Flash back to 2008, just before the great financial
meltdown. You’re a relatively famous
pastry chef at an upscale and popular New York restaurant. A guest having an
important business meeting asks her waiter if she could meet you and ask for a
dessert recommendation. You arrive, and
recommend your “Chocolate Decadence” and go on your way.
Three years later you receive a subpoena as a defendant
associated with a failed investment made by your guest, a pension plan trustee,
three years prior. It seems her dinner/business
meeting was with an investment advisor that was recommending AIG stock as a
pure bet. The stock of the largest
insurance company in the world he claimed was undervalued due to its financial
services sector association in a depressed market. Little did he know what a
small AIG office in London was doing with derivatives. AIG crashes and the
stock implodes, destroying much of the retirement savings of the plan’s
participants. The lawyer for the plan trustee claims her judgment was clouded
by the endorphins associated with your dessert. She claims she never would have
agreed to risk that much of her plan assets in one stock, regardless of
attractive potential gains, had she not been under the influence of your
delicious desert. You are deemed to be a
fiduciary as a result of your recommendation which resulted in a bad
investment.
Now flash forward to 2011, where such a possibility could
become reality. Maybe not now, but beware the Employee Benefit Security Administration
of the Department of Labor (DOL), under Assistant Secretary Phyllis Borzi, intends
to roll out a new definition for the 36 year-old definition of “fiduciary” by
the end of 2011. Their proposal was
highly criticized by industry providers when they solicited written responses
and held public hearings on March 9th and 10th in
Washington. In fact, there were more
than 200 written responses and personal testimony from 40 individuals
representing their constituents. Furthermore,
there has been bi-partisan opposition from Congress and even some consumer
groups, concerned about the potential cost impact to investors.
On the surface the objectives are noble:
-Protect retirees’ nest eggs
-Protect Plan sponsors and participants from unscrupulous or
incompetent consultants
-Improve the DOL’s ability to enforce and prosecute
violations
-Ensure more accurate asset valuations, especially for stock
of private ESOP
-Obtain more responsible investment advice for plan trustees
However, the potential proposed redefinition of the
definition of fiduciary is so broad that it resulted in one of the largest
turnouts of those opposed in DOL history.
Even the U.S. Treasury Department and bi-partisan members of the House
of Representatives (who have sent letters to the DOL) are in opposition. Previously, following the enactment of ERISA
in 1974, a 1975 DOL definition calling for a five-part test was required
determine if investment advice was elevated to fiduciary status. With the current proposal not only is the
five part test abandoned, but now even ministerial actions such as reporting
the values of hard-to-value assets (e.g., hedge funds, etc.) would be
considered fiduciary actions.
So what’s the big deal?
Well, being deemed a fiduciary that is associated with an investment
loss, particularly, one under an ERISA plan, virtually ensures that you will be
threatened with settlement of the case even if the facts in the case would
prove otherwise. Under the new proposal
which is very vague and ambiguous in most cases, plaintiffs’ attorneys would very
likely use the “F” (Fiduciary) word against you and have a field day doing so.
The threat of losing the case, particularly if the losses were substantial, may
encourage your insurance carrier to consider settling sooner than later,
assuming that you’ll be able to get insurance, with risks enhanced under the
new definition. If this goes through as
currently crafted, my advice is to invest in a law firm that specializes in
securities litigation, particularly if you fall under the new definition. Not only would this be a wise decision, it
would hedge your position as a new fiduciary.
However, wouldn’t you know, you can’t.
That’s because law firms don’t need your capital as they are already
making tons of dough. Of course, I
retract my advice for risk of the “F” designation!
Many of those opposed have indicated that the industry costs
associated with the proposed change are so great that they might result in the
demise of many current providers, particularly those who will not be able to
obtain or pay for the necessary insurance.
Personally, I see the proposal as the 20/80 rule, or the inverse of the
80/20 rule, where you spend 80% of your resources for 20% return. This is because the new proposal in its
current form is so broad that it will sweep in thousands of individuals and
their firms that heretofore, under the previous definition of “fiduciary” were
by statute NOT deemed to be fiduciaries. The costs associated with
implementation (legal, training, policies and procedures, etc.), not to mention
insurance are daunting and, most agree, totally underestimated by the DOL. All to catch a few more bad guys. But as Sheila Blair has recently stated,
regulation doesn’t guarantee integrity.
Proof of that is in your daily paper, with articles of reported
settlements, prosecutions of firms and individuals that are already heavily
regulated.
Under the proposal, for example, IRA service providers would
be considered fiduciaries. That’s
because the proposal states that any person who reports values (even if
determined by other fiduciaries) of hard to value assets would be fiduciaries.
IRAs are not subject to ERISA, nor were they within the DOL’s sphere of
enforcement authority. Ironically, I learned form a senior employee of the IRS
in Washington, that the IRS was not even notified of the proposal which
includes indirect authority over IRAs, previously the domain of the IRS, due to
the proposed change of the fiduciary definition.
IRAs were established as further protection for the
individuals saving for retirement from unscrupulous pension trustees. These Individual Retirement Arrangements
(IRAs) were to allow savers to choose their own investments. In fact, many of these IRAs are self-directed
for that reason, because it is up to the owner of the IRA account to choose
investments for it. Under the new DOL
proposal, such self-directed IRA custodians would be in the untenable position
of challenging the investment direction of the true fiduciary of the IRA
account, the IRA owner!
According to Ms. Borzi, because more money is now flowing
into IRAs than ERISA plans like 401(k)s (due primarily to retiring baby boomers
that are rolling their plan assets over to IRAs), the Government has to step in
to protect the average American from himself.
The now prevalent Administration attitude that the Government knows
better what’s good for you reminds of a movie I saw on a flight to Chicago for
an Alternative Asset Strategies conference.
The movie is called “The Adjustment”.
Starring Matt Damon, who plays the main character that falls in love
with a women he meets accidentally, it is a metaphor to what we are seeing more
and more- the restriction of free will under the guise of social
responsibility. The main character’s love interest but is thwarted by agents of
the “Chairman” (aka God or think big Government), who claim he doesn’t know
what’s good for him. It was frustrating enough to watch this fictional story,
much less contemplating having to live with it in real life.
But being serious for a moment, there seems to be an acute
overreaction to the financial crisis and the Bernie Madoff era, and despite its
flaws, the DOL’s proposal is not the best example. The Dodd-Frank Wall Street
Reform Act is a more egregious example.
It is 2319 pages long (the last sweeping recent law affecting the financial
services industries (Graham, Leach Bliley Act) was only 145 pages long). And, by the way, you can get a copy of the
U.S. Constitution, its, Amendments, the Declaration of Independence And the
Bill of Rights, all in 45 pages!! The
Dodd-Frank bill is so indigestible that the SEC went back to Congress to act
for a delay on their mandated response, because they couldn’t write the
regulations fast enough! You can imagine the scope of regulation, previously
non-existent, that will ultimately come from each agency’s and financial services
firms’ response to it. The cost to
comprehend it, procedualize it and enforce it will be immeasurable. Once again, however, litigators will be the
primary beneficiaries. By the way, who
do you actually wrote the Dodd-Frank bill?
That’s right-attorneys.
But back to the fiduciary matter. It is possible that we could all find that the
DOL’s final version of their proposal will take the enormous industry input
into consideration. We all want to
prevent crime, fraud, and the development and implementation of best practices
for our businesses, industries, and employees and customers. That small percentage of us that either don’t
take these responsibilities seriously enough or that fall astray and commit a
crime, should be punished. But I don’t
think it makes sense to create an environment with checks and balances affecting everyone and, therefore
imposing a social and economic cost that essentially says no one can be
trusted.
If the DOL can find that balance where the benefits far
outweigh the costs, which will help the economy, while increasing control over
those most influential in participants’ investment decision through advice, I
think pension plan trustees, administrators and retirement savers will all
benefit. And investors’ ability to choose their own investments through self-direction will be retained. Here’s hoping.
Last week, the Retirement Industry Trust Association (RITA), which consists of the majority of the regulated self-directed IRA custodians in the country, held its Spring Conference in Washington, D.C. The three day conference, included a number of speakers and panelists from the Government, including the Treasury Department, the House of Representatives, and the IRS, as well as many industry experts from the legal profession and elsewhere.
We were fortunate to learn first hand what the priority issues are for the retirement industry and American retirement savers. Unfortunately, not all the news was good.
There appears to be a growing concern amongst important influencers in the Government and many of the regulatory agencies that the IRA industry does not have enough regulatory oversight. More alarming is a emerging philosophy that the average American may not be able to handle self-direction or that he needs to be protected from himself! Much of this focus comes from the recognition of the reality that there is now more money (and assets) in IRAs than there is in defined contribution plans (e.g., 401(k)s), and that that trend is going to continue due to the increasing numbers of boomers retiring, as most of new IRA funds and IRAs come from rollovers of pension plans. Some agencies see their span of influence declining with this shift from pension plans to IRAs, and are attempting to sweep IRAs into their purview. This is exemplifying itself as regulatory agency food fights between the FDIC, SEC, Department of Labor, Consumer Financial Protection Bureau (CFPB), and the IRS amongst others.
The problem with all this is that the potential outcome is that more legislative action and new regulations will result, placing increased burdens on providers of IRA services and then ultimately their clients. The purported objective of these initiatives to try to prevent more “Bernie Madoffs” from happening, and to make sure people don’t squander their retirement by making foolish decisions, etc. While these are noble objectives, you cannot legislate away all crime. There are many laws already on the books that Bernie violated and which could have been used to stop him sooner had they been enforced. There will always be crime, and, of course, some laws and regulations designed to prevent it or detect and eliminate it are necesssry and effective. But there has to be a reasonable balance and cost/benefit relationship between trying to prevent something and that something actually happening on a large scale.
It is not all the regulators fault either. The Dodd-Frank Wall Street Reform Act (no irony intended that the primary target was Wall Street) that is the catalyst for the current regulaltory modus operandi, is so voluminous that it is estimated that it would take the average American six weeks to read it working 48 hours per week. How could anything like that lead to understandable and practical (in an economic sense) legislation? The agencies have even asked for delays for their mandatory delivery of the regulations to come from the Act, BECAUSE THEY CAN’T WRITE THE REGULATIONS FAST ENOUGH!!!
A good example of what is likely to come from Dodd-Frank is the recent DOL proposal for changing the definition of “fiduciary” so that more individuals and businesses will be subject to the fiduciary standard of acting in their customers’ “best interests”. In reality, it appears to be another attempt to gain more control over an individual freedom’s for the supposed greater good. It is yet to be determined that the Department of Labor’s proposal will have a net cost/benefit to society and American savers. However, it does appear that the impact of the proposal, if made into law, would be to make IRAs more like pension plans and subject to ERISA-like contraints, virtually eliminating the ability to self-direct and/or to invest in anything other than traditional investments such as stocks, bonds and mutual funds. From the current Aministration’s viewpoint, as expressed indirectly through Federal regulators, this would be a good thing. I’m am sure you can guess how mutual fund companies and broker/dealers would feel about the potential that people with IRAs would only be able to buy their products. How do you feel?
I testified on behalf of RITA on March 9th in opposition to the DOL’s proposal (see http://www.dol.gov/ebsa/pdf/1210-AB32-064.pdf”>written testimony sent prior to verbal testimony) as one of 81 presenters during a two day hearing and following written testimony from 201 organizations, the majority of which were opposed to the DOL’s recommendations. The DOL indicated following the testimony that they intend to produce a modified version of their initiative by the end of 2011 after considering all the input. They did not, however, indicate which elements of their proposal (which in its current form would affect tens of thousands of professionals from the broker/dealer, banking, IRA custodial, valuation, financial advisor and other related industry groups and their customers) would be likely to be changed. This obviously is of major concern to all of us who are potentially subject to the final implementation, and the self-directed IRA industry, and a high priority issue to be monitored.
It is clear to this observer and participant in the evolution of the retirement savings industry, that there could be a sea change in the retirement sector if the the intent by regulators as expressed above becomes a reality. IRA custodians like PENSCO Trust and those competitors that make up RITA, may be forced to either exit the industry or to raise fees significantly to address the additional costs of training, documentation and disclosure and liability insurance that would be required if we were deemed fiduciaries. Furthermore, being a fiduciary we would place us in the untenable position of having to challenge the investment decisions of the primary fiduciary, our client. This conflict would eliminate the entire concept of “self-directed” and would severely restrict the client’s choice of investments. No doubt, the primary beneficiaries of such a designation, would be litigators, who would have a built-in basis to claim negligence and violation of fiduciary duty on the part of the custodian if an investor were to lose money, even if they chose the investment and directed their custodian to acquire it. This makes no sense.
I happen to believe that retirement account owners are well served by the self-directed industry and that our industry plays an important role in supporting our clients, the economy, savings and innovation. I also believe our industry has an outstanding record of integrity, trust and quality service. We offer clients the ability to invest and diverify into alternative assets in addition to those in the stock market. The value of diversification has been well-established by the Modern Portfolio Theory and others, and and is an even more valuable concept in tax-advantaged accounts such as IRAs. I am confident, that with enough education, knowledge, and understanding, that those who are currently intending to severely limit the ability for our industry to provide such benefits, will change their views.
If you have a concern that you ability to self-direct may end with the potential enactment of the DOL’s proposal, I urge you to contact your Government representatives. Members of both the House and Senate were among those who also expressed their concerns over the proposed changes, including members from both sides of the aisle. You can visit the DOL’s Employee Benefit Security Administration site and read all the http://www.dol.gov/ebsa/regs/cmt-1210-AB32.html”>comments .
I intend to fight hard for our industry and our customers. I hope you share my concern and join me in battle!
Crisis for sure. No one knows how or when we are going to emerge from our current economic crisis. Every day there are conflicting signs of recovery and further recession. Some are predicting a steep decline in the stock market, future inflation, and the devaluation of the U.S. dollar. Bear in mind, however, that not all of those who hold these views are prominent prognosticators. However, some go so far as advising their clients to store at least six months of food and water in anticipation of riots in the streets! Scary stuff, indeed! They also predict rampant and extraordinary inflation, and a significant alteration of the standard of living as a result, if the U.S. dollar loses its status as the World’s reserve and trading currency. While these views are extreme, there is a general concern among many that such could be the outcome if the U.S. deficit is not reduced.
Accordingly, the National Inflation Association stated on November 16, 2010 that “if the U.S. stays on its current path, we are guaranteed to see hyperinflation this decade. The only way it will be possible to prevent hyperinflation is if the U.S. government dramatically cuts spending across the board immediately and if the Federal Reserve raises interest rates from near zero percent (where they have been for nearly two years) to a level that is higher than the real rate of price inflation. Considering that the Federal Reserve still claims to fear deflation and just announced massive quantitative easing, we see very little chance of any major interest rate hikes taking place during the next six months.” Others would say that the chance for hyperinflation where a trillion dollars won’t buy you a coke (think Iceland or Yugoslavia) in the U.S., with its diverse economic system, not only has never occurred but is very unlikely to occur.
Nevertheless, those of in Washington are appropriately working diligently to find ways to reduce the deficit spending and the debt, on the heels of a clear message from the U.S. public to do so. The challenge will be difficult and we should be paying attention to what our lawmakers come up with. For example, even the Federal Agency on Fiscal Responsibility and Financial Reform has indicated that even if all Americans were currently taxed on 100% of their income, the revenue would not be sufficient to stem the tide of the growing debt. Obviously, then, revenue programs will need to be coupled with cost and debt reduction programs for the U.S. to retain its international trading advantage that helps to sustain our economic world power.
But let’s talk about “Opportunity” rising on the heels of economic crisis still nagging us . Despite the varying forecasts for our economic future, one thing that is for sure is that there are new investment opportunities that have not been available to the average American that have been created a result of the downturn beginning 2008 . While many of these opportunities are available to individuals, they are particularly attractive to those with retirement funds, especially Roth IRAs. The reason is that many offer the potential for significant gains once (and it IS only an amount of time, in my opinion), that the U.S. economy gets back on track.
But when will it and why act now? While all of these financial threats surround us and restrain our efforts to aggressively invest for fear of failure, they are also indicative of the need for even greater vigilance over our investing and the need for proactive action to protect what we have and our savings for the future. The economic turmoil underlines the importance of diversifying your investment portfolios so that you are not dependent on only one thing going well (e.g. a stock market rebound). Suppose we are headed for another downturn as some predict? More than 95% of IRAs are invested in the stock market, so whither the market so go your retirement savings. It is estimated that 75-90% of the stock market is controlled by systems belonging to large pension funds and corporations that sell off portfolios in seconds overnight, so that dramatic turbulence in the economy can find the average investor caught in the sudden cross-fire of competing institutions. If inflation is on the horizon, sitting in cash isn’t a good choice either; and while gold and silver and other commodity prices have been increasing in value, a general economic recovery with increased consumer demand for goods and services and the liquidity necessary to purchase them, will surely drive most of the precious metal prices down.
So what should one do faced with all the conflicting economic news and forecasts? I think that at the very least it would be prudent to assess you resources (e.g., assets, income, savings, retirement funds, Social Security, dividends, interest, etc.) and your liabilities including debts (e.g., mortgages, credit cards, etc.) ad evaluate the trends associated with both to determine your financial situation today and near future. Are most of your assets tied up in one asset class? Are your retirement funds predominantly in one market (e.g., the stock market)? Should you do more to diversify, reduce your debt or mortgage interest rates, spending? Probably a little of all of the above would be advisable.
If you feel that you may need more investment diversification, new avenues and investment products are emerging from the crisis, and are a reflection of the Chinese proverb “where there is crisis there is opportunity”. For example, we are all aware of the downturn in the domestic real estate market, the increasing foreclosures and the decline of real estate values. But if you a believer that the downturn has is about to or will eventually hit bottom, there are new ways to take advantage that didn’t previously exist. For example, thousands of financial institutions (there are over 8,700 banks in the U.S. alone) have taken back properties on their books from foreclosures. More are to come when they resolve their paperwork issues that have temporarily stemmed the tide. These are called REOs (Real Estate Owned) and private investors are gobbling them up at well below market value (sometimes as much as 50% of market). Purchasing such properties inside retirement funds (e.g., 401(k)s, self-directed IRAs and self-directed Roth IRAs), can shelter any gains as the market recovers and values start to return to pre-2008 figures.
Moreover, you can essentially become your own bank by buying mortgages from these same financial institutions by offering a bid through such new web-based services like loanmarket.net (www.loanmarket.net). Let’s say the outstanding loan balance on a first mortgage is $400,000 and you think the current market value is $300,000. You could potentially offer the bank $250,000, assume the title to the property, retain the current resident and borrower and establish your own interest rate on a new mortgage. If vacant, you could rehab it and then later sell it at market, or simply rent it until the market recovers. There are other similar debt resellers such as DebtX, Big Bidder, and even EBay on a retail basis and all seem to have their own specialty. Regardless, the ability for consumers to play in this market, much less than electronically where all the paperwork is handled by the vendor (e.g., loanmarket.net), stems from the presence of a large previously non-existing non-performing mortgage market that spurred the innovation necessary to support it. Americans are advised to do their due diligence but there are new investment opportunities being created that many savvy investors are now taking advantage of.
On the private equity side of the alternative asset space (e.g. away from the traditional markets like the stock market and bank CDs), new companies are making it possible for private investors to access private equity of such companies as Facebook, Twitter, Zynga, etc., are also emerging. Once again these represent excellent potential for those with retirement accounts, because potentially large gains can be temporarily protected from tax (with traditional deductible plans and IRAS) or permanently protected from taxation (Roth 401(k)s and Roth IRAS). NYPPEX (www.NYPPEX.com) provides trading and advisory services for investors and sellers of private equity. Others in the emerging industry include Sharepost and SecondMarket. Like any new industry, firms like these will be faced with their challenges and challengers including the SEC, so investigate thoroughly before you invest. Undoubtedly, however, the door has been permanently opened to more Americans having access to private markets previously only available to large corporations and wealthy individuals.
The moral to this article, therefore, as bad as things may appear, running against the herd and finding new investment opportunities may prevent you from falling off a cliff. That being said, not all venturing West for gold made it through, but many of those that did were happy that they made the effort! Take your blinders off and proceed cautiously, and at the very least take stock of your financial assets.
