Advisers should sound off on 401(k) plan advice

Most 401(k) plan participants need investment advice. Unfortunately, most will not pay for it, nor will most plan sponsors, especially in today’s economic and business climate.

The Labor Department estimates that individuals in 401(k) plans make investment errors that cost them between $5.5 billion and $10.9 billion annually. It estimates that the cost of such errors might be cut in half with investment advice.

Of course, many plan participants could get advice from the brokers or investment advisers working with or for the fund companies that provide the funds used in the plans. But the current Labor Department, suspicious — along with many others — that such advice would be conflicted and self-serving, withdrew a proposed rule that would have allowed it.

The department and other observers were concerned that the proposed rule did not adequately protect investors from advisers who recommend funds that most benefit their own personal income statements, not necessarily those that are most appropriate for plan participants.

The agency appears to be on the right track in its proposal that would allow broker-related advisers to provide advice to 401(k) plans if they based the advice on third-party-provided computer-based models.

But it has asked for comment on a number of questions regarding investment theory, investment performance, historical returns and the factors that should be acceptable in such models.

Among other questions, the department asks: What investment theories are generally accepted, and what investment practices are consistent or inconsistent with such theories?

Should the regulation specify such theories and require their application? Should the model specify a minimum number of years in performance data used in the models? Is a fund’s past performance relative to the average for its asset class an appropriate criterion?

Under what, if any, conditions would it be consistent with generally accepted investment theories and with consideration of fees to recommend a fund with superior past performance over an alternative fund in the same asset class with average performance but lower fees? Should the regulation specify such conditions? On what, if any, bases can a fund’s superior past performance be demonstrated to derive not from chance but from factors that are likely to persist and continue to affect performance in the future?

The last three questions appear to suggest that the Labor Department might require the models to include only index funds in their options.

Whether or not it is appropriate to exclude actively managed funds from a model depends on how efficient the stock market really is. While some sectors of the market — large-cap stocks, for instance — appear efficiently priced most of the time, other sectors, notably small cap stocks and especially foreign small-caps, appear not to be.

There is also the issue of whether the Labor Department should be endorsing constrained models (i.e., those limited to index funds).

The department has asked for comment on these and a number of other questions before it makes its rule final. Financial planners and investment advisers should make their expert opinions known.

Comments should be emailed to [email protected] (enter into subject line: 2010 investment advice proposed rule) or by using the Federal Rulemaking portal at regulations.gov.