Retirement Security Rule – Strengthening Protections for Americans Saving for Retirement | CEA
Today, the Biden administration is announcing a new rule proposed by the Department of Labor to close loopholes and ensure that the financial advice Americans get for retirement is in their best interest. The rule would expand the current fiduciary standard, which typically covers advice on purchasing securities such as mutual funds, to include new types of non-financial securities such as fixed index annuities, advice to employers and fiduciaries, and one-time advice for transactions such as 401(k)s. ) ) Coups. The rule would reduce unwanted fees in retirement products, potentially providing billions more in savings for those saving for retirement. This CEA blog explains why the proposed rule change is important to consumers by focusing on a specific but fundamental market transaction: the conversion of retirement savings into fixed-index annuities.
As background: In 2022, Americans transferred nearly $779 billion from defined contribution plans, such as 401(k)s, to IRAs.(1) The decision to roll over assets is a complex and personal one, and investors have many asset options after deciding to roll over . Current securities laws provide several important protections for people saving for their retirement. For example, financial advisors generally must adhere to a “fiduciary standard” when recommending the purchase of securities such as stocks and mutual funds, meaning the advisor must put the client’s interests above his or her own commissions. You might think this would always be the case in the investment industry, but right now, it’s often one-time financial advice on transactions like a 401(k) rollover. no It is required to meet a fiduciary standard under the Employee Retirement Income Security Act, the federal law that governs retirement plans. Furthermore, securities laws and regulations do not broadly cover buy recommendations non– Securities, such as real estate, certain types of annuities, or commodities such as gold. It also does not cover planning advice for sponsors on what investments to put in their 401(k). These blind spots in current rules can increase costs and fees for consumers, negatively impacting their retirement savings.
One example of a non-security investment is a “fixed index annuity.” Fixed index annuities are financial products typically issued by insurance companies (and thus subject to state law rather than federal securities law) with features that may be attractive to risk-averse investors. Their returns involve less risk on both the upside and downside, because they generally limit returns while also setting a lower bound on losses. However, this greater certainty comes with additional costs and fees compared to investments in similar mutual funds, as well as extended lock-in periods where investors face fees if they withdraw their money.
The primary source of fixed index annuity costs to investors is the caps placed on the returns the annuity receives from the underlying index on which it is based. Under certain circumstances, the cost of maximum returns can outweigh the benefits of downside protection, in which case the investor can, in principle, get a better deal without a lock-in period. Different financial products have different terminology, but in the appendix, we provide an example of how, under the current system, a retirement saver could end up with lower returns than they would have under the proposed rule.
There may also be strong incentives for brokers to encourage investment in fixed index annuities even if it is not in the best interest of investors. This is likely evidenced by the large commissions paid to brokers. For example, the annuity mentioned in the appendix gives commissions ranging from 6.5% for sales to those under 75 to 3.5% for sales to those over 80. Numerous academic papers have examined the impact of conflicting investment advice on portfolio performance across markets.(2) These estimates show return losses ranging from 95 to 170 basis points in the markets studied. Even taking into account the conservative estimate of 95 basis points from Egan (2019) – who examines the role of conflicting advice in the sale of convertible bonds – the losses appear large. As a rough estimate: Total assets held in fixed index annuities have risen rapidly, from $185 billion in 2010 to $559 billion at the end of 2021. (3) Even if this market does not continue to grow, the amount consumers are paying into In contrast, maximum returns could be as high as $7 billion per year, and the amount lost due to conflicting investment advice could be as high as $5 billion per year for this single category of investment.
The Biden Administration’s proposed Retirement Security Rule today expands protections for retirement savers, ensures sounder financial advice, reduces unwanted investment fees, and gives every American retirement saver greater peace of mind about their investment portfolios.
Appendix: Explanation of the benefits and costs of a fixed index annuity
Fixed index annuities are complex products whose costs and benefits are not easy to determine. At the time of investment, the combination of downside protection and loss of upside potential is equivalent to the investor receiving a call option and giving the call option to the insurance company. Therefore, one way to visualize costs is to use the fair market value of these options.
Market prices change frequently, but as a purely illustrative example: The maximum return on Nationwide’s Annual Peak 10 Index, indexed to the S&P 500, was 6.75% as of August 2023. The estimated maximum contract value of this contract was 6.75% net of Nationwide’s 0% minimum during the first year of investment, based on option prices on S&P 500 futures, equals 1.2% of the total amount invested in the annuity.(4) This suggests that Nationwide can pay the broker as much as to $120 for every $10,000 a consumer invests, still expecting to make a profit on average. This is the implicit cost to the investor before accounting for explicit sales fees or charges. Pricing these costs and benefits over the life of the annuity is more complex because Nationwide changes the contract price caps each year.
Of course, this example ignores any transaction or operational costs that Nationwide faces. Furthermore, a risk-averse investor may be willing to pay an amount higher than fair value to insure against the possibility of loss. In principle, an investor could create the same portfolio as a fixed index annuity at a lower cost using options, but this is difficult in practice for the retail investor. This exercise simply highlights the initially imbalanced fair value of the contract; However, a fixed index annuity may still make sense for some investors.
(1) Cerulli Associates, Inc. The Ultimate Investor for US Retirement 2023: Personalizing the 401(k) Investor Experiencep. 145.
(2) Chalmers and Reuter (2014), Christophersen et al. (2013), Del Guercio and Reuter (2014), Forster et al. (2014), Egan (2019)
(3) According to the Cerulli Report on U.S. Annuity Markets 2022, p. 46.
(4) The estimate was constructed with end-of-day prices on August 1, 2023, using the historical volatility of the S&P 500 Price Index on Bloomberg’s Options Pricing Calculator. The put option strike price is the current index price, and the put option strike price is 6.75% higher than the index price on August 1. The option vesting period is one year (365 days).