IRA Rollovers

Investments: IRA

By Chuck Lowenstein, Faculty, Kaplan University School of Professional and Continuing Education 
Published August 2014

Imagine the following scenario presented to a registered representative of a broker/dealer:

"A client comes into your office and tells you that she has just received a note from her employer that, due to separation of service, she will have to decide what to do with the $150,000 in her 401(k) plan. Another client gives you the news that he must decide what to do with the $100,000 in his 403(b) plan now that he has reached mandatory retirement age."

This should be a slam dunk, right? Simply roll over the funds into an IRA where the client (and you) will have control without the restrictions and expenses inherent in the qualified plans.

Not so fast! Both FINRA and the SEC have stated in their 2014 priorities that IRA rollovers from qualified plans are high on their list of items that will be the subject of member firm examinations, and you, as the registered representative, are the bull’s-eye in the target.

The primary objective of this article is to explain exactly what the regulators will be looking for, what practices they consider potentially abusive, and how to minimize exposure to disciplinary action.

During the first weeks of 2014, a literal “shot across the bow” was fired, giving warning that broker/dealers and investment advisers had better toe the line when it comes to the IRA rollover transaction. Both the SEC and FINRA have issued warnings to financial professionals who provide guidance to clients looking to roll traditional workplace 401(k) accounts into IRAs, and this focus on the importance of proper guidance should be keeping all financial advisers on their toes. For many, this means charting a new course in IRA rollover compliance, as even the most experienced professionals may find themselves in the dark over the new requirements being ushered in by the industry’s most prominent regulators.

First, it was FINRA with Regulatory Notice 13-45, technically posted on December 30, 2013, but not widely circulated until after the first of 2014. Then, only three days later, FINRA published its 2014 Regulatory and Examination Priorities Letter, and one of the featured items was qualified plan rollovers. This is the first time in memory that the regulator has published warnings about the same issue twice in one week.

Rounding out the attack, on January 9, 2014, the Securities and Exchange Commission published its 2014 examination priorities for its National Examination Program (NEP). The NEP covers all markets and entities examined by the SEC and includes the SEC exam program for SEC-registered investment advisers. Six major bullet points are listed, including Retirement vehicles and rollovers, specifically the targeting of retirement-age workers and the use of potentially misleading professional designations when recommending the movement of assets from a retirement plan to an IRA “rollover.” 

But, these are not the only regulators getting into the act. According to a January 18, 2014, article in The Wall Street Journal, the Department of Labor is planning to propose more stringent rules for advisers on all retirement investments.  

Why the sudden interest? Some would say that the primary catalyst was the March 2013 report by the United States General Accountability Office (GAO), titled “401(K) PLANS

Labor and IRS Could Improve the Rollover Process for Participants.” This 70-page report highlighted some of the industry's shortcomings regarding rollovers. Investors "often receive guidance and marketing favoring IRAs when seeking assistance regarding what to do with their 401(k) plan savings when they separate from their employers," the GAO study said.

The GAO also found that service providers’ call center representatives encouraged rolling 401(k) plan savings into an IRA even with only minimal knowledge of a caller’s financial situation. “Participants may also interpret information about their plans’ service providers’ retail investment products contained in their plans’ educational materials as suggestions to choose those products,” the GAO wrote in its report.

What’s more, the Labor Department’s current requirements do not sufficiently assist participants in understanding the financial interests that service providers may have in participants’ distribution and investment decisions, the GAO said. The GAO wrote at the time that 401(k) plan participants separating from their employers may find it difficult to understand and compare all their distribution options: “Information participants currently receive is either too generic and without detail, leaving participants without understanding of the key factors they need to know to make decisions about their savings, or too long and technical, leaving participants overwhelmed and confused.”

The upshot of the report was that the Labor Department and IRS should take certain steps to reduce obstacles and disincentives to plan-to-plan rollovers. And, the Labor Department should also ensure that participants receive complete and timely information, including enhanced disclosures, about the distribution options for their 401(k) plan savings when separating from an employer.

Then, FINRA comes out with its Regulatory Notice, reminding member firms about their responsibilities when: 1) recommending a rollover or transfer of assets in an employer-sponsored retirement plan to an IRA; or 2) marketing IRAs and associated services.  

To properly frame the discussion, FINRA quoted statistics from various sources, giving an idea of the size of the market.

According to the 2013 Investment Company Fact Book, IRAs account for about 28 percent of all U.S. retirement assets, which totaled $19.5 trillion at the end of 2012. Approximately 98 percent of IRAs with $25,000 or less are brokerage accounts. These are generally referred to as “small” accounts and, at least as a percentage of assets, tend to have the highest costs associated with maintaining the account.

You should not be surprised that rollovers from employer-sponsored retirement plans are the largest source of contributions to IRAs. A June 2013 Employee Benefits Research Institute report states that in 2011, assets rolled over into IRAs were almost 13 times the amount of direct contributions. Considering that the maximum annual IRA contribution that year was $5,000, or $6,000 for those age 50 or older, it doesn’t take much of a rollover to be 13 times greater—only $65,000 to $78,000. Even with the current annual maximums of $5,500 and $6,500, that multiple shouldn’t change.

Although not a part of the FINRA notice, another report has given much credence to the concerns by the regulators. Cerulli Associates, a well-known industry research firm located in Boston, released the following information.

In 2012, about 3 million American workers rolled over some $289 billion from their employer-sponsored retirement plans into an IRA or into their new employer’s retirement plan.

The bulk of that money—$204 billion, with an average account balance of $128,400—went into IRAs controlled by broker/dealers or investment advisers. That is about 70 percent of all of the rollover money.

Next, about $85 billion, with an average account balance of $53,900, went into self-directed IRAs. And the balance of $1 billion, with an average account balance $91,000, was rolled into a new employer’s plan. Cerulli went on to say that by 2017, Americans will roll an estimated $451 billion into IRAs, making this an $8 trillion marketplace. So, as you can see, we’re talking lots of money, and that is why the regulators are taking steps to ensure that investors receive a fair shake.

As outlined in both the FINRA and SEC releases, the primary concern is proper dealing with the potential conflict of interest. When a securities professional is presented with a client who was a participant in his employer-sponsored retirement plan, whether a 401(k) or 403(b), who has terminated employment, either voluntarily or involuntarily, and is now asking for advice on how to invest their plan assets, it is only natural that that little “devil” in his brain suggests that he can make lots of money if he only tells the client rollover the funds to an IRA controlled by him. That may be the best alternative to meet the client’s needs, but FINRA and the SEC want that professional to exam those needs and objectives, as well as a number of other considerations, to determine if, in fact, there might be a better solution.

It is important to understand that the regulators are not saying, “IRA rollovers are a bad thing.” What they want securities professionals to recognize is that financial advisers’ obligations to their customers requires that they do their best to make the recommendations that are most suitable for the customers.

There are four basic choices that a participant has:

1)    Leave the money in the former employer’s plan (if permitted).

2)    Roll over the assets to the new employer’s plan (if there is a new employer and if rollovers are permitted).

3)    Roll over to an IRA.

4)    Cash out the account value.  

It is important to note that only the first three options allow a participant to preserve the tax-deferred status of their plan savings. Once the choices are known, all of the various factors can be evaluated in an attempt to determine the best course of action for the client. Part of the problem, at least from the client’s standpoint, is that, according to the GAO report, participants are subjected to pervasive marketing of IRAs, but may receive limited assistance regarding their distribution options. This places an even greater responsibility on the financial professional.

First of all, it must be determined if choice 1 is even possible. In many cases, the magic number is as high as $5,000. Unless the participant’s vested interest in the plan is large enough, the plan may not allow the funds to remain, or the plan may even call for a mandatory rollover into an IRA. This information is relatively easy to find and may be obtained by the client, usually with a quick phone call or email to the HR department.

The same is true with choice 2. First of all, there must be a new employer and, even if there is, one of the problems pointed out in the GAO report was the difficulty involved in making the transfer. Some plans flat out don’t allow it and, in other cases, whether it be a long rollover waiting period or a complex verification process, too many participants just don’t want the hassle and look for a simpler, although not necessarily the best, option.

Of course, choice 3 is quite simple—almost all providers will hold their clients’ hand and do everything step by step with them.

Finally, although choice 4 may be best for some, for most under 59½, the taxation of the proceeds, plus the 10 percent tax penalty, is a factor that ranks at the top of the discussion. It helps if we analyze the pros and cons of each of these choices.

Let’s start with choice 4, first because it is clear that the only real benefit to the participant is cash. That can be useful, even after paying taxes and penalties, if there is high-interest debt that can be paid off, or special expenses, such as medical treatment or education. In fact, if the participant is at least 55, it is possible to avoid the 10 percent penalty, but that is only true with an employer-sponsored plan, not an IRA. In fact, rolling over into an IRA “kills” this option.

Choices 1 and 2 are viewed basically the same. One major difference is that the client already knows the original plan and, if happy with the performance and service, it is hard to make a case for leaving it and moving the assets to a strange one. One point that could be made is the consolidation of assets. Many would prefer having all of the 401(k) assets in one location, rather than in the plans of several former employers. If analysis of the new employer’s plan shows lower fees and expenses and/or a wider selection of investment opportunities, that could also be a good reason to make the switch.

Finally, the participant must be careful in making the transfer. If a direct transfer, there shouldn’t be any tax problems, but, if an indirect transfer, where the check is made out to the participant, there is the 20 percent withholding rule and a requirement that 100 percent of the funds be placed into the new plan within 60 days.

Of course, the real issue raised by the regulators is rolling over into an IRA. This is where there are some distinct differences, so let’s point them out:

  •  If the separated employee is or turns 55 during the year, there is no 10 perent penalty if from the employer plan. This is not available with an IRA.
  • 401(k) plans tend to offer low-cost investment options, typically institutional class mutual funds that are much less expensive than the retail mutual funds available to IRA investors.
  • Better access to advice, especially for smaller account holders.
  • ERISA plans, a 401(k) for example, offer creditor protection under federal law, but IRAs are protected under state law, which can vary state to state.
  • Employer matching can only take place in an ERISA plan—it does not apply to an IRA.
  • Participants in a 401(k) plan can borrow up to 50 percent of their vested interest, or $50,000, whichever is smaller. No loans are permitted from an IRA.
  • Qualified Domestic Relations Orders (QDROs) escape the 10 percent penalty, but only in ERISA plans.
  • RMDs do not apply, as long as the participant is working for the employer. This would only apply when a separated employee rolls over to a new employer’s plan. IRAs do not offer this benefit.
  • If the plan contains appreciated employer stock, keeping the asset in the plan offers a number of tax benefits (too complicated for this discussion).  

After looking at these, it seems that the choice is clear—keep it in the old plan or roll over to the new one. However, we do need to look at some of the advantages of an IRA rollover.

In general, there are more investment options available in an IRA.

  • Because many ERISA plans require distributions in either a lump sum or a fixed schedule, withdrawal flexibility is generally far greater with an IRA.
  • For those who have had multiple employers and have not been able to transfer into each new employer’s plan, rolling over into an IRA puts all of your retirement assets into one place, making it much easier to keep track of.
  •  Fees could actually be lower in an IRA because there are no administrative fees.
  •  There is no such thing as a “stretch” 401(k).
  •  Penalty-free withdrawals are permitted for first-time home buyers and certain education expenses.
  • Control. If the assets are left in the former employer’s plan, the participant is less likely to keep up with ongoing changes to the plan.

As you can see, there are pros and cons to both, and that is exactly what the regulators want explained to clients. There is much evidence of participants making choices solely because they didn’t know what else to do. The job of the financial professional is to educate in this respect and truly look out for the interests of the client.

That leads us to the undeniable potential for conflicts of interest. After all, the broker/dealer is in business to make money executing transactions. The investment adviser is in business to make money charging for advice. If the client is told that it is in his best interest to keep the money in the existing plan, or transfer it to the new employer’s plan, it is doubtful that any compensation will be realized by the firm. No one likes to work for nothing, but that will happen frequently when the clearest choice for the customer puts no money in the adviser’s pocket.

The January 9 SEC letter stated, "Investment advisers and broker-dealers may have incentives to recommend that the assets be placed with an IRA or other alternative offered by a financial services firm." FINRA’s concluding statement under conflicts of interest in Notice 13-45 expressed the same idea: “A financial adviser has an economic incentive to encourage an investor to roll plan assets into an IRA that he will represent as either a broker/dealer or an investment adviser representative.”

Avoiding conflicts of interest are done in two basic ways.

  • Put the client’s interest first. 
  • Make full disclosure.

Of course, making recommendations is nothing new under FINRA Rules. Rule 2111 goes into great depth regarding the procedures and information necessary to make suitable recommendations. In that vein, FINRA has made it clear that recommending IRA rollovers is no different from making any other recommendation to a client; it must be suitable when taking into consideration the client’s needs and objectives, as well as all of the relevant factors. One additional consideration is that following the recommendation to roll over the assets, in most cases, there will be a substantial portion liquidated and reinvested into new securities. The exchange must, of course, be suitable.

This can call for enhanced suitability monitoring. Some firms will want to create exception reports whenever IRA funds reach a designated threshold. Others will require clients to complete special disclosure forms, not unlike those used with penny stocks. Some firms have limited their activity in this area to educational services only. If this is the case, training must include steps to take to avoid statements coming under Rule 2111 and, therefore, triggering the suitability requirements. This is generally done by ensuring that all material is checked and that no recommendations are made.

Another stated concern of both FINRA and the SEC is the use of advertising or other promotional materials urging clients to roll over their retirement plan assets. FINRA Rule 2210 deals with communication with the public and requires that misleading or incomplete information may not be disseminated. As stated earlier, when referring to the GAO report, there is much more in the way of information presented dealing with why and how you should roll over than keeping the plan. Furthermore, advertisements promising “fee-free IRAs” can be misleading if the charges are bundled into other costs.  Just as with any other communications under Rule 2210, the communication may be deemed misleading if it omits information needed to cause the description to be fair and balanced in terms of its comparison to other options. So, if the example of the “fee-free” account contained a statement in close proximity, in similar type size, stating “other account fees and charges may apply,” FINRA would find that acceptable.

The final step in compliance is proper supervision. NASD Rule 3010 (one of the few remaining rules that has not been converted to a FINRA rule) requires that all member firms have adequate supervisory procedures to monitor compliance with all applicable rules. The key tool is the firm’s Written Supervisory Procedures (WSP) manual.

If the firm is going to be promoting or otherwise handling IRA rollovers, the WPS must specifically deal with how the firm is going to supervise and train personnel, as well as the controls put in place to ensure that suitability standards are kept.


Chuck Lowenstein is a full-time faculty member at Kaplan University. The views expressed in this article are solely those of the author and do not represent the view of Kaplan University.

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