Financial Plans v. Investment Policy Statements: One, None or Both?

As an investment adviser consultant, one of the first things I ask new adviser clients is whether they prepare financial plans for clients. If so, I advise them not to do so going forward. Simply put, a financial plan in the hands of a knowledgeable securities attorney is an accident waiting to happen.

Dually registered advisers often counter by saying that their advisory activity is separate from their brokerage activity under the “dual hats” theory. Having been a compliance executive in the brokerage industry, I am aware of such arguments. However, I do not believe that argument is valid.

The “two hats” theory is derived from legal decisions involving ERISA and the separation of purely administrative duties from fiduciary duties under ERISA.  While a clear division can be established under ERISA, the courts have generally held that the functions of advisers and brokers are so intertwined that they cannot be clearly separated. As the court stated in the 1949 decision in Hughes v. Securities and Exchange Commission,

The record shows clearly that, except for a few isolated instances, petitioner acted simultaneously in the dual capacity of investment adviser and of broker and dealer. In such capacity, conflicting interests must necessarily arise. When they arise, the law has consistently stepped in to provide safeguards in the form of prescribed and stringent standards of conduct on the part of the fiduciary. More than 100 years ago the Supreme Court set forth this principle as follows:

“In this conflict of interest, the law wisely interposes. It acts not on the possibility, that, in some cases, the sense of that duty may prevail over the motives of self-interest, but it provides against the probability in many cases, and the danger in all cases, that the dictates of self-interest will exercise a predominant influence, and supersede that of duty.” (Michoud et al. v. Girod et al., 1846, 4 How. 503, 554-555, 45 U.S. 503, 554-555, 11 L.Ed. 1076.

The cornerstone of most financial plans is some sort of asset allocation or portfolio optimization recommendations generated by a commercial software program. Such programs usually rely on past performance data, even though advisers and investment product ads are required to disclose that past performance does not guarantee future performance. Some plans use projections of future performance, or “guesstimates,” which pose obvious potential liability problems.

Financial plans generally make use of various spreadsheets to make projections regarding financial goals and future financial needs. The software typically used in generating such projections is often highly unstable, often resulting in dubious projections. A careful review of such spreadsheet calculations will generally point out calculation errors, errors which invalidate all or a significant portion of such calculations.

A well-known saying  is that “trees don’t grow to the sky.” History shows that the performance of the stock market is cyclical, alternating between secular bull and bear markets. And yet, financial plans calculations are usually based on assumptions of constant growth , with no allowance for downturns in the market. From a liability standpoint, this flawed premise can result in serious miscalculations regarding a client’s future needs.

Financial plans and their components also pose potential issues under  with regard to the anti-fraud provisions of Rule 10b-5 under the ’34 Exchange Act and/or Section 206 of the ’40 Adviser Act. These issues often arise when an adviser’s implementation recommendations differ significantly from the scenarios and assumptions used within a financial plan.

Some advisers use disclaimers in an attempt to protect against potential liability for plan/implementation variances. However, the extent and language of such disclaimers may create liability issues under the legal concept of quantum meruit. Quantum meruit stands for the proposition that clients who pay for a financial plan have a legal right to receive something of equal value in return. Financial plans with disclaimers may effectively diminishes or totally destroys any inherent value of the financial plan.

The various quality-of-advice issues presented by most financial plans provided by financial advisers has led Nobel laureate Dr. William F. Sharpe to refer to such practices as “Financial Planning in Fantasyland. Those who do offer financial plans to clients would be well advised to consider Dr. Sharpe’s analysis, especially in terms of potential liability issues.

Based on my experience, many financial advisers prepare financial plans, yet few take advantage of the benefits available from investment policy statements. (IPS) From a risk management perspective, an IPS avoids all the subjective elements of a financial plan and allows a financial adviser to clearly define the terms of the adviser-client relationship. In the event that a dispute should arise, the value of such an agreement cannot be overstated.

Another advantage of an IPS is that it demonstrates to a client that the financial adviser is interested in truly understanding a client and the client’s goal and need, not just using a client as a means to an end, selling product. In this regard, an IPS serves to address the old saying that “people do not care how much you know until they know how much you care.” Prudent financial advisers will take the time to sit down with a client and create a mutually agreeable IPS.



About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ member and an Accredited Wealth Management Advisor™. I am a 1977 graduate of Georgia State University and a 1981 graduate of the University of Notre Dame Law School. I am the author of "CommonSense InvestSense: The Power of the Informed Investor" and " The 401(k)/403(b) Investment Manual: What Plan Sponsors and Plan Participants REALLY Need To Know. " As a former compliance director, I have extensive experience in evaluating the legal prudence of various types of investments, including mutual funds and annuities. My goal is to combine my legal and compliance experience in order to help educate investors on sound, proven investment strategies that will help them protect their financial security.
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