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Popularity of new program could quell calls to end mandatory arbitration

By Dan Jamieson

After nearly a full year, the Financial Industry Regulatory Authority Inc.’s program to let investor plaintiffs exclude industry arbitrators from hearing panels has proved more popular than expected.

So popular is the program, in fact, that it could ease concerns about industry bias and help quell calls to end mandatory arbitration.

From the start of the all-public program in February 2011 through Jan. 26, more than three-quarters (76%) of investors chose the all-public option, which allows them to strike industry arbitrators from proposed lists of panelists.

That figure was up from a 54% opt-in rate during a 27-month pilot program, according to Finra.

Normally, investor cases are heard by three-person panels that include an “industry” arbitrator who works in or is associated with the financial industry.

SURPRISING POPULARITY

The popularity of the all-public program is a “bit surprising, because the pilot numbers were lower,” said Linda Fienberg, head of Finra’s arbitration program.

Observers said a growing familiarity with the all-public option by plaintiff’s attorneys is driving its widespread use.

The pilot also was limited to customer cases against a select group of firms and applied only to those cases where an individual broker was not named. The permanent program includes all firms, as well as cases against brokers.

“The program has given everyone an option” to use in a larger number of cases, said Ryan Bakhtiari, a partner at Aidikoff Uhl & Bakhtiari, and president of the Public Investors Arbitration Bar Association, which represents plaintiff’s attorneys.

The Securities Industry and Financial Markets Association also supports the program.

“We also think it’s quite important that an industry panelist remains an option for investors,” Kevin Carroll, associate general counsel at the trade group, wrote in an e-mail.

SIFMA was smart to support all-public panels, said David Robbins, a plaintiff’s lawyer and partner at Kaufmann Gildin Robbins & Oppenheim LLP.

The program has eased concerns about industry bias and helped counter the push by the plaintiff’s bar and state regulators to end mandatory arbitration, he said.

“Finra had to respond this way because … they were fearful they would be out of [the arbitration] business,” Mr. Robbins said.

Finra “wanted to assuage customer’s attorneys [about the process] and it’s worked,” he said.

DATA INCONCLUSIVE

“I do believe this [program] has removed the one issue [critics] could use to claim the [Finra arbitration] forum wasn’t as fair as it might be,” Ms. Fienberg said.

Data from the pilot program are inconclusive as to whether investors did better when they opted into the program.

Of 49 pilot program awards issued by all-public panels, investors were awarded damages in 26 of 40 cases, or 65% of the time, according to Finra. Another 23 pilot program awards were issued by panels with one nonpublic arbitrator, and in these instances, investors got relief 13 times, for a 62% win rate.

In nonpilot cases, win rates were lower: In 2009, arbitrators awarded damages to investors in 49% of cases; in 2010, the win rate was 48%.

However, Finra said that the award data are insufficient to draw meaningful conclusions about whether all-public panels tend to favor investors — a conclusion that others share.

“Talk to me in a year” about win rate data, Ms. Fienberg said.

“We’ll have a better idea then” whether customers do better with all-public panels, she said.

The growing use of the all-public option has worried some industry arbitrators, who insist that they can be as tough, if not tougher, on industry malefactors as public panelists.

“I’ve noticed inquiries for me [to sit on panels] have dried up,” said Neal Tourdo, national sales director at Mastrapasqua Asset Management Inc., who serves as an industry arbitrator.

Eliminating industry panelists “is a mistake,” he said.

“Finra doesn’t do a good job of educating [public] arbitrators about investments,” Mr. Tourdo said.

For more technical products, such as derivatives, “the public arbitrators are generally unprepared,” said Joseph Stineman, a partner and chief compliance officer at Fogel Neale Partners LLC, who is also an industry arbitrator.

He added, however, that his own caseload of four potential customer cases is heavier than ever.

Of the 1,431 cases in the permanent program that have ranked panelists, investors have chosen to strike all the industry people in 66% of the cases, according to Finra.

Despite the success of the all-public option, the plaintiff’s bar and state regulators still want an end to mandatory pre-dispute arbitration agreements.

“We think choice is working with the all-public program, and we think choice is the way to go in arbitration” overall, Mr. Bakhtiari said.

If arbitration were made optional, “I think [the industry] would improve the customer protection aspect of it,” such as providing for attorney’s fees and written decisions, said John Cronin, Vermont’s securities director and chairman of the North American Securities Administrators Association Inc.’s broker-dealer section.

The Dodd-Frank reform law gave the Securities and Exchange Commission authority to prohibit mandatory arbitration in brokerage contracts.

The commission hasn’t yet acted on that authority.

CUSTOMERS WINNING

Mr. Robbins doesn’t think that will happen, due in large part to the all-public option.

Customers “are winning” in Finra arbitrations, he said.

“Why kill a system where you can prevail?” Mr. Robbins said.

The SEC doesn’t have a timetable for looking into the arbitration issue, Ms. Fienberg said.

“My best guess … is, they are mightily working to do [other] things with a time requirement first,” she said.

Meanwhile, Republican control of the House and recent Supreme Court decisions make legislation prohibiting mandatory pre-dispute agreements less likely, Ms. Fienberg said.

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By Ashlea Ebeling

If your income is too high, you can’t contribute directly to a Roth individual retirement account, but you can get one in a backdoor way. Step 1: Open a traditional IRA (in your case, it’s nondeductible). Step 2: Convert it to a Roth IRA. Is it worth it? “It’s a no-brainer if you have the cash to do it,” says Kevin Huston, an enrolled agent in Asheville, N.C. who has clients both young and old doing it to shore up their retirement savings. “It especially makes sense for people who are younger because they have all these years of tax-free growth,” he says.

Basically, you get an extra $5,000 (or $6,000 if you’re 50 or older) each year that grows in the Roth IRA income-tax free. That’s $10,000 (or $12,000) a year for a married couple. Repeat each year, and you can amass a nice retirement kitty. The audience for backdoor Roths is a niche, appealing to those earning too much to contribute to Roths directly but not so much that the extra tax savings doesn’t seem worth the effort. Vanguard says that “backdoor Roth” contributions represented about 2 percent of traditional IRA contributions in 2010. That’s the year that income restrictions were lifted, and anyone—regardless of income—could convert a traditional IRA to a Roth, leading to a boomlet of Roth conversions.

Why go through the hoops of getting money into a Roth IRA? They are an amazing deal, especially for folks looking long-term and expecting higher tax rates in the future. With a Roth IRA you don’t ever have to take money out, and when you do start taking money out, it’s all income-tax-free, including the earnings. By contrast, with a traditional IRA, earnings grow tax-deferred, you have to start taking required mandatory distributions the year after you turn 70.5, and distributions count as income. A Roth can help keep your tax bite down in retirement. (Ideally you want a mix of taxable, tax-deferred and tax-free accounts to draw from in retirement.)

A Roth IRA also has other benefits. Medicare premiums are based on income, so by keeping your income down, you’ll pay a lower premium. And if you leave a Roth account to a child, he or she will have to take money out each year, but there will be no income tax hit. (Inheriting a $100,000 Roth IRA is a whole lot better than inheriting a $100,000 traditional IRA; the higher your beneficiary’s tax bracket, the bigger the savings).

Here’s how the strategy is helping a couple in their 40s build their nest egg. The wife’s in marketing with a pharmaceutical company, and the husband is a stay-at-home dad. First, she’s maxing out on her company pre-tax 401(k) plan contributions—putting away the full $17,000 for 2012—her employer doesn’t offer a Roth 401(k) option. The couple told their tax advisor Huston they want to save more, but they can’t contribute to Roth IRAs directly because her income is nearly $200,000 a year. (Once your modified adjusted gross income is $183,000 for a couple filing jointly or $125,000 for singles, no Roth IRA contributions are allowed).

But they can each contribute to a traditional IRA. They don’t get a deduction because of the wife’s high income, so it’s called a nondeductible IRA. She puts away $5,000, and he puts away $5,000 (his IRA is based on her earning and called a nondeductible spousal IRA; otherwise you have to have earned income to contribute to an IRA). Then they convert the IRAs into Roth IRAs. That sounds complicated but you can do it online, and it’s almost as easy as transferring money from checking to savings. You pay income tax the next April only on any earnings accrued between the time you contributed to the nondeductible IRA and converted to a Roth.

There’s one big caveat to the backdoor Roth: the pro rata rule. When you calculate the taxes due on a conversion, you have to take into account all your IRA assets, not just the new $5,000 nondeductible IRA. For example, if you have a traditional IRA with $95,000 of money from a 401(k) rollover (the $95,000 contributions were made on a pre-tax basis), and you make a $5,000 nondeductible contribution to a new IRA, the conversion would be 95% taxable.

So when might it make sense to skip this whole exercise? Ronald Finkelstein, a CPA and lawyer with Marcum in Melville, N.Y., said he personally makes nondeductible IRA contributions each year and has considered doing a Roth conversion but passed because he has accumulated a large sum in a traditional IRA he opened 30 years ago when he had a newspaper route. Plus, he may retire to Florida, so paying the New York state tax bite wouldn’t make sense. “You have to do the calculations,” he warns.

But sometimes it can still make sense for folks, even older folks, with big traditional IRAs, to do the backdoor Roth. Another Huston client, a 68-year-old builder, does them as part of a holistic plan to get more of his net worth into tax-free accounts so he and his wife (and grandchildren) will have the accounts to tap as part of a tax diversification strategy. He just did a $6,000 backdoor Roth for the third year in a row. At the end of each calendar year, Huston and he look at his income and decide how much to convert from his traditional IRA too (one year it was $50,000; one year $25,000), keeping in mind what would push him into a higher tax bracket.

There’s still time to make an IRA contribution for calendar year 2011 through April 17, 2012. You can double up and make your 2012 contribution too. How long should you wait to convert? “It’s a grey area,” says Robert Keebler, a CPA in Green Bay, Wisc. He suggests a waiting period of six months, although other advisors say to convert the next day to limit the tax bite on the conversion.

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by Andrew Taylor

Republicans would cut federal employee benefits. President Barack Obama would raise fees for airline passengers and eliminate Saturday mail delivery. Democrats in Congress would charge employers higher premiums for federal pension guarantees.

As Congress returns from a three-week holiday break, those are a few of the ideas for how to pay for extending an average $20-a-week Social Security payroll tax cut through the end of 2012 without adding to the government’s long-term debt.

Obama and fellow Democrats had insisted on taxing the wealthy to offset the deficit impact of the payroll tax cut and of providing jobless benefits to the long-term unemployed. While still useful as campaign fodder, that idea is largely a bygone one.

House and Senate negotiators are drawing on Obama’s budget and the work of the defunct congressional supercommittee on deficit reduction to come up with the $160 billion or so needed to continue the tax cut and federal jobless benefits. Both are set to expire Feb. 29.

Republicans controlling the House took a political drubbing in a December battle that produced a two-month extension of unemployment aid and the 2 percentage point tax cut for 160 million workers.

While House Republicans went after Democratic sacred cows such as federal worker benefits and health care spending, leading senators made progress on a bigger deal before it collapsed because of a lack of time, aides in both parties say.

Health care remains part of the equation. To prevent a 27% cut in Medicare payments to doctors under an outdated 1997 formula, negotiators are trying to find $39 billion in cuts elsewhere in health care spending. That would fix the problem for two years.

Some of the money being considered to offset the lost payroll tax revenue is practically free. For example, auctioning portions of the electromagnetic spectrum to wireless companies would raise perhaps $16 billion over the coming decade.

Obama wants to raise $4 billion more by selling off surplus federal property. There’s an additional $3 billion to be reaped by preventing state and local government workers from improperly claiming Social Security benefits.

One idea seen as likely to make it into the final package is the repeal of a tax break taken by businesses that buy corporate jets. It would raise about $5 billion over a decade.

Other ideas illustrate the uneasy trade-off of big spending cuts or new fees stretched out over a decade to finance only 10 months of a temporary tax cut.

For instance, eliminating Saturday mail delivery and other Postal Service changes raises enough money to pay for only about two months of the payroll tax cut. That may seem like a bad deal for many Americans, especially retired people who don’t get the tax cut. The postal reform plan was proposed by Obama and embraced by the supercommittee, but so far has been left out of the payroll tax legislation.

Similarly, an Obama plan to double the Transportation Security Administration’s security fee for nonstop air travel from $5 to $10 a round-trip ticket — a sure bet to anger travelers — would raise only enough money to pay for about one month of the tax cut. It gained currency in supercommittee deliberations but is not being pressed now, according to aides in both parties.

“This is definitely a situation in which there’s a lot of pain for not that much gain and that trying to do a lot of these things absent a big, broader budget deal is going to be difficult to do,” said Ed Lorenzen, an analyst with the Committee for a Responsible Federal Budget, a Washington-based group that advocates fiscal discipline. “Nickel and diming savings is not easy.”

A new $100 per flight fee on airlines and owners of private jets that would bring in more than $1 billion a year seems to be gaining momentum. So is a proposal to raise billions of dollars by making businesses with underfunded defined benefit pension plans pay higher premiums to the Pension Benefit Guaranty Corporation, which insures such plans. Many businesses and their GOP allies in Washington are resisting the proposals.

Democrats appear set to fight moves by House Republicans to require federal civilian workers to contribute 1.5% more of their salaries toward their pensions and absorb a third straight annual pay freeze. Obama wants to give federal workers a one-half of 1% pay increase in 2013.

Republicans’ proposal to trim the federal workforce through retirements and attrition faces opposition from Democrats who supported it as part of a big deficit-cutting package. Politically wrenching changes to Medicare appear to be off the table.

“When you’re talking about a major $1.2 trillion or more deficit reduction plan, there are some things you’re willing to consider that you might not in the context of a much smaller agreement,” said one Democratic negotiator, Rep. Chris Van Hollen of Maryland.

Despite powerful opposition from the Democratic-leaning Hispanic community, Republicans appear likely to win a provision that would save at least $9 billion by blocking illegal immigrants from claiming the refundable child tax credit. A separate proposal would raise billions of dollars by imposing Social Security taxes on some foreign temporary workers now exempt from them.

Lawmakers already have snapped up $36 billion in projected receipts over the coming decade to finance the two-month jobless benefits and payroll tax extension enacted just before Christmas. The money comes from a 0.10 percentage point increase in home loan guarantee fees charged by mortgage giants Fannie Mae and Freddie Mac that promises to increase the cost of a typical $200,000 mortgage by more than $5,000 over 30 years.

One thing Democrats are loath to do is revisit the overall cap on day-to-day agency budgets set under last summer’s budget and debt limit deal. That makes it more difficult to bank savings from cutting the federal workforce.

House Republicans hope for some victories for conservatives, such as letting states test unemployment benefit applicants for drugs and preventing welfare recipients from using ATMs in casinos, strip clubs or liquor stores to collect their benefits. GOP lawmakers also prefer maximizing spending cuts to raising fees.

Republicans promise to try to make sure the package is funded more with real spending cuts than new fees or easy money such as spectrum auctions. But they don’t seem to be spoiling for a fight.

“Given the work that has already been done, there is no reason this bill cannot be completed swiftly and with little acrimony,” said Michael Steel, a spokesman for House Speaker John Boehner, R-Ohio. “Frankly, the only way this process will not go smoothly and through regular order is if the White House chooses to disrupt it for political reasons.”

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By Darla Mercado

In a bid to appeal to fee-based and fee-only financial advisers, life insurers are resurrecting a product intended to generate a steady stream of retirement income outside the VA arena.

So-called stand-alone living benefits combine the benefits of variable annuities that offer guaranteed- lifetime-withdrawal benefits with an investment account overseen by fee based or fee only adviser.

Here is how they work: Investors turn a lump of cash over to their advisers in exchange for a steady stream of retirement income, say, 4% or 5% a year. The insurance kicks in if and when that investment account is drawn down through systematic withdrawals or eroded by market forces.

SALBs, as they are known, were first introduced in 2008, but that introduction got waylaid by the ensuing downturn. Lately, however, interest in SALBs has been rekindled.

Aria Retirement Solutions LLC and Transamerica Life Insurance Co. will take the wraps off a SALB today. That SALB is intended to be sold by fee only advisers.

Great-West Retirement Services is also planning to launch a SALB aimed at both fee- and commission-based advisers.

“The reason for creating SALBs is to broaden the tools for advisers. Advisers have a disinclination to use insurance products,” said Noel Abkemeier, a consulting actuary at Milliman Inc.

“Their approach tends to be, “If we diversify properly and manage investments well, we don’t have to do anything else.’ That leads them to preferring mutual funds over variable annuities,” Mr. Abkemeier said.

Insurers are hoping that registered investment advisers’ desire to offer guarantees in the context of a fee-based or fee-only business model will fuel sales of SALBs.

That said, the complexity of the products poses a significant hurdle to their widespread acceptance.

“It’s not an, “If you build it, they will come’ concept,” said Bing Waldert, director at Cerulli Associates Inc. “Guaranteed retirement income makes sense, but I’m not sure the insurance industry has done a good job of showing advisers what this is and how to use it.”

There also are regulatory concerns.

A group of regulators at the National Association of Insurance Commissioners noted last year that it is difficult for state insurance cops to vet SALB product filings and debated whether they are annuities or a financial guaranty that is similar to bond insurance.

The American Academy of Actuaries last month filed a report with the NAIC, arguing that SALBs aren’t financial guaranty products but are actually life insurance products.

“The regulatory concern is really about the fact that the insurer doesn’t have the same kind of control as it does with variable annuities,” said Tamiko Toland, managing director of retirement income consulting at Strategic Insight. “The regulatory issues will eventually be resolved, but another key here is getting this style of guarantee out to a different clientele — to reach out to a set of advisers who may not be all that familiar with or crazy about variable annuities.”

Although SALBs will vary by the company issuing the coverage, the product offered today by Aria Retirement Solutions and Transamerica Life Insurance features a range of withdrawal percentages — from 4% to 8%— based on interest rates and when the client locks in his or her annual payment.

This way, a 65-year-old client who invests $500,000 into an account wrapped by the SALB is eligible for a guaranteed 4% withdrawal at $20,000 annually — if he or she decides to lock in the income benefit right now. If the interest rate rises after the lock-in, the client can obtain a higher payout amount.

In a situation where a 55-year-old client invests $500,000, benefits from gains in the market and then experiences a decline by age 65, the customer locks in the high-water mark and can obtain income based on the interest rate at the time.

Transamerica begins making annual payments to the customer — and his or her spouse, if the client elects it — only if the covered account is depleted.

Naturally, there are contingents. Transamerica won’t make benefit payments if the client makes excess withdrawals or if the assets aren’t allocated to investments delineated by the insurer.

APPEAL TO RIAS

The expected appeal to the RIA audience is that the client’s assets aren’t being held by the insurance company.

The adviser maintains control of the assets and continues to receive an advisory fee on top of the 0.85% to nearly 2% that the client pays to participate in the SALB, exclusive of fund fees.

By comparison, a typical retail variable annuity can cost about 3% to 4%, as the client isn’t paying only for the guarantee but for expenses related to the variable annuity itself.

The cost of a SALB will depend on the level of risk for the selected investments. Although advisers may have a large pool of potential funds, the insurer providing the guarantee will still require allocation limitations.

“The design of these products puts parameters around the investments, so I can’t just walk in with a volatile holding and get a product for it,” said Joan E. Boros, who is of counsel with Jorden Burt LLP.

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