Three Investment Adviser Fiduciary Traps to Avoid

My last post advising advisers not to prepare and distribute financial plans resulted in several emails, some nice, some not so nice. With over nineteen years of experience in RIA law, both as a director of RIA compliance for FSC Securities and an RIA consultant, I stand by my earlier post.

It seems that nowadays there are RIA consultants everywhere, some good, some not so good. A test I often offer to those who ask how to evaluate an RIA compliance consultant is to ask the prospective consultant to explain what the SEC’s position is with regard to non-cash payments for client referrals and the name of the actual decision addressing same. Here’s a hint, most RIAs are in violation of the SEC’s decision and the ’40 Act.

Most of the people holding themselves as RIA compliance consultants only address the registration aspects of RIAs – the Form ADV and the related books and manuals. I like to address the liability aspects of RIA law, as far too often that is overlooked and/or ignored. As I tell RIA firms, the firm, the firm can have all the required manuals and files, but all that is meaningless if the firm has not set up an effective risk management program for the firm itself.

In my last post I addressed the liability issues that I have seen with regard to financial plans. In short, the commercial software programs are often unstable and often produce advice that is not only counter-intuitive, but flat out wrong.

From a liability standpoint, it’s like shooting fish in a barrel. I had several emails telling me that all an RIA has to do is include disclaimer language in the plan to protect the planner. Really, you’re charging some hundreds or thousands of dollars and you’re going to include disclaimer language saying, essentially, this may be totally worthless and, if so, we are not liable. Here’s some free legal advice – if that’s your defense, bring your checkbook with you to the arbitration hearing.

Along those same lines, I advise my RIA consulting clients not to include any binding arbitration requirement in their client advisory contracts. While these arbitration agreements are standard in most broker-dealer client agreements, there is increasing pressure to prohibit such requirements going forward.

RIA firms and their representatives are held to a fiduciary standard by law. Therefore, the firms and their representatives are required to always act in the best interests of their clients, to always put a client’s interests first. Requiring an advisory client to waive an important legal right, the right to a jury trial, is clearly not in a client’s best interests. The arbitration process mandated by the securities industry has long been the subject of serious criticism, and rightly so.

While the process has improved somewhat by the recent decision to allow clients to opt for an all-public hearing panel, there are still genuine and serious shortcomings with the securities arbitration process. Therefore, requiring an advisory to submit to such a process can be seen as a breach of the fiduciary duty of loyalty by an RIA firm.

Finally, there is the issue of variable and indexed annuities. Two primary duties of a fiduciary are first, to always act in the best interests of a client (the duty of loyalty), to always put their interests first, and second, to avoid excessive and unnecessary fees and costs, (the duty of prudence). Variable annuities and indexed annuities fail on both accounts.

Most variable annuities calculate their annual M&E fee on the accumulated value of the variable annuity rather than the cost of their potential liability. commonly referred to as “inverse pricing.” Since most variable annuities limit their liability exposure to the owner’s actual contributions to the annuity, it is easy to see situations where the accumulated value of the variable annuity far exceed the own actual contributions. Therefore, basing the annual M&E fee on accumulated value rather than the variable annuity issuer’s actual legal liability results in both an unmerited and inequitable windfall for the variable issuer at the annuity owner’s expense, as well as a clear breach of a fiduciary’s duties of loyalty and prudence.

Even insurance executives are admitting the inequitable nature of the inverse pricing system used by variable annuity issuers. John D. Johns, Chairman and CEO of Protective Life Corporation noted the need for change from inverse pricing with regard to variable annuity in his article, “The Case for Change,” in the September 2004 issue of Financial Planning magazine.

What’s more, the price charged is significantly higher than the value of the actual benefit conveyed. A noteworthy study by Moshe Milevsky and Steven Posner, “The Titanic Option: Valuation of the Guaranteed Minimum Death Benefit in Variable Annuities,” concluded that variable annuity issuers were charging variable annuity owners a fee that was anywhere from 5 to 10 times the actual economic value of the death benefit. actual The study is available at

So variable annuities are charging fees that are inequitable both in terms their legal obligations to annuity owners and in terms of the actual value of the benefit conveyed. Since each additional 1 percent of fees and costs reduce an investor’s end return by approximately 17 percent over twenty years, these practices and the windfall that they provide for variable annuity issuers clearly violate a fiduciary’s duties of loyalty and prudence.

Indexed annuities are actually fixed-income products, not investments. The confusion is often due to the fact that indexed annuities base their interest rates on the return of a stock market index, such as the S&P 500 Index.

That’s the way indexed annuities are marketed, but the rate of interest an investor earns is usually significantly lower than the index’s actual return. Index annuity issuers often limit an investor’s return by applying so-called cap rates and participation rates.

For example, lets assume that the index used by an index annuity issuer earns 20 percent in one year. Let’s also assume that the indexed annuity issuer applies a maximum rate cap of 10 percent and a participation rate of 70 percent. In this scenario, despite the fact that the applicable index earned 20 percent, the indexed annuity issuer would only receive a return based on 7 percent (10 percent times 0.70 percent).

Most investors, especially the elderly, do not understand such marketing shenanigans. The courts have recognized these issues and have increasingly imposed fiduciary duties on brokers and advisers, even for non-discretionary accounts, when the court determines that an investor lacked the knowledge and/or experience to independently evaluate a broker’s recommendations. Legal decisions such as Carras v. Burns and Follansbee v. Merrill Lynch are two cases illustrating this new pro-investor position of the courts. Where courts impose fiduciary obligations to protect investors, they may also impose both compensatory and punitive damages for violations of such fiduciary duties.

I get email asking me why I even write this blog, saying that most people will simply ignore the advice provided. I realize that that is probably true, but I also realize that there are some who do value my advice and realize I am only trying to help them protect their practices. Hopefully prudent investment advisers will consider the advice provided and the spirit in which it is offered.






About jwatkins

I am a securities and ERISA attorney. I am a CFP Board Emeritus™ 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 and investment fiduciaries on sound, proven investment strategies that will help them protect their financial security and/or avoid unnecessary fiduciary liability exposure.
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