Going Forward: Quantifying “Best Interest,” Reasonable Compensation and Suitability for Investment Professionals

With the DOL’s recent release of their new fiduciary rule (Rule)and the related Best Interest Contract Exemption (BICE), there has been an increased interest in the concepts of “best interest” and prudence, two of the key concepts involved with both the Rule and Bice. Chris Caruso, the fine editor of the FiduciaryNews group on LinkedIn, recently raised the question whether the current fiduciary movement is “the beginning of the end or the end of the beginning.” John Bogle recently opined that the current fiduciary movement is just the beginning of a bigger, industry-wide movement.

Opponents of the Rule, Bice and the overall fiduciary movement argue that both “best interest” and prudent are highly subjective concepts and, thus , open to differing interpretations. However, the DOL has taken a lot of steam out of that argument by choosing to define “best interest” in terms of prudence, a simple, common sense principle. The association of prudence with “best interest” become even more meaningful given the admonition of Section 7 the Uniform Prudent Investor Act – “wasting beneficiaries’ money is never prudent.”

The reasonableness of a financial advisor’s compensation in connection with the provision of Retirement Advice is another key, yet arguably highly subjective, concept under both the Rule and BICE. In discussing this issue with my colleagues from both the legal and financial services professions, an important consideration seems to be whether reasonableness is seen in absolute or relative terms. In “absolute” terms means that reasonableness is determines solely in terms of actual monetary compensation, often in terms of peer/industry standards.

Evaluating reasonableness in “relative” terms means comparing the monetary compensation paid by a client/customer to the inherent quality and value, if any, of the investment advice provided, a legal concept known as “quantum meruit.” Given the abundance of evidence establishing the poor historical performance of actively managed mutual funds and the inequitable nature of the “inverse pricing” method used by many variable annuity issuers in computing a variable annuity annual M&E fee, a strong argument can be made that the fees and other costs charged by many investment professionals are not reasonable at all, as shown by the recent decisions and settlements in the ERISA excessive fees cases.

The renewed interest in the concepts of “best interest” and prudence has also spilled over to the interpretation of suitability, the standard of care that is still applicable to most stockbrokers and broker-dealers providing non-Retirement Advice situations. While suitability is considered a far less demanding standard of care than “best interest,” it should be noted that both FINRA and its predecessor, the NASD, are both on record stating that both stockbrokers and broker-dealers must always act in the best interest of their customers. Enforcement decisions involving both entities have consistently upheld this position.

In assessing suitability of advice, there are two significant aspects of suitability. The reasonable-basis obligation requires a member or associated person to have a reasonable basis to believe, based on reasonable diligence, that the recommendation is suitable for at least some investors. The customer-specific suitability standard requires that the advice provided to a customer must be suitable in connection to the customer financial need, objective and personal investment parameters.

As an attorney, I am always interested in relevant evidence and the proof of a case. For that reason, I created a metric, the Active Management Value Ratio™ 2.0 (AMVR), that allows investors, financial advisers and attorneys to quickly and effectively evaluate actively managed mutual funds in terms of “best interest,” reasonableness and suitability.

An example will help demonstrate the value of the AMVR in mutual fund analysis. Assume the following facts: Fund A, an actively managed fund, has an annual expense ratio of 100 basis points (1.00%), a turnover ratio of 30 percent and a 5 year annualized return of 19 percent. A comparable index fund has an annual expense ratio of 16 basis points (0.16%), a turnover ratio of 3 percent and a 5 year annualized return of 20 percent.

The AMVR analyzes a mutual fund  in terms of its incremental costs and the incremental return, if any, that it provides. In this example, the actively managed fund does not provide any incremental return, but still costs an investor a significant amount of incremental costs, 116 basis points (1.16%) Investors should remember that each additional 1 percent in fees and costs reduces an investor’s end return by approximately 17 percent over twenty years. Given the lack of any incremental return and the impact of the incremental costs associated with Fund A, an investment in Fund A would actually costs an investor money, hardly a prudent or suitable investment for anyone.

Assume the scenario, with the exception that Fund A’s 5 year annual return is 21 percent. Fund A would provide an incremental return of 100 basis points (1.00%). However the fund’s incremental costs would exceed fund’s incremental return, once again resulting in a net loss from anyone investing in the fund. Furthermore, 85 percent of the fund’s fee would only be producing 4.7 percent of the fund’s overall return. Again, hardly a prudent or suitable investment for anyone.

A recent study by Eugene Fama and Kenneth French concluded that only the top three percent of active managers manage to produce returns that even manage to cover their costs. The AMVR provides a simple means for investors, investment professionals and attorneys to analyze an actively managed fund to see if the fund qualifies as a prudent and/or suitable investment. Given the historical evidence regarding the under-performance of actively managed mutual funds and the continuing trend of decisions and settlements in the ERISA excessive fees/fiduciary breach cases, prudent financial advisers will take greater care in ensuring the quality of the investment advice they provide to the public.





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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