest and the potential for financial harm hinder participants’ retirement security and call into question the integrity of the 401(k) system, and may undermine participants’ trust and willingness to save for retirement.

EBSA has a pivotal role in helping plan sponsors ensure that plans are operated in participants’ best interests. In order to make prudent investment decisions, plan sponsors and participants need to understand when a service provider is acting in the role of a salesperson rather than a fiduciary adviser, required by law to act in the best interests of the plan and its participants. It is especially important for plan sponsors and participants to know if a service provider stands to gain from the selection of particular investment options. EBSA has recently taken several important steps to address the potential for conflicts of interest in investment advice. In particular, EBSA’s interim final regulations, which require service providers to give enhanced disclosure of compensation arrangements, could help plan sponsors more clearly identify potential conflicts of interest and the fiduciary status of service providers. These regulations should help address the challenges faced by plan sponsors and participants. However, unless the disclosures are presented in a format that allows for a consistent comparison across investment options, it will inhibit the effectiveness of these regulations. If changes are not made to current disclosures, plan sponsors will not be able to make meaningful comparisons among different funds and providers. In addition, given that EBSA’s enforcement efforts for conflicts of interest focus on service providers rather than plan sponsors, EBSA should finalize its proposed regulations to revise the current five-part test to better ensure that service providers that recommend investment options are subject to ERISA’s fiduciary standard, and enhance disclosure to plan sponsors when investment assistance is not impartial. If the five-part test is not changed, service providers may still make investment recommendations to plan sponsors without being subject to ERISA fiduciary standards, and EBSA’s ability to take enforcement actions will continue to be limited. Moreover, if disclosures to plan sponsors are not required to be made in a consistent and prominent manner, some plan sponsors may continue to be unaware of the distinction between ERISA fiduciary advice and sales or marketing activities.

Additional measures are also needed to better ensure that participants are protected from the potential consequences of conflicted investment advice. To better ensure that participants are not improperly swayed by educational communications, requirements for guidance to participants on the difference between education and advice may need to be evaluated. Without a change in current standards, participants may continue to perceive education as advice and make decisions on the basis of information communicated by service providers with a financial interest in the investment funds. Improved disclosures may also be needed to help participants understand whether their service provider is acting as a salesperson rather than a fiduciary adviser when providing assistance to participants in acquiring financial products outside of the plan, such as an IRA rollover. Otherwise, participants will continue to be unaware if their plan’s service provider is not required to provide advice in the best interest of the participant and may be earning a commission from these product sales. Efforts for improved disclosure may be strengthened through coordination with the Department of the Treasury on proposed regulations designed to help participants understand the potential consequences of moving assets outside of their plan. If no action is taken and conflicts of interest persist, participants’ confidence and willingness to save in the 401(k) system may be weakened and an untold number of 401(k) participants may pay unnecessarily high costs, through investment fees and IRA rollovers; accrue lower investment returns; and have correspondingly less savings available for retirement.

Recommendations for Executive Action

To better ensure that plan sponsors and participants can rely on impartial information in making investment decisions, we recommend that the Secretary of Labor direct the Assistant Secretary for EBSA to take the following actions: Amend and finalize proposed regulations to change the definition of a fiduciary for purposes of investment advice. Specifically, the Secretary should amend the proposed regulations to require that service providers’ written disclosures specifying that they are not undertaking to provide impartial investment advice be provided to the plan sponsor in a consistent and prominent manner.

Amend and finalize interim final regulations regarding disclosure of service providers’ direct and indirect compensation from plan investments and fiduciary status to require that the information be provided in a consistent and summary format.

Evaluate and revise Labor’s interpretive bulletin on investment education, which is important in helping participants and beneficiaries make investment decisions. Specifically, in light of current practices, the Secretary should revise current standards, which permit a service provider to highlight certain investment alternatives, such as proprietary funds, which may result in greater revenue to the service provider, in educational materials. Labor could consider a variety of steps to address this potential conflict of interest, such as requiring service providers to disclose that they may have a financial interest in the options highlighted or prohibiting them from using proprietary funds as examples.

Require that service providers, when assisting participants with the purchase of investment products offered outside of their plan, disclose in a consistent and prominent manner, either before or at the point of sale, any financial interests they may have in the outcomes of such transactions and inform participants as to whether their assistance is subject to ERISA fiduciary standards.

In addition, to better ensure that plan participants have sufficient information when deciding whether to move plan funds into investment alternatives outside their plan, we recommend that the Secretary of the Treasury amend the applicable requirements of its proposed disclosure rule to specifically require that service providers, when recommending the purchase of investment products outside retirement plans, inform plan participants that fees applicable outside their plans may be higher than fees applicable within their plans.

Agency Comments and Our Evaluation

We provided a draft of this report to the Department of Labor, SEC, and Treasury for their review. Treasury generally agreed with our recommendation to amend its proposed disclosure rule to specify that fees applicable for investment products outside of plans may be higher than fees applicable within plans. Treasury and SEC also provided technical comments, which we have incorporated where appropriate.

Overall, Labor generally agreed with our findings and to consider our recommendations as it conducts a review of these issues and evaluates public comments received on pending regulations. Labor noted that the interim final regulation to require enhanced disclosure of service providers’ compensation arrangements represents significant progress and disagreed with our conclusion that these disclosures will not be effective unless they are presented in a format that allows for a consistent comparison across investment options. We concur that the disclosures required by this regulation would provide plan sponsors with valuable information and could enhance their ability to evaluate potential conflicts of interest. However, industry experts we spoke with noted that such disclosures can be very complicated and difficult to understand. Furthermore, as Labor has previously pointed out in the interim final rule regarding fee disclosure (75 Fed. Reg. 41,600), in the absence of a summary format, a service provider can fulfill this requirement by providing different documents from separate sources. Providing disclosures in multiple formats in different documents will inhibit the effectiveness of this regulation, particularly for plans that do not have the requisite expertise or the resources to hire an independent adviser to review their options.

Additionally, Labor noted that GAO did not conduct a cost-benefit analysis of recommendations to address potential conflicts of interest. GAO conducts its work in response to congressional requests for information and employs a variety of qualitative and quantitative methodologies in carrying out our mission. We choose these methodologies based on a variety of factors and constraints, such as the scope of our research objectives, availability of reliable data, costs and time constraints, as well as other considerations. We acknowledge that there are a number of options Labor could consider for the format of a summary disclosure and we agree that this requirement should be implemented at minimal cost to service providers and sponsors. We support Labor’s following the appropriate administrative procedures in conducting its regulatory reviews and initiatives, including conducting a cost-benefit analysis. In this context, we wish to reiterate our past concerns about the harm plan participants can experience from undisclosed conflicts of interest. For example, as we reported in 2007, our analysis of available data on pension consultants and DB plans revealed a statistical association between inadequate disclosure of conflicts of interest and lower investment returns for ongoing plans. We also note that disclosing potential conflicts of interest in a manner that is readily apparent could benefit EBSA’s oversight and enforcement efforts. Further, if Labor found the cost to service providers in preparing a summary document to be significant, this would also point to the difficulty that plan sponsors would have in extracting this information from multiple documents to obtain consistent information to allow for comparisons across different investment options and providers.

Labor also noted, regarding our recommendation to revise the interpretive bulletin on investment education, that current standards take a number of steps to limit the potential for abuse and Labor would need to evaluate several factors in considering any changes. While we concur that the interpretive bulletin includes several requirements to address the potential for conflicts of interest, it does not specifically alert participants when the service provider has a financial interest in investment options highlighted as examples, nor does it state that these examples do not constitute investment advice. Without an explicit disclaimer to this effect, participants may believe that providers are giving investment advice that is in participants’ best interests, even in situations where this may not be the case. We look forward to Labor’s evaluation of this issue and options to address it.

Finally, Labor noted that it may not have the authority to act on our recommendation to require service providers to disclose financial interests they may have in the sale of financial products outside of the plan, such as IRA rollovers. In the recently proposed regulation to amend the definition of an ERISA fiduciary, Labor noted concerns that participants may not be adequately protected from advisers who provide distribution recommendations that subordinate participants’ interests to the advisers’ own interests and solicited comments on possible actions to take to address this issue. We look forward to Labor’s evaluation of whether or not it has the authority to address conflicts of interest related to the sale of financial products outside of the plan. If Labor determines that it does not have the authority to act in this area, it may be appropriate for Congress to consider possible legislative remedies. In the absence of any action to address this issue, participants may continue to be unaware when their plan’s service provider stands to gain from the sale of IRA rollovers and other financial products outside of the plan.

Labor also provided technical comments on the draft report, which we have incorporated where appropriate.

As arranged with your office, unless you publicly announce its contents earlier, we plan no further distribution of this report until 30 days from the date of this letter. At that time, we will send copies to the Secretary of Labor, Secretary of the Treasury, and Chairman of the Securities and Exchange Commission.

If you or your staff have any questions concerning this report, please contact me at (202) 512-7215. Contact points for our Office of Congressional Relations and Office of Public Affairs may be found on the last page of this report. GAO staff that made major contributions to this report are listed in appendix V.

Appendix I: Scope and Methodology

To determine the circumstances where conflicted investment advice may be provided to plan sponsors, we analyzed available research and documentation, including a report from the Securities and Exchange Commission (SEC), industry white papers, and documentation from the Department of Labor (Labor) and SEC cases pertaining to service provider conflicts of interest. We also interviewed industry professionals; pension consulting firms and other service providers; officials from Labor, SEC, the Department of the Treasury, the Financial Industry Regulatory Authority, and the Securities Industry and Financial Markets Association; and other relevant organizations. To determine how the fiduciary duty of the Employee Retirement Income Security Act of 1974 (ERISA) applies to investment advice provided to plan sponsors and the scope of ERISA’s prohibited transactions rule, we reviewed relevant laws, including ERISA securities laws, regulations, and Labor advisory opinions, and interviewed industry professionals. As part of our research, we reviewed available information, including a report from Labor’s Office of Inspector General, and conducted interviews with industry professionals and Labor officials to determine the extent to which advisers to plan sponsors are considered ERISA fiduciaries.

To determine the circumstances where conflicted investment advice may be provided to plan participants, we reviewed available literature and interviewed industry professionals and plan service providers. Additionally, we reviewed relevant statutes, including ERISA and the Pension Protection Act of 2006 (PPA), as well as regulations promulgated by Labor to understand where applicable law draws the distinction between investment education and advice. To determine what is known about the extent to which plan participants have access to investment education and advice, and to identify the common formats for furnishing such information, we reviewed available data from industry studies and conducted a poll of plan sponsors and service providers, as described below: We reviewed data from the Profit Sharing/401(k) Council of America’s (PSCA) 2008 survey of retirement plans (published in 2009, but reflecting 2008 plan experience). The results of PSCA’s 2008 survey are based on the experiences of 908 plans—including 28 profit-sharing plans, 607 401(k) plans, and 273 combination profit-sharing/401(k) plans—with 7.4 million participants. The plans that participated in PSCA’s survey range in size from 1 participant to 5,000-plus participants. PSCA is a nonprofit association of 1,200 companies that sponsor defined contribution plans for 5 million employees. PSCA represents the interests of its members and offers assistance with profit-sharing and 401(k) plan design, administration, investment, compliance, and communication.

In addition to reviewing industry data to assess the availability of investment education and advice for plan participants, we created an online questionnaire in coordination with the Society of Human Resource Management (SHRM) and the Society of Professional Asset-Managers and Record Keepers (SPARK). In the questionnaire, we asked plan sponsors that are members of SHRM and service providers that are members of SPARK whether investment education and advice are provided to plan participants, the format for delivering such information, and whether investment products and services unrelated to plans are marketed to participants. We implemented the Web-based questionnaire with SPARK members using our Web application, while SHRM implemented the questionnaire with its members using SHRM’s Web application. SHRM and SPARK officials solicited responses from their members by distributing, to their members, our e-mail introducing the study, describing the question topics, and directing members to an Internet address for the questions. SHRM and SPARK officials also sent out periodic reminders about the questionnaire over several weeks between July 2010 and August 2010. SHRM distributed the introductory e-mail among 2,698 of its members, and SPARK distributed the e-mail among its board members, which included representatives from every SPARK member organization (over 250 companies). In total, 700 members—627 from SHRM and 73 from SPARK—responded to the questionnaire. The survey results are not representative of the general plan sponsor and service provider populations because our respondent population excludes plan sponsors that are not members of SHRM and service providers that are not members of SPARK. Because of the methodological limitations associated with deploying these questions, information obtained represents only the views of the respondents, not the overall population of 401(k) plan sponsors and service providers. In addition, we took steps in the development of the questions to minimize the variability of survey results. Prior to administering the questionnaire, the questions were reviewed by an independent survey expert in our methodology group and officials from SHRM and SPARK. We made changes to the content and format of the questionnaire based on reviewers’ feedback.

To analyze the incidence of IRA rollovers among plan participants, a circumstance in which conflicted investment assistance may be provided to plan participants, we collected and analyzed industry data from three sources to determine the frequency with which plan participants are rolling plan funds into IRAs: The Survey of Income and Program Participation (SIPP), which is a survey conducted by the U.S. Census Bureau. The main objective of the SIPP is to provide accurate and comprehensive information about the income and program participation of individuals and households in the United States. The SIPP is conducted on a continuous series of national panels, with durations from 2 ½ to 4 years, with sample size ranging from approximately 14,000 to 36,700 interviewed households. The SIPP sample is a multistage-stratified sample of the U.S. civilian, noninstitutionalized population. We used data from the 2004 topical module 7 survey and extracted survey responses to determine the percentage of survey respondents who took cash distributions from their retirement plans and rolled distributed funds into individual retirement accounts (IRA). In particular, we used variables EPREVLMP (for survey respondents who have ever received a lump-sum payment from a pension or retirement plan from a previous job, including any lump sums that may have been directly rolled over to another plan or to an IRA) and ELMPWHER, answer choice IRA (for survey respondents who rolled lump-sum payments into IRAs). The 2004 SIPP survey results are based on responses from people surveyed in different waves over a 2 ½-year period, with survey interviews lasting into 2006. Specifically, for wave 7, interviews were conducted from February 2006 to May 2006. Results are generalizable to the population at the time of survey.

The Investment Company Institute (ICI) is the national association of U.S. investment companies, and it works to promote public understanding of mutual funds and other investment companies. ICI publishes statistics on the U.S. retirement market every quarter as an information resource for mutual fund companies, the media, policymakers, and researchers. ICI combines data from its own mutual fund survey database and from other trade associations with data from the U.S. Department of Labor, the Federal Reserve Board, and the Internal Revenue Service (IRS) to compile detailed IRA asset information, including the portions of funds flowing into IRAs from rollovers and contributions. Total IRA market assets are derived from tabulations of total IRA assets provided by the IRS Statistics of Income Division for tax years 1989, 1993, 1996-2002, and 2004; with preliminary data provided for 2006 and 2007. Tabulations are based on a sample of IRS returns. GAO did not conduct any direct analysis of ICI data.

Three service providers that service defined contribution plans also compiled proprietary data on what happens to plan participants’ defined contribution plan funds when participants terminated their retirement plans. Results from service provider 1 were based on 976,600 terminated participants in the provider’s defined contribution retirement plan services from March 1, 2005, through May 31, 2010. Results from service provider 2 were based on 9,790 terminated participants in the provider’s retirement plan services 401(k) plans from January 1, 2008, through March 31, 2009. Results from service provider 3 were based on participants with termination dates in 2008. The universe consisted of more than 3 million participants from more than 2,200 plans. In addition, the proprietary data from plan service providers are not generalizable to the universe of retirement plan participants. However, the results are consistent with and corroborate each other.

We assessed the reliability of the data we present and found the data to be sufficiently reliable as used in this report.

To describe the steps that Labor has taken to address conflicts of interest, we reviewed documentation of Labor’s enforcement activities related to conflicted investment advice practices. We also reviewed past GAO and Labor Inspector General reports and interviewed Labor officials to evaluate the adequacy of Labor’s enforcement efforts to prevent conflicted investment advice. In addition, we reviewed documentation from Labor and industry participants related to three recent or soon-to-be-released Labor regulations: (1) a proposed rule amending the definition of ERISA fiduciary duty regarding investment advice (published in October 2010), which would amend the regulatory definition of the fiduciary duty for plan investment advisers to include pension consultants and other plan advisers who do not fall under the current regulatory definition; (2) an interim final rule regarding service provider disclosures of direct and indirect compensation to plan sponsors (issued in July 2010); and (3) PPA eligible investment advice arrangements (issued in March 2010), which fall under a statutory exemption to the ERISA prohibited transactions rule. Finally, we interviewed Labor officials to discuss the scope of each regulation and key features that may mitigate conflicts of interest.

We conducted our review from January 2010 through January 2011 in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives.

Appendix II: Common Formats for Delivering Investment Education and Advice

Investment education and advice may be provided to participants in different formats, most commonly through brochures or other written materials and computer modeling. Other formats for providing education or advice include one-on-one sessions with service providers and seminars and workshops. A number of studies have been conducted about the availability of investment assistance for participants; however, these studies do not always discern whether participants are provided investment education or advice. According to a poll of 401(k) plan sponsors and service providers that we conducted in coordination with SHRM and SPARK, investment education is more commonly offered than investment advice, although many respondents offered both. As shown in figure 6, of the 475 SHRM respondents who sponsored a 401(k) plan, 380 provided investment education and 215 provided investment advice. Of these respondents, 202 provided both education and advice. Among respondents, brochures or other written materials were the most commonly used formats for delivering education and advice. Computer modeling, including Web-based tools, was the second most common method of delivery reported. Industry research by an organization of 401(k) and profit-sharing plans yielded similar results, with 51.8 percent of plans providing investment advice to plan participants and with 28.3 percent of participants using advice when it was offered. Among plans providing investment advice, the most common methods of delivery are one-on-one counseling sessions, Internet providers (including those with computer modeling programs), and telephone hotlines. Industry survey results also indicate that smaller plans with fewer than 50 participants are more likely to use one-on-one counseling sessions, while larger plans of 5,000-plus participants tend to use Internet providers.

Appendix III: Types of Computer Model Advice Arrangements

Computer models can be used to render investment advice to participants in three different arrangements: (1) the direct service arrangement, (2) the SunAmerica arrangement, and (3) the PPA computer model arrangements. As shown in figure 7, the direct service arrangement is utilized when a plan sponsor contracts directly with an independent advisory firm, which develops a computer model that renders advice to plan participants. The independent advisory firm should not be affiliated with any investment fund or accept payments from funds that its model recommends as investment options. Accordingly, the firm should operate without a vested interest in its recommendations and not incur any conflicts of interest.

For advice arrangements where providers offer their own investment funds and thus have a conflict of interest, Labor has set forth specific requirements under which these providers may offer investment advice. As shown in figure 8, the SunAmerica arrangement allows the service provider to contract with an independent advisory firm to develop and administer a computer model to provide investment advice. Because the primary service provider may have a conflict of interest for certain investment options offered to participants, Labor requires that, among other things, the independent financial expert—who is not the primary service provider—develop and maintain the computer model that renders advice to participants solely in the interest of plan participants.

As shown in figure 9, the PPA computer model arrangement, on the other hand, allows the service provider to develop the computer model in-house, subject to certain requirements the PPA has established to address the service provider’s conflict of interest.

Labor has proposed regulations that would allow a primary service provider to develop and maintain the computer model that renders advice to participants if, among other things, the model has been certified by an independent financial expert and undergoes annual audits. Therefore, unlike the direct service or SunAmerica arrangements, where an independent advice provider is the creator of a computer model that renders advice to participants, the PPA computer model arrangement bypasses the independent advice provider and allows the primary service provider to create the computer model that renders advice to participants. In addition to permitting the use of the computer modeling advice arrangement, the PPA also permits a level fee advice arrangement, which allows a provider who may otherwise have a conflict of interest—such as a provider whose proprietary funds are part of a plan’s investment lineup— to furnish investment advice to participants. Specifically, Labor’s proposed regulations specify that a provider may furnish advice to participants if the provider’s fees do not vary depending on participants’ investment decisions. A Labor publication indicates that the level fee requirement applies to the service providers’ representatives and their employers, but not their affiliates.

Appendix IV: Comments from the Department of Labor

Appendix V: GAO Contacts and Acknowledgments

GAO Contact

Acknowledgments

In addition to the contact named above, Tamara Cross, Assistant Director; Sharon Hermes, Analyst-in-Charge; Jessica Gray; and Kun-Fang Lee made important contributions throughout this report.

Susan Baker, James Bennett, Susan Bernstein, Rachel DeMarcus, Cody Goebel, Ying Long, Sheila McCoy, Karen O’Conor, Roger Thomas, and Walter Vance also provided key support.

Related GAO Products

Private Pensions: Changes Needed to Provide 401(k) Plan Participants and the Department of Labor Better Information on Fees. GAO-07-21. Washington, D.C.: November 16, 2006.

Employee Benefits Security Administration: Enforcement Improvements Made but Additional Actions Could Further Enhance Pension Plan Oversight. GAO-07-22. Washington, D.C.: January 18, 2007.

Defined Benefit Pensions: Conflicts of Interest Involving High Risk or Terminated Plans Pose Enforcement Challenges. GAO-07-703. Washington, D.C.: June 28, 2007.

Private Pensions: Fulfilling Fiduciary Obligations Can Present Challenges for 401(k) Plan Sponsors. GAO-08-774. Washington, D.C.: July 16, 2008.

Private Pensions: Conflicts of Interest Can Affect Defined Benefit and Defined Contribution Plans. GAO-09-503T. Washington, D.C.: March 24, 2009.

Retirement Savings: Better Information and Sponsor Guidance Could Improve Oversight and Reduce Fees for Participants. GAO-09-641. Washington, D.C.: September 4, 2009.

Defined Contribution Plans: Key Information on Target Date Funds as Default Investments Should be Provided to Plan Sponsors and Participants. GAO-11-118. Washington, D.C.: January 25, 2011.