Watchdog casts doubt on federal oversight of conflicts of interest

Conflicts of interest in mutual funds and other complicated costs for retirement savers are hurting their nest eggs, according to a new government watchdog report.

Savers, with more than $18 trillion dollars individual retirement accounts and 401(k) plans collectively, may be losing out on potential higher returns in their mutual funds when wealth management firms receive compensation based on the level of assets, and the IRS should ramp up its enforcement of excise taxes against prohibited transactions in IRAs, according to a report released Aug. 28 by the Government Accountability Office. The watchdog agency conducted the study at the request of lawmakers who asked the GAO to evaluate "where issues around conflicts of interest and investment advice stand today," the report said.

That's a loaded question in an area of the law involving at least five different regulatory agencies at the federal level — the IRS, the Treasury and Labor Departments, the Securities and Exchange Commission and FINRA — and for an industry in which trade groups' lawsuits have blocked the implementation of President Joe Biden's new "retirement security rule."

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The IRS needs to create better internal infrastructure for identifying transactions that don't place IRA clients' interests first and should develop stronger means of collaborating with Labor in that area, according to the GAO report. Based on its review of mutual fund data from Morningstar, the regulatory disclosures of 15,000 firms, and undercover calls posing as clients to 75 financial advisors and other industry professionals, the watchdog concluded that the agencies must do more to scrutinize conflicts.

"Firms' disclosures of conflicts are available to investors, although — based on GAO's review of disclosures and prior GAO work — investors may not review or understand these documents. Federal agencies encourage investors to ask professionals about conflicts of interest, but GAO's undercover calls found that doing so may not always produce helpful information," wrote Tranchau "Kris" Nguyen, the agency's director of education, workforce and income security.

"GAO's analysis of Morningstar mutual fund data from 2018 to 2021 found that funds that compensate financial professionals based on whether their clients invest in those funds (a proxy for conflicts) is associated with lower average returns before fees," Nguyen continued. "This could reduce retirement savings' growth over time and could make a difference of tens of thousands of dollars for investors in actively managed domestic equity funds at retirement."

Sen. Patty Murray, a Democrat from Washington; Sen. Bernie Sanders, an independent from Vermont who caucuses with the Democrats; and Rep. Bobby Scott, a Democrat from Virginia, called for the GAO study. Their request came after another industry-backed legal effort succeeded in 2018 in overturning Labor's last attempt to expand the fiduciary duty in retirement advice. That prior rule drove some changes that stayed in place even after the appeals court vacated the earlier regulation, according to the GAO's study.

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More pertinent to the industry today, the watchdog cast doubt on the oversight of IRAs by the IRS — and the agency agreed with its recommendations. Currently, the IRS waits on referrals of prohibited transactions from Labor or self-reporting from the fiduciary advice provider themselves, according to the GAO study.  

"DOL does not have authority to audit IRAs for prohibited transactions and, therefore, is generally unable to refer IRA fiduciaries to IRS for excise tax enforcement," Nguyen wrote. "Until IRS implements an audit process for IRA fiduciaries, IRA investors may continue to be exposed to adverse impacts of prohibited transactions that can jeopardize their financial security in retirement."