Until now fund companies have been precluded from offering specific investment allocation advice to participants in 401(k) plans. As a "party in interest" ERISA prevents fund companies from providing advice on assets for which the fund company recieves fees. Yet 401(k) plans are typically "participant-directed", meaning that the employees investing through the plan must make their own investment decision. For many employees their 401(k) account is their largest pool of money yet they are prevented from being advised on it.

This week the issue of advice in 401(k) plans goes before Congress. The issue was raised this week as series of bills were introduced into the U.S. House of Representatives that would enable service providers to 401(k) plans to provide investment advice without a prohibited transaction exemption.

A number of companies -- notably Salomon Smith Barney and the Trust Company of the West (TCW) -- skirted the current regulations by applying for a "prohibited transaction exemption" from the Department of Labor. To achieve the exemption both companies created structures in which they were paid a level fee no matter which investment option the participant invested in.

Enter the Internet. Realizing the opportunity, and the regulatory wall blocking natural competition from existing investment advisory firms, a number of entrepeneurs have built business to fill the need for investment advice. The leading firms are leveraging the Internet to build a channel for mass advice and beat the wire houses at their own game.

Financial Engines, mPower, Direct Advice, Standard & Poor's, Morningstar and Intuit/TeamVest are among the high profile firms that have rolled out Net-based investment advice products over the past five years. Each of these companies has been building relationships with fund companies to act as distributor for their product.

Twelve companies including Merrill Lynch, Scudder, Principal, State Street Global Advisors, Great-West Life, Prudential, Northern Trust, Key Corp and National City Bank have all gone with Palo Alto-based Financial Engines.

Fifteen providers including American Express Retirement Services, Putnam Investments, Dreyfus Retirement Plan Services, Mellon Financial, First Union National Bank, GE Asset Management, Paine Webber, Credit Suisse Asset Management, ManuLife Financial and Aetna Retirement Services are among those paired with San Francisco-headquartered mPower.

Meanwhile MetLife, John Hancock Funds, Diversified Investment Advisors, and Pan-American Life have gone with New York-based Standard & Poor's.

Charles Schwab and T. Rowe Price have chosen both Financial Engines and mPower as advice partners for its clients.

Notably missing from the alliance dance are Fidelity and Vanguard. Both have offered their own product instead. Vanguard claims that it is exempt from the party in interest rules since it does not charge more than its cost to manage the funds. Fidelity has argued that what it offers is education not advice under Section 404(c) of ERISA.

Indeed, Fidelity is rumored to be one of the key movers behind the bill. If this bill passed Fidelity would no longer have to split legal hairs to market its own solution.

On one side of the debate are representatives of the financial services industry, such as the Investment Company Institute and the Securities Industry Association, who are in favor of the bill. On the other are third-party advice providers such as mPower and Financial Engines and groups supporting participants such as the AFL-CIO, AARP, The Pension Rights Center and ASPA.

At issue is who will deliver advice to 401(k) plan participants. At the crux of the debate are three bills introduced by Rep. John Boehner (R, Ohio).

According to Boehner, the bills were written to modernize ERISA and clarify that plan sponsors are allowed to provide access to investment advisors within a 401(k) plan. It is also intended to open up the playing field to new competition. The bills arose from hearings held as part of a review of ERISA on its twenty-fifth anniversary.

"We're trying to close the advice gap that employees face in defined contribution plans," explained Dave Schnittger, press secretary to Boehner. "Twenty five years ago when ERISA was enacted defined benefit plans were all of the rage and very few workers had the responsibility of allocating their retirement dollars. Today there has been a shift to defined contribution plans that require workers to choose how their money is invested. That is a reality that lawmakers could not have anticipated."

He added that sponsors are limited in offering advice today because of the "way the law is written." One of the three bills, HR 4747, is intended to clarify that sponsors can offer investment advice without adding to their liabilities, he said.

The second bill, HR 4749, would exempt plan vendors from being subject to prohibited transaction rules as long as they disclose any conflicts of interest they have in providing the advice. Conflicts would include receiving different levels of fees for different investments, and presumably any revenue sharing agreements they have with funds offered in the plan.

"Essentially what we are doing is throwing this market open to competition," said Schnittger. "As with any case in which there is increased competition the consumer, in this case the employees, is going to be the beneficiary." He adds that the bill is intended to let all regulated entities (RIAs, banks, insurers, broker-dealers) and their affiliates, employees and agents provide investment advice within a plan without being subject to the prohibited transaction rules.

The third bill, HR 4748, is the combination of the two bills introduced together for markup purposes, he said.

Critics of the bills argue that they are a solution to a problem that does not exist. Boehner, on the other hand, contends that the way ERISA is written effectively bars sponsors from providing investment advice.

"That is positively not true," counters Scott Campbell, vice president and general counsel for advice provider Financial Engines. Campbell points out that Financial Engines already serves 12 partners with roughly 15 million participants. "It is appropriate to reform ERISA, but that should not be done at the expense of the retirement accounts of workers. It is absolutely untrue that sponsors cannot now offer advice," he says.

Michelle Farmer, in-house counsel to mPower, agrees. "We are providing advice to plans of 15 participants to plans to of 50,000 participants. So the perception that advice is not available now is erroneous," she told the 401kWire.com.

Both Campbell and Farmer pointed out that there are a myriad of subtle ways a provider of advice can benefit if it is also the asset manager, even if it is providing the best advice. For instance, is active management better than passive management? A third-party advisor may recommend an index fund to cover an asset class while the investment management firm would recommend its active options, Campbell pointed out. There are clearly arguments for going either way. The possible problem is that active management pays higher fees than passive.

These are among the subtleties that may well be beyond the average plan participant to untangle, argues Campbell.

Furthermore, he points out that if participants do have a problem with the conflict of interest, disclosure is not a cure. "Where can participants go? Unlike in the retail environment they are captive," he points out.

Of course both Financial Engines and mPower have an interest in preventing existing service providers from delivering investment advice directly without the use of a third-party. Neither wants added competition from mutual fund companies.

Also concerned are small recordkeepers and firms that provide only recordkeeping services. They fear that if Fidelity is able to offer advice as a free feature of its product, firms relying on paying a third party for their advice will be at an economic disadvantage. Essentially, this argument echoes the argument used against Microsoft by its competitors. In that case Microsoft competitors complained that Bill Gates incorporates their products into Windows as free features. Some are worried that Ned Johnson and Bob Reynolds have evolved a similar strategy.

There is another interesting fallout if the bill passes, in that case brokerage firms would be free to purchase the third-party advice companies without compromising their ability to offer clients the advice service. Both Financial Engines and mPower have taken significant investments from brokerages and fund companies such as Merrill Lynch and PaineWebber.

It is unlikely that the bills will be passed in the current Congress, says Ed Ferrigno, counsel for the Profit Sharing/401(k) Council of America, which has taken no stand on the bills. "There has been significant reaction from a lot of parties," he says, meaning that it will take time for the interested parties to weigh the issues involved.

Both the Treasury Department and the Department of Labor are likely to want to provide input into the bill and both are likely to be skeptics until convinced that it is needed.

Even if passed the bills will not significantly change the playing field for plan sponsors directly. "If you give advice and the investment drops you are going to get sued. You are going to win but you are going to get sued," Ferrigno points out. 

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