Monday, September 30, 2013

Wild West in Government 403(b) Continues

When the IRS issued new regulations for the 403(b) several years ago there was hope that the "wild west environment" that existed for k-12 Government plan participants would change for the better.  Nearly five years after those regulations went into affect (and seven since issued) there have been some positive changes, but the "wild west environment" remains.

In some aspects things have changed for the worse, specifically the category of Compliance Third Party Administrators (CTPA).

(For questions you should be asking your CTPA, scroll to the bottom)

CTPA's act as the gatekeeper and policeman of a multi-vendor 403(b) plan.  They maintain the plan document(s), determine which vendors are allowed, collect vital information from the various parties and are tasked with keeping a plan in compliance.  The CTPA's role is critical to staying on the right side of the Internal Revenue Service in a multi-vendor plan environment.

One particularly concerning aspect of CTPA's is how they are compensated.

There are many compensation schemes for CTPA's, but one in particular has emerged as the winner, "vendor pay". The "vendor pay" model works exactly like it sounds, the vendor of a product pays a fee (tied to some participant metric) to the school employer's chosen compliance company.  In my opinion, this arrangement is problematic in certain circumstances.

A Bit of History

When the new IRS regulations were being implemented, the financial crisis of 2008 was either on the horizon or in full swing as districts rushed to comply by January 1, 2009.  School Employers didn't want to pay compliance fees for a retirement program that they saw as being "supplemental."  When what appeared to be a "free" compliance service was offered, most School Employers jumped at the opportunity.  At first, these "free" services took the form of 403(b) product-selling firms, a huge conflict of interest.

As it became clear that providing compliance was an expensive proposition, most product-selling "free" CTPAs began to charge fees.  But "who" paid the fee became the next question.  Should the school district (no money)? Participants (they might complain)? 403(b) product vendors?

The vendors ended up with the bill.

The pitch went something like the following:

"It's the vendors who benefit financially from the 403(b) plan offered by the employer, so it should be the vendors who pay for it."

This makes sense to an extent, but you must remember that most Government 403(b) plans are not subject to a fiduciary standard, meaning there is no single individual or entity charged with protecting the plan participants.  This line of thinking also ignores the obvious - it's the participants who benefit the most from a well run plan.  In the 401(k) world the participant does usually pay for the services of a vendor, but there is only a single vendor, which can drive down costs considerably.

Most 403(b) plans have multiple vendors and typically those vendors are not chosen via a competitive process.  Instead vendors are chosen by state law (which might allow any and all vendors), the CTPA, internal politics or pay-to-play schemes.  In most cases the CTPA has enormous influence in determining which vendors make an "approved" list.  This represents a conflict of interest because the influential CTPA may also be receiving an income stream from the vendors they are selecting.

Once a vendor makes it on an "approved" list, they must pay the CTPA a fee, usually per participant. The vendor who is most successful in getting new participants into the plan will pay the most in fees to the CTPA.  The CTPA has an incentive to add vendors to the program who have a history of adding participants - not because it's good for enrollment, but because it makes the CTPA more money.  The issue is that the enrollment happens regardless of if the product that vendor is selling is appropriate.

The worst vendors have a higher likelihood of adding participants in a multi-vendor system since they pay the highest commissions (and are willing to sit in school teacher lunch rooms).  This situation leads to the counterintuitive outcome that competition leads to higher costs and worse overall outcomes.  While the participants suffer, the CTPA is collecting its fee.

Many CTPA's advertise themselves as "Independent" and "Fee-based" which sounds objective and unbiased.  However, one must question the objectivity of a company whose revenue may come directly from the 403(b) vendors they are charged with choosing and overseeing.

Before I go further, I'd like to point out that some Independent CTPA's have adopted a "vendor pay" program reluctantly, solely in a bid to survive.  I'd also point out that if an employer engaged in a competitive bidding process using an unbiased and objective proposal process (not one ran by a conflicted consultant or CTPA) then a negotiated fee paid by each vendor to an unbiased CTPA (one who had no influence or input into the proposal process) could, in my opinion, still be appropriate.

The switch to "vendor pay" happened very fast, CTPA's who didn't adapt faced going out of business in certain regions.

School Employers with free 403(b) compliance options available to them and a fiscal crisis on their hands had little choice but to work with CTPA's who wouldn't add a line item to their budget.  Those CTPA's who had spent years charging their compliance fees directly to the employer to avoid conflicts of interest concerns where suddenly looking at a tough choice - charge the vendor or go out of business.

In many regions of the country, independent CTPA's were hamstrung and chose to start taking money directly from 403(b) vendors in order to stay in business.  This is not to say that some CTPA's didn't continue to charge employers, a few continue to do so where the School Employers are less pressured or more forward thinking.

I can state from experience (in California), there was no other option, either find a way to offer the service for free...or shut down.

The CalSTRS Comply (full disclosure: I provide consulting services to CalSTRS) product began offering a form of vendor pay by 2010, reluctantly as an alternative payment solution.  The thinking being that it's better to have a trusted product, administered by a competent organization in the marketplace rather than just let the market be overtaken by conflicted, expensive, incompetent and product selling CTPA's (which did and continue to dominate in the marketplace).

Of course, the Comply product has its flaw - in order to be maintained it receives some revenue from the vendors it polices.  There is a difference in the Comply model though - in California if a company is on (an online disclosure databank) and meets simple administrative requirements, it must be offered. Thus, Comply doesn't act as a gatekeeper or in a consultative capacity in terms of what vendors should be offered, they simply offer all eligible vendors, removing the main conflict.  But the conflict of removing a vendor (for non-compliance) and risking the loss of revenue remains.

Many CTPA's are increasingly offering consulting type services. I've even ran into a CTPA who acts as a consultant for school employers and runs request for proposals for CTPA services, I'll give you one guess who wins the bid (imagine your health care provider being in charge of the bid for health care services).

Increasingly, conflicted CTPA's are providing fiduciary based consulting services to school districts, but without taking on any fiduciary responsibility.  These CTPA's are making or heavily influencing vendor decisions, yet, the CTPA is at the same time receiving revenue from those vendors.  In some cases the revenue is significant.

An analogy that comes to mind is that of a regulatory body funded and ran by the very entities it is charged to regulate.

This symbiotic relationship with the vendors is creating a system that is designed to protect the vendors and the CTPA's business models, not the participant.  No one has the best interest of the participant in mind, no one is looking out for the little guy.  All business decisions are run through a filter of "is it good for the CTPA and vendor business?" 

The vendor inmates are running the CTPA asylum.

While I don't believe the only solution is a single-vendor structure, it certainly could go a long ways to solving the problem.  The core issue in the the 403(b) world is a lack of fiduciary responsibility on behalf of the participants.  This lack of oversight and consumer protection allows a wild west environment to prosper.  CTPA's are not, for the most part regulated and government 403(b) plans are not, for the most part, subject to a fiduciary duty.

Cleaning up the wild west is not easy, it begins with a sheriff.   Strong leadership and good stewardship is essential.

In order to strengthen the 403(b) and make it a consumer friendly plan we need to do the following:

  • School business officials and particularly the Chief Financial Officers must get educated in defined contribution plans and how to be good stewards of them.
  • Low cost fiduciary and stewardship training should be made available to all school business officials on a continuous basis.
  • CTPA's must disclose more information about where their income is derived.
  • School Employers should have a Fiduciary Duty to their employees when it comes to their defined contribution plans.
  • School Employers should have a simple way to discharge their Fiduciary Duty, such as a state-based plan Multiple Employer Plan (or a private MEP with a good reputation).  This would allow for participants to be protected, while ensuring School Employer budgets are not impacted.
  • School districts should move to a single-vendor solution.  If implemented correctly, "single-vendor" can be a far superior solution to a multi-vendor system.  For smaller school districts (and large ones as well), a Multiple Employer Plan ran by the state can be a great option.
  • School employee unions should focus on protecting their members defined contribution rights in addition to their defined benefits and realize the importance of doing so.
  • CTPA's should NOT be paid by vendors (with the exceptions I outlined above), should be subject to 408(b)2 and should publicly disclose their funding structure (who they owe money to and who owns the equity).  Put the conflicts of interest cards on the table and let the consumer make an informed decision.
  • Like the DB plan, the 403(b) plans should be automatic.  Employees should be automatically enrolled into the DC plan and their contributions automatically increased periodically.  
  • The 403(b) should be subjected to a competitive bidding process that is not run by a conflicted party (for example, a CTPA who receives revenue from the bidders) or who has a financial interest in the outcome.
  • The IRS should admit defeat and allow for a structure that could eliminate the need for a CTPA by making it simple for a School Employer to take their plan to a single vendor environment.

While the task at hand seems daunting, there has been some progress.  This progress will build on itself and begin to spread exponentially and there will be no stopping it.  But it starts with good people.

Progress starts with people who are willing to take a stand and pledge to work in the best interest of participants, it starts with Fiduciaries.

Is Your CTPA Really "Independent"?
(Questions Every CTPA Should Answer)

If you are a school employer and are looking to hire a CTPA you need to ask them the following questions in order to understand the potential conflicts involved:

1.a.  Does your firm, any of its affiliates or any employees receive revenue in any form from 403(b)/457(b) vendors that you currently monitor or oversee or could potentially monitor or oversee in the future?  In other words, do you receive income from vendors that appear on school employer approved provider lists that you are the compliance administrator for?

1.b. If the answer to 1.a is yes, please list each vendor and the revenue received in the past twelve months.

2.a.  What percentage of your company revenue is derived from fees paid:
                  Directly by employers,
                  Directly by participants (payroll deduction or a line item on their statement)
                  403(b)/457(b) vendors

2.b.  What percentage of your company revenue is derived from commissions from financial product sales?

3.  List any trips paid for by any vendor you oversee or could potentially oversee (whether as compliance or in an RFP), even if you only have influence over a process and not direct decision making authority.

4.  List each insurance company you are appointed with to sell financial products.

5.  Is your firm affiliated with a Broker/Dealer? Are any employees or affiliates registered as Registered Representatives?

Update: Additional questions submitted by readers

Does the CTPA or any of its affiliates perform any services of any kind for vendors for which they are paid? If yes, please explain,
Does the CTPA remove (or recommend removal) of vendors from the plan who do not pay them TPA or other fees? If yes, please explain.

Any other questions you think should be here? E-mail me and I'll add them.

Scott Dauenhauer, CFP, MSFP, AIF