2017: Brave New World

Posted on December 31, 2016 by jwatkins

2016 will be remembered by most financial advisers as the year of the fiduciary standard, the year everything changed forever. Some would challenge this statement, claiming that the Trump administration will make sure the DOL’s new fiduciary rule is reversed.

Only time will tell if that change comes to pass. However, even if the DOL’s new rule and accompanying “best interest contract” exemption, or BICE, are reversed, the publicity that the debate received and the issues involved received such publicity that a significant portion of investors, especially the high net worth investors, are better educated on the issues involved and more willing and able to demand that their advisers adhere to such fiduciary standards as the duties of prudence and loyalty.

Going forward, successful financial advisers will have to pay more attention to key fiduciary issues, trust and transparency. As a former securities compliance director, both in terms of RIA compliance and general securities compliance, I can fully appreciate the special challenges that dually registered representatives will face, with their broker-dealer potentially denying them the flexibility that independent RIAs have to properly address these two issues. For that reason, we may continue to see an increase in the number of registered representatives deciding to drop their securities licenses and go totally independent in order to be more marketable and competitive with other investment advisers.

There is a well-known saying that may come to define the evolution of the investment advisory industry – “people don’t care how much you know until they know how much you care.” This dovetails perfectly with the concepts of greater transparency and trust, as greater transparency will demonstrate a greater amount of openness and fairness in treatment, promoting a higher level of trust between a client and an adviser.

I have read a number of articles speculating on what the Trump administration will do with the new fiduciary rule and any idea that the SEC will follow the DOL’s lead. I have also read a number of articles suggesting that advisers and brokers should go ahead and adopt the standards set out in the new fiduciary rule in order to be competitive with the newly informed/educated investing public and to remain competitive with RIAs, who already legally required to comply with fiduciary laws.

Another reason for financial advisers to go ahead and adopt the fiduciary standards is that the courts have shown that they are willing to impose such duties on brokers and other financial advisers after-the-fact if necessary to protect inexperienced investors and ensure that they are treated fairly, the mission statement of both the SEC and federal securities laws. Furthermore, some states already impose a fiduciary standard on stockbrokers and other financial advisers, whether or not they are RIAs or investment advisory representatives.

Being proactive in adopting such standards simply allows brokers to better protect their practices and to be more competitive in the market. There are various online sites that allow financial advisers to perform a higher level of analysis on their investment recommendations. My free metric, the Active Management Value Ratio 2.0 (AMVR) is being used my more advisers and attorneys to analyze the suitability and prudence of investment recommendations. As a  result, the courts and the regulators are demanding a new, higher level of due diligence from those offering investment advice to the public.

Along those lines, I think an area that may receive greater attention in 2017 is the inconsistency between recommendation in financial plans and/or asset allocation modulcs and the actual products sold to customers in implementing such recommendations. While the industry likes to argue the “two hats” theory as a defense to any potential liability, decisions like the Arlene Hughes case seem to nullify such arguments. 

Rule 10b-5 prohibits any practice or scheme that operates as a fraud or otherwise misleads investors with regard to investments or investment advice. Since advisers often use risk and return data from generic asset categories in preparing financial plans and/or asset allocation modules, knowing that the actual products that they will eventually recommend and use in implementing such recommendation have significantly different risk and return characteristics, their failure to disclose such differences to their customers arguably violates the conduct addressed by Rule 10b-5. The failure of most financial advisers to go back and prepare revised financial plans and/or asset allocation modules based on their actual recommendations, despite the ready availability of tools to do so, only serves to strengthen the Rule 10b-5 argument.

In short, the debate that surrounded, and continues to surround, the DOL’s fiduciary rule only served to open the proverbial Pandora’s Box, both in terms creating new liability standards and educating the public on the various conflicts that often exist between themselves and their financial advisers. Financial advisers need to be ready to properly respond to such issues and the resulting demands and expectations of the public, especially in terms of trust and transparency.

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, compliance, DOL fiduciary standard, ERISA, evidence based investing, fiduciary compliance, fiduciary law, fiduciary standard, investment advisers, investments, pension plans, retirement plans, RIA, RIA Compliance, securities compliance, Trust marketing, trust realtionships | Tagged , , , , , , , , , , , , , , , , , , , , , , , | Leave a comment

The Fiduciary Standard is Dead? Long Live the Fiduciary Standard!

Posted on December 3, 2016 by jwatkins

A lot of people have asked me about the impact of the recent election on the future of the fiduciary standard. My answer is always in two parts – one based on existing legal precedent, the other on the DOL’s recent rule and the SEC’s possible adoption of a similar rule.

From the DOL/SEC standpoint, no one knows for sure what impact the election will have on a fiduciary standard. Based on some of Mr. Trump’s early choices for key positions and early statements from Congress the future of a universal fiduciary do not appear to be promising.

From the legal standpoint, the law has long recognized the requirements of a fiduciary’s duties, especially with regard to the fiduciary duties of loyalty and prudence. In interpreting and enforcing those duties, the courts and the regulators typically look to the Restatement of Trusts and existing case-law applying the Restatement’s principles. Breaches of one’s fiduciary duties are generally based on a fiduciary’s failure to adhere to the so-called “prudent person” standard – how would a prudent person handle similar situations.

The recent election, both in terms of the Presidential and Congressional results, are simply not going to change existing fiduciary precedent. I think that is one of the reasons some of the major broker-dealers are being proactive and announcing changes to some of their business platforms in favor of fiduciary friendly practices.

From a potential liability standpoint, the investment industry needs to recognize that the courts have shown an increasing willingness to impose a fiduciary standard on brokers where the courts perceive the need to do so in order to protect inexperienced investors from unethical brokers who have taken control over an investor’s account. As the courts have stated

The touchstone is whether or not the customer has sufficient intelligence and understanding to evaluate the broker’s recommendations and to reject one when he thinks it unsuitable.

As a result, many of the statements from the investment industry factions expressing a belief in the death of both the DOL’s new fiduciary rule and the SEC’s adoption of a similar rule are shortsighted and indicate nothing more than a false sense of security. In fact, all of the public discussion about the DOL’s fiduciary standard and the need for greater transparency may have increased public awareness of such issues, resulting in increased litigation based on alleged breaches of one’s fiduciary duties.

As I tell people, regardless of what becomes of the DOL’s fiduciary rule, the mission may have been accomplished by increasing the public’s awareness of certain unethical and/or inequitable practices in the investment industry  and their need to be more proactive in protecting their financial interests. The decision by some broker-dealers to adopt more fiduciary friendly practices is simply a wise business decision, as it gives them a sound marketing platform and arguably reduces potential liability exposure if such practices are actually implemented and followed.

Prudent investment advisers will recognize this new emphasis on greater transparency and use their existing fiduciary duties as a marketing tool. This was the message before the DOL acted and should always be the message. Since registered investment advisers have long been held to be fiduciaries, such advisers should always use their legal obligations as fiduciaries to differentiate themselves from non-fiduciary competitors and to educate the public on the advantages such legal obligations provide for investors.

 

 

 

Posted in BICE, compliance, DOL fiduciary standard, ERISA, fiduciary law, fiduciary standard, investment advisers, pension plans, RIA, RIA Compliance, securities compliance | Tagged , , , , , , , , | Leave a comment

Risk Management and Liability Housekeeping for RIAs

Posted on November 19, 2016 by jwatkins

In providing consulting and compliance auditing to investment advisers, I often see what they often consider meaningless issues, but I see as potentially significant issues. Two such issues are improper identification of the registered investment adviser and improper handling of customer complaints.

All documents issued by a RIA firm should properly reflect the name of the registered entity. Firms often use what is known legally as a fictitious, or “doing business as/aka” dba, name. Since such a firm does not legally exist, it cannot legally enter into contracts or hold itself out in such a way that would confuse the public as to the true identity of  the RIA firm. For instance, if XYZ, LLC is the actual registered RIA firm, but it does business as “World’s Greatest Wealth Management Company,” then the firm should identify the RIA in all documents as “XYZ, LLC d/b/a World’s Greatest Wealth Management Company.”

The usual response I get from firms is that they are not going to go through all that. Fine, it’s their business, but it begs the question, why didn’t the firm just register as “World’s Greatest Wealth Management Company”  in the first place. What such firms do not consider is that by entering into customer contracts with the RIA properly identified, a customer can come back at any time and invalidate the contract, since the alleged contract involves a legally non-existent party. The customer can demand not only the return of all fees paid pursuant to the legally invalid contract, along with interest on all such money paid.

The potential penalties do not end there. regulators can then follow-up with various charges, including fraud pursuant to Section 206 of the Investment Advisers Act of 1940. Since the states also retain jurisdiction on investment adviser fraud, they can press civil and criminal charges for misrepresentation of the RIA’s true identity. Since this is such an easy violation to establish, regulators often do not hesitate to pursue such actions.

The second common housekeeping mistake I see with RIA firms is the way that they handle customer complaints. While no RIA firm wants customer complaints, RIA firms need to understand that they simply cannot resolve all complaints by returning a client’s money just because they complain. Firms need to have a formalized procedure for evaluating and handling customer complaints.

While it may be expedient to simply return a client’s money, RIA firms need to understand that such a policy can be viewed from a legal and regulatory sense as an admission of wrongdoing. By adopting and following a formal procedure for handling customer complaints and properly documenting the findings from such a procedure, the RIA firm can reduce its potential liability exposure while efficiently resolving the customer complaint. 

As a former securities and RIA compliance director, one of the first things you learn is the proper way to handle customer complaints. The “click your heels three times, just throw money at it and make it go away…quickly” is not the proper way to resolve customer complaints. In fact, such an approach can quickly raise suspicions with attorneys and regulators, which usually only serves to exacerbate a firms immediate and long-term problems.

As a I routinely tell investment advisers, take the time to get it right from the start and it makes it that much easier to protect the firm and concentrate on providing customers with excellent services and growing your practice.

Posted in fiduciary compliance, fiduciary law, investment advisers, investments, RIA, RIA Compliance | Tagged , , , , , , , | Leave a comment

Make a Little Magic: Developing Trust Relationships With Clients

Posted on October 23, 2016 by jwatkins

As both a securities attorney and a CFP® professional, I get to see a side of the financial planning and wealth management industries that few get to see – the consumer’s inside viewpoint on the marketing and service practices side of such industries. When consumers contact me about potential litigation and/or providing a forensic analysis of their investment portfolios and the financial/investment advice they have received, they often provide valuable information and opinions that they have not discussed, and probably would not discuss. with their financial advisers.

In my 35 years as an attorney and 28 years as a CFP® professional, I have noticed definite long-standing trends in consumer expectations about the provision of financial planning and investment advice. Some of those trends are becoming even more apparent with the emergence of the millennial generation, a generation that is more likely to question financial planning and investment advice from a so-called “expert.”

Financial planners and investment advisers looking to gain such clients or continue to serve families with millennials need to understand and be prepared to provide not just an answer to “why” questions, but a meaningful answer. Millennials have less of a sense of allegiance than their parents and have no problem walking away from those that cannot provide the information they need and fail to do so in a respectful manner.

A recent post on LinkedIn discussed a university professor’s findings that the two most common questions that the public uses to evaluate a person are (1) whether the person can be trusted, and (2) whether the person can be respected. For what it’s worth, my experiences in dealing with potential clients, in both practices, completely support the professor’s findings.

In college, my minor was in psychology. I did my thesis on trust, concentrating on the factors that influence the decision to trust someone and the cognitive biases that sometimes contribute to incorrect decisions to trust someone. Some 39 years later, my paper still remains as relevant as ever, as most of the points I discussed remain valid, points that financial planners and investment professionals should remember in order to grow and protect their practices.

The two primary points that I discussed in my thesis were the importance of transparency/openness and respect. Transparency has obviously become a significant issue in the financial services industry, especially in connection with the DOL’s recently announced fiduciary rule and an anticipated SEC version of a fiduciary rule.

One interesting trend that I have noticed, especially among millennials and other recent generations, is a desire to not only receive valuable financial advice, but advice that they are able to independently verify. That was one of the reasons I created my proprietary metric, the Active Management Value Ratio™ 2.0 (AMVR)and released it for free to the public. For more information about the AMVR and the simple, two-minute process required to calculate the metric, click here.

Each week I get emails and calls from people who have read the articles about the AMVR and have either taken the time to calculate the AMVR scores on their own investments or want to evaluate new investment advice they have received. When I decided to make the metric available for free online, people immediately asked me why I did so. The simplicity of the metric itself and the fact that I made it available for free has made the AMVR a tremendous marketing tool. In most cases, people have told me that both facts made them easily feel that they could trust me, especially since I provided them with a means for them to independently verify what I told them.

When I released the AMVR, I expected the legal community to quickly accept and adopt the metric since it provided a means to quantify suitability and prudence. At the same time, I expected a less positive response from the financial services industry for the very same reason. Surprisingly, many investment advisers have realized the value of the AMVR as a marketing tool, both in terms of providing prudent advice to their clients and protecting their practices. Many of those same advisers have told me that their clients commented on the adviser’s openness and willingness to give them a means to independently evaluate the advice the adviser gave to them.

If, as expected, the SEC replaces the current suitability standard and adopts a fiduciary standard similar to the DOL’s fiduciary rule, I believe that the use of the AMVR as both a quality of advice/practice protection and a marketing tool will increase significantly since it is free and simple, only requiring the “My Dear Aunt Sally” (multiplication, division, addition and subtraction) we all learned in grade school. To quote Apple legend Steve Jobs, “simplicity is the new sophistication.”

While transparency is a significant factor in the trust process, the people who I speak with stress that respect is equally important factor in the trust decision. Most people quickly point out that both are essential factors in order for a trust relationship to develop.

When I see the various lists of “top” financial advisers, I always shake my head over the fact that AUM plays such a significant role in such rankings. AUM may indicate one’s marketing ability, but it certainly is not necessarily an indicator of one’s wealth management skills. I can make that statement based on the number of forensic fiduciary prudence analyses that I have performed for fellow securities attorneys, investment fiduciaries and investors.  While many advisers may see inclusion on such lists as a means of gaining immediate respect among investors, with some even willing to pay for the opportunity to be on such lists, knowledgeable investors are aware of the “secrets” involved with such lists and demand far more for an adviser to gain the respect necessary for them to form a trust relationship with an adviser.

Based on numerous studies that have conducted on the issue of respect, as well as my personal experience, respect involves doing things to indicate to a client or prospective client that they are more than simply a means to an end. In many cases an investor will contact me to discuss litigation over simple things like the failure to return phone calls, either in a timely manner or altogether, or the failure to keep them updated on their accounts beyond just the required quarterly report. Despite what many marketing experts tell advisers, most knowledgeable clients could care less about the annual birthday and Christmas cards they usually receive from their various professional advisers. Clients want to know about the relevant information, which it he information about their accounts with the respective professional.

As discussed earlier, millennials and the younger generations are especially more information oriented and demanding in their professional relationships. If you talk to members of such generations, they often perceive such obligatory marketing tools as disrespectful in and of themselves. These generational clients would be more appreciative of an annual or semiannual client appreciation reception accompanied with a presentation of timely and useful information. I have a valued friend who has recognized this fact and offers a free monthly presentation that clients can attend, with a nice, yet simple, lunch box provided. He gets it and his practice is thriving.

When people ask me about creating and maintaining a trust relationship with a client, I usually go over the same points that I have outlined here. But I also tell them to remember two familiar quotes that apply to any successful relationships, whether business of personal.

Do unto others as you have them do unto you.

People do not care about how much you  know until they know how much you care.

Both obviously involve the issue of respect and the treatment of others. As an attorney, I have often heard it pointed out that we have thousands of laws and regulations, all stating the Golden Rule in one form or another. Likewise, transparency and openness are signs of respect, a sign of disclosing information that may be important to a client and not trying to hide any potential conflicts of interest that may improperly influence an adviser’s decisions and recommendations.

I see the current situation as analogous to the situation discussed in the classic, “Art of War,” Sun Tzu points out that those who, like rivers, shape their course according to the nature of the ground over which it flows, are those who will be victorious. Like most people, I think that the financial services industry  is going to see significant changes in business practices during the next decade. Financial advisers who embrace such change and see the inherent opportunities presented by such changes will be the ones who prosper while protecting their practices.

 

Posted in DOL fiduciary standard, evidence based investing, fiduciary compliance, investment advisers, Trust marketing, trust realtionships, wealth management, wealth preservation | Tagged , , , , , , , , , | Leave a comment

The 401(k)/404(c) Plan Sponsor’s Achilles Heels – Redux

Posted on September 21, 2016 by jwatkins

With the effective date for the DOL’s new fiduciary standard getting closer, I have been receiving questions and calls from plans and fellow attorneys regarding the various obligations under the new standard. For that reason, I am re-posting an updated version of an article I posted earlier this year.

401(k)/404(c) plan sponsors need to realize that the primary reason that plans are being successfully sued involves a plan sponsor’s fiduciary duty that will not be changed due to the DOL’s announcement, a duty that plan sponsors need to address to “bulletproof” their plans. In far too many cases, liability is based primarily on a plan sponsor’s failure to properly perform the personal investigation and evaluation of a plan’s investment options.

ERISA requires that a plan sponsor make an independent investigation and evaluation of the merits of both the investment (1) and any and all service providers(2) chosen by a plan. In determining whether a plan sponsor properly fulfilled their fiduciary duty to investigate and evaluate,

[T]he determination of whether an investment was objectively imprudent is made on the basis of what the [fiduciary] knew or should have known; and the latter necessarily involves consideration of what facts would have come to his attention if he had fully complied with his duty to investigate and evaluate.(3) (emphasis added)

This fiduciary duty to conduct an independent investigation and evaluation of a plan’s investment options is a plan sponsor’s first “Achilles heel.” In applying the “objectively prudence” standard, the court have held that

a decision is “objectively prudent” if “a hypothetical prudent fiduciary would have made the same decision anyway.” (4) (emphasis added)

Plan sponsors and plan service providers often try to justify questionable investment choices by relying on modern portfolio theory (MPT), the idea that investments in an investment portfolio should be evaluated individually, but in the context of the portfolio as a while. While that argument may be applicable with regard to defined benefit plans, where the employer is essentially selecting one investment portfolio which will applicable to all plan participants, the courts have rejected the MPT argument when defined contribution plans are involved.(5) As the DiFelice court pointed out with regard to defined contribution plans

Here the relevant ‘portfolio’ that must be considered is each available fund considered on its own…not the full menu of Plan funds. This is so because a fiduciary cannot free himself from his duty to act as a prudent man simply by arguing that other funds, which individuals may or may not elect to combine [with another investment option], could have theoretically, in combination, create a prudent portfolio.

The case cited by the district court in support of its heavy reliance on modern portfolio theory involves a plaintiff challenging the prudence of one investment, contained in a monolithic, fiduciary-selected portfolio. [In that case], …the fiduciary himself  consciously coupled risk y securities with safer ones to construct one ready-made portfolio for participants….Here, in contrast, modern portfolio theory alone cannot protect [the plan sponsor]…just because it also offered other investment choices that made a diversified portfolio theoretically possible.(6)

While many plan sponsors are experts at the services their company provides, many lack the knowledge, expertise and experience needed to properly evaluate and select investment options. In such cases, the plan sponsor’s fiduciary obligations require them to hire independent professional advisers.(7)

What many plan sponsors do not realize, their second “Achilles heel,” is that they cannot blindly rely on any advice provided by a third party such as a service provider or any other professional adviser.(8) The plan sponsor still has a fiduciary duty to independently “review, evaluate and understand” the third-party advice.

The plan sponsor’s Achilles heel is made more vulnerable by the fact that a plan sponsor is not legally entitled to rely on the advice of a third-party unless the third-party is “independent and impartial.”(9) As the court pointed out in the Gregg decision, parties who do, or can, receive compensation from or produce compensation for other related third parties, such as stockbrokers and insurance agents, do not meet the impartiality requirements. This simple requirement has ensnared more than one plan sponsor and will undoubtedly ensnare others since very few plan sponsors or service providers are aware of the “independent and impartial requirement.

So, a plan sponsor’s duty to investigate, evaluate and select a plan’s investment options applies whether a plan sponsor attempts to do so independently or on the basis of advice provided by a truly “independent and impartial” third-party. And as the Supreme Court recently pointed out,

[A plan sponsor’s] duties apply not only in making investments but also in monitoring and reviewing investments, which is to be done in a manner that is reasonable and appropriate to the particular investments, courses of action, and strategies involved…. In short, under trust law, a [plan sponsor] has a continuing duty of some kind to monitor investments and remove imprudent ones.(10)

The takeaway from these decisions is that plan sponsors need to be able to properly investigate and evaluate a plan’s investment options. And the numerous successful cases that have been filed, and will be filed, against 401(k) and 404(c) plans strongly suggests that many plan sponsors lack the ability to perform this vital fiduciary duty.

It has been argued that requiring a plan sponsor to perform a service that it is not suited for is inequitable and not in the best interests of the plan participants and beneficiaries. Proponents of that position argue that plan sponsors should be able to retain and completely rely on the advice of third-party experts on such duties.

Yet, experience has clearly shown that competing, and conflicting, best interests of such third-parties does not necessarily ensure that the best interests of a plan’s participants and beneficiaries are not served by reliance on a plan’s third-party advisers. Plan sponsors are often unaware that their contracts with third-party providers include “escape” clauses that effectively negate any fiduciary duties and/or liabilities that the third-party would otherwise have to a plan and its participants, leaving the plan sponsor potentially exposed to complete and personal liability for any issues that arise under the plan.

People often ask me why I publicly released my metric, the Active Management Value Ratio™ 2.0 (AMVR). This is exactly why I did so, to provide a simple means for plan sponsors to perform a simple initial evaluation of actively managed mutual funds, as they are the type of funds commonly found in most plans. While there are other aspects of a plan’s prospective or current investment options that will always need to be investigated and evaluated, the AMVR is a simple cost/benefit analysis that is based on sound, proven principles and is an appropriate due diligence technique with regard to an investment’s cost efficiency relative to a fund’s return.

I believe that most plan sponsors truly want to do the right thing, but simply lack the knowledge, expertise, and experience to do so. History has clearly shown that third-party advisers have actual or potential conflicts of interest that prevent them from providing truly independent impartial advice to a plan or its participants. That is the very reason the DOL is revising ERISA’s current provisions to hopefully better protect plans and plan participants and beneficiaries.

But plan sponsors need to understand that the new DOL fiduciary standards will not relieve them of their personal ongoing fiduciary duty to independently investigate, evaluate and monitor a plan’s investments options, even when a third-party expert, such as a 3(21) or 3(38) fiduciary, is retained. The importance of understanding how to properly evaluate a fund’s prospective and actual investment options cannot be overstated. As one court stated

 [I]f fiduciaries imprudently evaluate, select, and monitor a plan’s investment options, or do so for any purpose other than the best interest of the plan, they breach their fiduciary duties. (11)

The new fiduciary standard that the DOL will introduce provides an opportunity for truly independent and impartial third-party advisers to demonstrate their value-added proposition to plan sponsors. Plan sponsors that retain the services of third-party experts should select only those experts that are willing to assume a fiduciary status and both advise and educate both the plan and the plan’s participants on the appropriate evaluation of investment options, thereby promoting a true win-win situation for both the plan, its participants and the third-party adviser.

Notes

1. U.S. v. Mason Tenders Dist. Council of Greater New York, 909 F.Supp. 882. 887 (S.D.N.Y. 1995); Liss v. Smith, 991 F. Supp. 278, 298 (S.D.N.Y. 1998); Fink v. National Sav. and Trust Co., 772 F.2d 951, 957 (D.C.C. 1984).
2. Liss, at 300.
3. Fink, at 962.
4. Tatum v. RJR Pension Investment Committee, 761 F.3d 346 (4th Cir. 2014)
5. DiFelice v. U.S. Airways, 497 F.3d 410, 423 and fn. 8.
6. DiFelice, at 423
7. Mason Tenders, at 886; Liss, at 296.
8. Howard v. Shay, 100 F.3d 1484, 1488 (9th Cir. 1996); Donovan v. Mazzola, 716 F.2d 1226, 1234 (9th Cir. 1983 ); Donovan v. Bierwirth, 680 F.2d 263, 272-73 (2d Cir. 1982).
9. Gregg v. Transportation Workers of America Intern., 343 F.3d 833, 841 (6th Cir. 2003).
10. Tibble v. Edison International, 135 S.Ct. 1823, 1828-29 (2015).
11. In re Regions Morgan Keegan ERISA Litigation, 692 F.Supp.2d 944, 957 (W.D. Tenn. 2010).

© Copyright 2016 InvestSense, LLC. All rights reserved.

This article is for informational purposes only, and is not designed or intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances.  If legal, investment, or other professional assistance is needed, the services of an attorney or other professional adviser should be sought

Posted in 401k, 401k compliance, 404c, 404c compliance, DOL fiduciary standard, ERISA, fiduciary compliance, fiduciary law, pension plans, retirement plans | Tagged , , , , , , , , , , , , , | Leave a comment

Point to Ponder: A Reverse BICE Cause of Action?

Posted on September 20, 2016 by jwatkins

In talking with some of my colleagues on both the legal and financial planing sides, an interesting question has come up with regard to potential liability under the new BICE provision of the DOL’s new fiduciary standard. I’m writing this short post to throw it out in hopes of getting some “think tank” responses.

This source for the current discussion is this recent article in InvestmentNews http://www.investmentnews.com/article/20160908/FREE/160909948/dol-fiduciary-rule-could-cause-half-of-potential-ira-rollover-assets?utm_content=buffer1445d&utm_medium=social&utm_source=linkedin.com&utm_campaign=buffer.

The article discusses the concern among some financial services individuals regarding advising potential clients on IRA accounts and potential 401(k) rollovers into an IRAs. The article suggests that the potential liability concerns among financial advisers may result in a lack of advice for employees, resulting in some employees just leaving their money in their company’s 401(k) once they retire.

Is it possible that financial advisers should also consider the possibility of a reverse BICE action against them as a result of advising a customer to stay in their 401(k) plan? Given the numerous legal actions against 401(k) plans and the adverse decisions and settlements against such plans, a strong argument can be made that there are a number of plans that are not in the best interests of the plan’s participants, increasing the possibility of unnecessary financial losses.

Under BICE, a financial adviser has a fiduciary duty to determine whether they can provide advice and recommendations that are in the best interests of the customer, that are an improvement from the customer simply leaving their money in their company’s 401(k) plan. This obviously requires a financial adviser to analyze the customer’s 401(k) in order to determine if they can improve the customer’s situation. While a financial adviser cannot make a customer choose a particular course of action, does a financial adviser have a fiduciary duty to point out a poorly structured 401(k) plan and the resulting potential for losses due to funds with excessive fees and/or a history of poor performance?

Once the parties enter into a BICE agreement, there is no question that a fiduciary relationship exists. The question is exactly what fiduciary duties are required under the BICE agreement. Clearly the anticipated duties involve recommendations of possible alternative investment products and/or strategies that better a customer’s situation. But if a financial adviser has additional information that is material and the customer would want to know in making their decision as whether to follow the adviser’s advice, does a financial adviser have a duty to disclose such information to a customer as well?

This is an interesting question, as existing fiduciary, agency and security law and decisions would seem to indicate that a strong argument could be made in favor of a duty to disclose such information. The first thought would be to draft the BICE agreement to expressly provide that the financial adviser does not have a duty to disclose such information. However, if such a fiduciary duty does exist under a BICE agreement, then the law would probably hold such an attempt to waive one’s fiduciary duties unenforceable given the judiciary’s strong position on fiduciary duties and protecting the public.

If a financial adviser does such a duty to disclose information and opinions regarding a customer’s company’s 401(k) plan, is there anything they can, or should do. to protect themselves from unwarranted liability in connection with providing services under a BICE agreement? At a minimum, I would document the fact that such information was provided, as well as the specific information that was provided. I would also have the customer acknowledge that the disclosure was made and sign the document.

I do not have a definite answer to this question. I’m hesitant to provide such advice and document same for several reasons. Any document becomes potential evidence if a claim is made. More importantly, based on my personal experience as a compliance director, not every financial adviser can properly determine whether an investment or investment strategy meet applicable suitability or prudence standards.

At this point, I have made my own personal decision as to what I am going to advise my clients to do. However, due to potential liability issues, I do not feel comfortable disclosing that decision here in case I am wrong. I have what I consider to be strong legal grounds for my position, but I cannot afford to have the LinkedIn world and my millions of loyal readers come after me if I am wrong. Mama didn’t raise no fool.

I look forward to your comments and insight on this matter.

 

Posted in 401k, 401k compliance, 401k investments, 404c, BICE, compliance, DOL fiduciary standard, ERISA, fiduciary compliance, fiduciary law, investment advisers, investments, IRAs, pension plans, retirement plans, RIA, RIA Compliance | Tagged , , , , , , , , , , , , , , , , | Leave a comment

A Fiduciary Blueprint: The Restatement of Trusts, the Prudent Investor Rule and the DOL’s New Fiduciary Rule

Posted on September 13, 2016 by jwatkins

A [fiduciary] is held to something stricter than the morals of the market place.  Not honesty alone, but the punctilio of an honor the most sensitive, is the standard of behavior….
Meinhard v. Salmon, 249 N.Y. 458, 464 (1928)

Ever since the DOL announced its new fiduciary rule, much has been made of the alleged “ambiguity” of certain aspects of the rule, such as “best interests” and “reasonable compensation,” with suggestions that the meaning of the rule and the full extent of one’s obligations under the rule will not be clear until the courts have interpreted the rule.

I realize that as a fiduciary attorney, I probably follow fiduciary matters and legal decisions more closely than others. However, I think those that adopt such a position may well be exposing themselves to unnecessary potential liability exposure.

Fred Reish, one of the nation’s leading ERISA attorneys, has been publishing an excellent series of articles on various aspects of the rule. Reish has appropriately suggested that those seeking clarification on some of the fiduciary issues associated with the rule can turn to the forty-plus years of DOL guidance and fiduciary legal decisions involving and developing such principles. Reish’s articles are available here.

To that, I would add the suggestion that the Restatement of Trusts would be a valuable resource in obtaining better understanding of a fiduciary’s duties under the new rule and a fiduciary’s duties in general. The courts have consistently turned to the Restatement of Trusts in interpreting a fiduciary’s obligations.1 More specifically, the courts have looked to the Restatement’s Prudent Investor Rule (PIR)2 for guidance in determining such matters. There is nothing to suggest that the courts would, or should, do otherwise with regard to a fiduciary’s obligations under the DOL’s new fiduciary rule.

It has always struck me as strange how many people involved in providing fiduciary services have never taken the time to review the Restatement and the PIR, including the associated comments and notes,  given the legal system’s reliance on the PIR in fashioning legal liability for fiduciaries. Granted the PIR is lengthy, but it is the recognized blueprint for compliance with one’s fiduciary duties.

Two of the primary fiduciary duties set out in the PIR are the duty of loyalty and the duty of prudence. The duty of loyalty is pretty straight forward. In the context of ERISA, the duty of loyalty requires that plan fiduciaries act solely in the best interests of the plan, its participants, and their beneficiaries, to always put the best interests of the plan participants and their beneficiaries first.

With regard to a fiduciary’s duty of prudence, the PIR stresses two consistent themes – cost consciousness and risk management through diversification. The Restatement and the PIR make it clear that cost consciousness is fundamental to prudence in the investment function.3 Section 88 of the Restatement cites Section 7 of the Uniform Prudent Investor Act – “[w]asting beneficiaries’ money is not prudent.”4

In addressing cost consciousness, the PIR points out that fiduciaries must perform a thorough and objective cost comparison of viable investment alternatives, especially when the fiduciary’s advice and recommendations involve actively managed investments or strategies.5 Since such investments and strategies usually involve higher costs and/or risks, the Restatement states that a fiduciary must be able to explain why it is reasonable to assume that the returns from such investments and/or advice will compensate for the higher costs and/or risks involved.6

In performing the required cost comparisons, the Restatement and the PIR state that fiduciaries should consider both a fund’s annual expense ratio and the fund’s trading costs.7 Trading costs are often overlooked in evaluating mutual funds, providing securities attorneys with a valuable evidentiary advantage in proving their cases. The SEC stressed the potential impact of trading costs in a December 2000 release, describing trading costs as “anti-performance” factors that reduce investors’ end returns8. Like the Restatement and the PIR, the SEC stated that fiduciaries need to document why they reasonably believe that a fund’s expected returns are justified any additional costs associated with an actively managed mutual fund.

Most financial advisers are quick to point out that the prudence of their advice should be evaluated on factors other than just cost. The Restatement agrees, pointing out that in assessing the prudence of investment advice, any and all costs of the investment products recommended should be evaluated relative to the value received in exchange for such costs.9

The issue with actively managed mutual funds is that the evidence clearly shows that historically, the majority of such funds underperform comparable, less expensive index mutual funds, thus failing to provide the required value to justify the extra expense and risk of such funds. This fact is one of the key foundations for the current trend in 401(k) and 403(b) litigation.

Fiduciaries need to remember that fiduciary liability is based on the prudence of their conduct, the prudence of the analytical process that they utilize in selecting investments and investment strategies, not on the basis of the actual performance of such investments and investment strategies.10 Process instead of results.

In evaluating the prudence of the analytical process used by a financial adviser, the Restatement and ERISA state that the fiduciary’s process must be acceptable from both a procedural and a substantive perspective.11 Procedural prudence examines the prudence of the process that the fiduciary used in gathering the relevant information about a prospective investment alternative. Substantive prudence focuses on how a fiduciary uses such information in deciding on their investment recommendations and investment strategies.

One of the key issues raised by the financial services industry is how the new rule’s “reasonable compensation” requirement will be interpreted.  Reish first notes that the issue of reasonable compensation naturally involves a determination of the value received by a customer in terms of the investment recommendations and/or investment advice received relative to the price paid for same. Reish then points out that Internal Revenue Code Section 4975(d)(2) already imposes a reasonable compensation requirement on adviser compensation in connection with advising IRA accounts. However, Reish also states that the requirement is often overlooked due a lack of overall enforcement.

One basic premise involved with the concept of reasonable compensation naturally has to be that a customer receives something of value in exchange for the fees paid for the adviser’s advice or investment product recommendations. The concept of reasonable compensation is derived from the legal concept of quantum meruit, a concept that basically states that parties involved in a transaction shall both receive appropriate consideration for their services or payments to ensure that neither party is unjustly enriched at the expense of the other.

Several years ago I created a metric that factors in all of the key criteria set out in the Restatement and the PIR. The Active Management Value Ratio™ 2.0 (AMVR) allows investors, fiduciaries, and attorneys to evaluate the cost efficiency, or relative value, of actively managed mutual funds. The AMVR is based on the principles set out in the Restatement and the PIR , as well as the studies of investment  icons Charles D. Ellis and Burton G. Malkiel.

One of the most attractive aspects of the AMVR is its simplicity, both in terms of calculation and interpretation. The AMVR clearly indicates whether an actively managed mutual fund is imprudent due to (1) its failure to provide value in terms of a positive incremental return, or (2) its failure to provide an incremental return greater than the fund’s incremental costs. For additional information about the AMVR and the calculation process itself, click here.

On a related fiduciary cost consciousness issue, the DOL’s new fiduciary rule created a special exemption that allows financial advisers to recommend investments that would otherwise be imprudent under the DOL’s new rule. However, financial advisers who decide to rely on the new Best Interests Contract exemption (BICE) need to remember that BICE still requires that financial advisers always put a customer’s best interests first and that all investment recommendations provided pursuant to a BICE agreement must still satisfy all fiduciary prudence requirements.

From my conversations with fellow securities and ERISA attorneys, there seems to a general consensus that recommendations involved variable annuities are expected to be the leading issue in BICE related litigation. Moshe Milvesky’s famous study established the fact that the method used by most VA issuers in assessing a VA’s annual fees result in excessive fees and result in an inequitable windfall for the VA issuer at the VA owner’s expense.12 Fiduciary law is based largely on the principles of equity law, and it is a well established that equity abhors a windfall.13

Conclusion

In adapting their practices to the DOL’s new fiduciary rule, financial advisers need to focus on the fact that fiduciary liability is generally based on a fiduciary’s imprudent conduct in developing their investment recommendations, not the actual performance of the actual investments and strategies. It is reasonable to assume that the courts will continue to rely on the Restatement of Trusts and the Prudent Investor Rule in interpreting imprudent conduct under the DOL’s new fiduciary rule.

Consequently, with regard to actively managed mutual funds, financial advisers should focus on ensuring that their investment recommendations are cost efficient, that the adviser can provide an acceptable explanation as to why they believed that an actively managed fund would provide a return that would be sufficient to compensate a customer for the additional costs incurred. Financial advisers who fail to adopt and follow a due diligence analytical process that is prudent, both procedurally and substantively, and choose to rely on a “good faith’ defense should remember the oft quoted admonition from the courts – a pure heart and an empty head are no defense to a breach of fiduciary duty claim.14

Notes
1. Tibble v. Edison International, 135 S.Ct. 1823, 1828 (2015); Donovan v. Mazzola, 716 F.2d 1226, 1231 (9th Cir. 1983).
2. Restatement (Third) Torts, § 90.
3. Restatement (Third) Torts, § 90 cmt b.
4. Restatement (Third) Torts, § 88 cmt a.
5. Restatement (Third) Torts, § 90 cmt m.
6. Restatement (Third) Torts, § 90 cmt h(1) and cmt m.
7. Restatement (Third) Torts, § 90 cmt h(1) and cmt m; “Division of Investment Management Report on Mutual Fund Fees and Expenses (December 2000), available online at https://www.sec.gov/news/studies/feestudy.htm
8. “SEC Staff Study On Investment Advisers and Broker-Dealers As Required By Section 913 of the Dodd-Frank Wall Street REFORM AND Consumer Protection Act of 2010, at 59 (January 2011).
9. Restatement (Third) Torts, § 90 cmt h(1) and cmt m.
10. Restatement (Third) Torts, § 77 and § 90 cmt b.
11. ERISA § 404(a)(1)(B), 29 U.S.C. § 1104(a)(1)(B); 29 C.F.R. § 2550.404a1(b)(1).
12. Moshe Milevsky and Steven Posner, “The Titanic Option: Valuation of the Guaranteed Death Benefit in Variable Annuities and Mutual Funds,” Journal of Risk and Insurance, Vol. 68, No. 1, (2001), 91-126.
13. Prudential Ins. Co. of America v. S.S. American Lancer, 870 F.2d 867 (2nd Cir. 1989).

Posted in 401k, 401k compliance, 401k investments, 404c, 404c compliance, Annuities, BICE, DOL fiduciary standard, ERISA, fiduciary compliance, fiduciary law, investment advisers, investments, IRAs, pension plans, retirement plans, RIA, RIA Compliance, securities compliance, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , , , , , | Leave a comment

What Mr. Schlichter Understands…and Plan Sponsors and Investment Fiduciaries Need to Understand As Well

Posted on August 19, 2016 by jwatkins

This week attorney Jerome Schlichter, already known for his actions against 401(k)s and plan sponsors for alleged breaches of their fiduciary duties, added a new category of defendants to his practice, 403(b) plans of private colleges and universities. By my count, he has filed twelve such actions to date against some of the most well-known colleges and universities in America.

Mr. Schlichter’s new strategy apparently surprised a lot of people, as they thought colleges and universities were not covered by ERISA and therefore were protected against such actions. While state colleges and universities are generally not subject to ERISA’s requirements, private colleges and universities are not afforded such protection. For future reference, it should be noted that even the 403(b) plans of state colleges and universities are subject to similar breach of fiduciary charges under a state’s common laws, such as agency, negligence and breach of contract laws. Click here for more information about possible fiduciary liability of non-ERISA pension plans.

The new complaints filed by Mr. Schlichter this week against the college and university 403(b) plans included many of the same allegations contained in his 401(k) actions – excessive fees and imprudent investment options within the plan. One of the more interesting new allegations in the 403(b) complaints was an allegation that the plans contained too many investment options, in some cases hundreds of investment options, many of which were similar to or duplicative of each other, arguably reducing the plan’s ability to negotiate with the plan’s service providers for more favorable concessions for the plan’s participants.

Having personally conducted forensic analyses on a number of 403(b) and 457(b) plans of American colleges and universities, these new actions should not have come as a surprise to anyone. One noticeable trait of the 403(b) and 457(b) plans of American college and universities is the fact that most of them have the same three service providers (TIAA-CREF, VALIC, and Fidelity Investments) and, in  most cases, offer exactly the same or extremely similar menu of investment options within their plan. For reason, I believe that more such actions will be filed by Mr. Schlichter and other firms, as the similarity between the 403(b) plans may well foretell a domino effect in both the filing of complaints and settlements of such actions.

The claims with regard to the alleged excessiveness of the plans’ fees should be easy to prove. As Mr. Schlichter, the fact that many of these plans were paying various fees to the three previously mentioned service providers, instead of trying to minimize costs by reducing the number of service providers, should be an easy argument to win.

The allegation regarding the imprudence of a plan’s investment options is something that, to be honest, continues to amaze me due to the fact that plan sponsors and other investment fiduciaries still either have not figured out their fiduciary duties in this area or simply have not figured out how to properly conduct a fiduciary prudence analysis.

As a fiduciary attorney and compliance officer/consultant, who has dealt with the fiduciary issues for some time, I decided to create a metric that investors, attorneys, plan sponsors and other investment fiduciaries could use to quickly and effectively evaluate the prudence of actively managed mutual funds. For those fearful of some complex mathematical function, math was never one of my favorite subjects in school. In fact I talked my way out of calculus in both high school and college since I was going to be an attorney. The metric, the Active Management Value Ratio™ 2.0 (AMVR) only requires the ability to add, subtract multiply and divide. Click here for more information about the AMVR and the required calculation process.

A fiduciary’s duty to conduct an independent and thorough investigation and analysis of any and all investments recommended and chosen for an account or a plan is essentially black letter law. A failure to satisfy this requirement is a clear breach of a fiduciary’s duty of prudence. In my securities practice, investment advisers and other investment fiduciaries know that they are definitely going to get asked three questions regarding the process they used to determine the prudence of the investments that they recommended to a client or a plan.

The first question to do with a fund’s nominal, or stated, annualized return. While there is no required time period for evaluating a fund’s annualized returns, the prudent fiduciary will normally choose a period of five or more years so that at least one down period is included to get a better idea of how the fund performed in both up and down markets. Unfortunately, too many investment fiduciaries look at a fund’s nominal returns and the fund’s standard deviation and believe that they have met their fiduciary duties. Obviously, I do not subscribe to that school of thought since I still have two more questions.

My second question has to do with whether the fiduciary evaluated a fund in terms of its risk-adjusted return. Many investment professionals dismiss risk-adjusted returns with the statement that “investors can’t eat risk adjusted returns.” My response is always that a failure to factor in a fund’s risk-adjusted returns may mean that eventually they cannot eat at all. In some cases, a fund’s risk-adjusted returns may actually make an otherwise imprudent fund, based on its nominal returns, into a prudent investment choice. What too many fiduciaries fail to consider is that a fund’s nominal return may not reflect the fact that a fund achieved a respectable return while assuming far less risk than a fund with slightly higher nominal returns.

My third question always addresses any possible “closet index fund” issues. Given the trend over the past decade of equity-based mutual funds, both domestic and international funds, to display a higher correlation of returns, the “closet index fund” issue has become an important in regard to fiduciary prudence, at least in the context of fiduciary litigation. The fiduciary’s duty to control investment costs and avoid wasting money is another basic and incontestable fiduciary duty.

When questioned about the “closet index fund”  issue and whether they considered this issue in their investigation and analysis, most fiduciaries will admit that they did not do so and that they had no idea how to even do so. Unfortunately, ignorance is no excuse. Even though investment fiduciaries are required to conduct their own independent investigation of potential investment options, the law allows, even encourages, fiduciaries to retina the services of experts if necessary to ensure that they fulfill their fiduciary duties of loyalty and prudence, their duty to put their clients or the plan participants’ best interests first.

In evaluating the potential impact of the “closet index fund” issue, there is no universally required metric or threshold. For that reason, most attorneys and fiduciaries rely on a metric known as the Active Expense Ratio (AER), a metric created by Professor Ross Miller. The AER converts a fund’s R-squared ratio into a number that arguably reflects the effective annual expense fee being charged by a mutual fund. Miller’s study found that in most cases, the AER for a fund is often much higher than the fund’s stated expense ratio, in some cases 6-8 times higher. In my practice, I use a metric I call the Active Management Fee Factor (AMFF), that is modeled after the AER, with some minor modifications to factor in elements that I think are important.

In my presentations in these subjects and the AMVR, I have found that an example helps people understand these principles. Fidelity offers a number the K share version of its more popular mutual funds in 401(k) and 403(b) plans. One of the more well-known Fidelity funds is the Contrafund. Will Dannoff, the long-time manager of the fund, is well-respected and often mentioned in the ranks of the legendary mutual fund managers. In the past, I have often recommend the fund to people who ask me for a recommendation.

But Contrafund is an excellent example of the value of conducting a thorough and objective fiduciary investigation and evaluation of a mutual fund. Based on Contrafund’s most current summary prospectus (available at morningstar.com, under the “Filings” tab on the Contrafund page), the fund has an annual expense ratio of 70 basis points (o.70), an annual turnover ratio of 35 percent, and an five-year annualized return of 12.80 percent. (Unless otherwise indicated, the figures referenced herein reflect the period ending December 31, 2015). Using the AMVR, we calculate the fund total costs for purposes of comparison as 112 basis points (1.12%).

For any comparison to have merit, it is important to ensure that the study compare similar funds, to compare “apples to apples.” While many choose to use Vanguard’s S&P 500 Index Fund (VFINX) as the benchmark for comparisons for any equity-based mutual fund, I do not believe that is a valid approach unless the fund being studied is also classified as a large cap blend fund, since that is how both the S&P 500 and VFINX are classified. Contrafund is categorized as a large cap growth fund.

I order to ensure an “apples to apples” comparison, I will use Vanguard’s well-known Growth Index fund (VIGRX), which is also classified as a large cap growth fund by Morningstar, as my benchmark. Morningstar  states that the Growth Index fund has an annual expense ratio of 22 basis points (o.22), an annual turnover ratio of 9 percent, and an five-year annualized return of 12.96 percent.

Using the AMVR once again, we calculate the fund total costs for purposes of comparison as 32 basis points (0.32%), resulting in Contrafund having 80 basis points in incremental, or additional, fees/costs (112bp-32bp). Contrafund’s annualized returns are less that the Growth Index fund’s annualized returns, so Contafund fails to provide a positive incremental return. Combining the incremental data, the Contrafund is clearly a less cost-effective choice than the Growth Index fund. Given the closeness of the annualized returns, one might still make an argument for Contrafund. But when one considers that each additional 1 percent in fees and costs reduces an investor’s end return by approximately 17 percent over twenty years, Contrafund’s 80 bp in incremental makes that argument hard to accept from a fiduciary standpoint.

The next step is to evaluate both funds from a risk-adjusted standpoint. To calculate each fund’s five-year annualized risk-adjusted returns we will simply use their respective five-year standard deviation numbers. Contrafund’s five-year risk adjusted return was actually higher than the same return for the Growth Index fund, resulting in a positive incremental return of 58 basis points (0.58%). However, the fund’s incremental risk-adjusted return is less than the fund’s incremental costs (80 bp), so the fund would be considered as imprudent by most people still it would still result in an overall loss for an investor, albeit small . In cases like this, a fiduciary might want to do additional investigation and analysis using rolling five-year periods to determine if the most recent five-year period reflects the fund’s overall performance history or not.

At this point I am sure that some readers are thinking that my methodology is solely for the purposes of advocating that only no-load/index funds are acceptable investment options with investment portfolios and pension plans. That simply is not true.

Each year I do an analysis of the top 10 mutual funds used in defined contribution plans, as reported by “Pensions and Investments” magazine. Fidelity Contrafund is a regular on the list. In my most recent analysis, four actively managed passed the prudence test by providing positive incremental returns in excess of their incremental costs – Vanguard PRIMECAP Admiral, T. Rowe Price Growth Stock, T. Rowe Price Blue Chip Growth, and American Funds Washington Mutual R-6 share class. However, all four of the funds had a R-squared score above 90, and thus would be classified as “closet index” funds, and thus imprudent, under my system. The fact that four actively managed funds passed the incremental return/incremental costs screens show that my system, which demanding, can be met by some actively managed funds.

In the final analysis, we will use the funds’ respective R-squared scores to compare their respective effective annual expense ratios. Morningstar shows Contrafund having an R-squared score of 86.35, which equates to an AER of 2.42. The Growth Index fund’s R-squared score is 94.27, which equates to an AER of 1.11. The significant difference between the AER scores once again suggests that the Growth Index fund is a more cost-effective, and thus a more prudent, investment choice.

In using a fund’s R-squared score, fund with a high R-squared score and/or a incremental cost number will have a high AER score. Some attorneys and fiduciaries do not compute a fund’s AER score at all, preferring to set their own threshold R-squared score for classifying a fund as a “closet index fund,” and thus eliminating the fund from consideration. As mentioned earlier, there is no universally designated “closet index” R-squared score. I know some people that use a score of 95 as their threshold and others that use a score as low as 80 as their threshold. I personally use a R-squared score of 90 in my analyses.

Conclusion

While various factions debate the proper way to define and evaluate fiduciary duty, prudence and “best interests,” TIAA-CREF succinctly addressed all three in a white paper, stating that

Plan sponsors are required to look beyond the fees and determine whether the plan is receiving value for the fees paid.

Short, simple and accurate. While the article is written in terms of 403(b) plans, the logic expressed is obviously equally applicable to 401(k) plans and wealth management in general.

The Active Management Value Ratio provides investors, attorneys, plan sponsors and other investment fiduciaries with a simple, yet effective, means of determining whether an investor or a plan is in fact receiving value for the fees and other costs it is paying a fund. If a fund is not producing a positive incremental return, or if the fund’s incremental is less than the fund’s incremental costs, then a fund is not providing any value for the fees and costs paid. It’s just that simple

Investment fiduciaries should always remember that fiduciary liability results not from the actual performance of the investments chosen, but rather on the failure to use a prudent process in selecting said investments. Given the soundness and thoroughness to the methodology discussed herein, I believe that this approach to fiduciary prudence analysis can provided plan sponsors and other investment fiduciaries with an effective means of fulfilling their fiduciary duties.

© Copyright 2016 InvestSense, LLC. All rights reserved.

This article is for informational purposes only, and is not designed or intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

 

 

 

Posted in 401k, 401k compliance, 401k investments, 403b, 404c, 404c compliance, DOL fiduciary standard, ERISA, evidence based investing, fiduciary compliance, fiduciary law, investment advisers, investments, pension plans, retirement plans, RIA, RIA Compliance, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , , , , , , , | Leave a comment

“Tipping Off” Potential ERISA Fiduciary Violations – Part 2

Posted on August 12, 2016 by jwatkins

The recent actions filed by Jerome Schlichter against seven private colleges and universities raised a number of new issues that I have encountered in the course of performing forensic analyses of 401(k), 403(b), and 457(b) plans. In many cases, I believe that the plans actually tipped-off their violations as a result of certain decisions and/or policies they adopted. I also believe that many plans will continue to tip-off plaintiffs’ attorneys and regulators by engaging in the same sort of practices that Mr. Schlichter’s actions have cited.

Yesterday I addressed a number of product related issues, most notably the decision to offer a large number of similar investments options within a plan. Schlichter’s actions also raise the issue of excessive fees, the most common issue these cases have cited. While the arguments in the new actions are essentially the same as in all of the previous 401(k) based actions, I would suggest that the arguments in the new complaints suggest that plans and plan sponsors often make decisions and adopt policies that may actually serve to tip-off plaintiffs’ attorney and regulators as to potential ERISA-based fiduciary violations.

The SEC is currently involved in a sweeps operation focused on the use of various classes of mutual fund shares by registered investment advisers (RIAs). It has been suggested that RIAs often base their choice of a fund’s share class on whether the class offers a financial incentive such as 12b-1 fees to the RIA. From the ERISA standpoint, the issue would be twofold. First, whether the plan sponsor simply blindly accepted their service provider’s recommendations without performing the independent and thorough investigation required by ERISA. Second, whether the plan sponsor chose the investment options for the plan based on the fact that the fund offered a revenue sharing plan to help plans cover all or a percentage of a plan’s administrative costs.

12b-1 fees and similar revenue sharing programs present a number of potential ERISA fiduciary liability issues. Service providers and plans are quick to point out that such fees are not illegal per se, and they are absolutely correct to a point.

Fred Reish, one of the nation’s top ERISA attorneys, has pointed out that 12b-1 fees may raise potential fiduciary liability issues, specifically the fiduciary duty of loyalty. The potential problem arises due to the fact that if only some of the plan participants select the funds that offer 12b-1 fees, and those 12b-1 fees are used by a plan to reduce administrative costs, then those choosing those funds are effectively subsidizing the costs for those who do not select such funds.

This is clearly inequitable. By knowingly allowing such a condition to exist and continue, a valid argument can be made that a plan sponsor has violated their fiduciary duty of loyalty,  their duty to put all of the plan’s participants interests first and to treat all plan participants equally and fairly.

Service providers and plan sponsors often attempt to justify 12b-1 fees and other revenue sharing programs on  the grounds that it prevents plan participants from having to personally pay for the plan’s administrative costs. However, if one does some basic calculations, the validity of that argument becomes highly suspect.

A plan has 100 participants. The plan offers several investment options that assess a 12b-1 fee of 0.25 basis points. Plan participants have invested $5 million dollars in Fund A. In this case, the 12b-1 fee would produce $12,500, some of which would presumably be returned as part of a revenue sharing agreement between the fund and the plan. That figure alone would probably be deemed excessive based on current industry standards. Multiply that by the number of plan options charging 12b-1 fees and it is easy to understand the rationale behind the excessive fee case, as plan participants would surely agree to pay a much lower and more reasonable per participant fee if given that option.

In the recent settlement of the Mass Mutual excessive fees case, the parties agreed to terms which I believe should become the blueprint for future settlements off such cases. In addressing record-keeping, the parties agreed that record-keeping fees based on the plan’s assets under management (AUM) would be totally prohibited, and that the fee would not exceed $35 per participant. While there may be some variance in the fee per participant based on factors such as the size of the plan, the concept of a total prohibition against fees based on AUM and a cap on per participant fees definitely produces a more equitable situation for plan participants. In our example, assuming the same $35 per participant cap on administrative fees, the total revenue from just the one fund charging a 12b-1 fee far exceeds the $3,500 that would be assessed under the per participant standard. For more information about the Mass Mutual settlement, click here.

Another fee-related issue that can tip-off plaintiffs’ attorneys and regulators as to potential ERISA fiduciary violations involves the choice among available share classes of investment options chosen for a plan. In most of the excessive fee cases to date, the issue has involved the use of retail shares instead of much less expensive institutional shares. However, I believe that cases focusing on the different fees of so-called retirement class shares will soon be filed. I believe that the SEC’s current sweep focusing on the use of share classes will simply speed up such litigation strategies.

In addition to institutional shares, most fund families now offer some sort of retirement class shares. For instance, Fidelity offers K shares, American Funds offers various levels of R shares, and TIAA-CREF offers Retirement and Premier shares to plans. In the case of of American Funds and TIAA-CREF, the difference in the types of their retirement funds is predominantly the 12b-1 fee charged by the shares. For instance, American Funds’ offers six different types of R shares, with 12b-1 fees ranging from 100 basis points (R-1) to no 12b-1 fee at all (R-5 and R-6). So if an attorney or regulator checks a plan’s Form 5500 and sees that a plan sponsor has chosen R shares in an American Fund that assesses a 12b-1 fee, obvious questions about possible breaches of the plan sponsor’s fiduciary duties of loyalty and prudence are raised.

The final point with regard to tipping-off potential fee-related ERISA fiduciary violations involves the decision by a plan sponsor to include proprietary investment products in their pension plans. Again, investment companies and plan sponsors are quick to point out that the inclusion of such products in their plans is not illegal. True, but as we have seen in a number of recent actions and settlements, the decision to do so will probably not end well if that decision is legally challenged.

The basic problems with the inclusion of proprietary products in a 401(k) or other pension plan are their high fees and/or poor performance record relative to less expensive options. After the Citigroup decision validating Vanguard’s funds as legitimate investment options to be considered in choosing a plan’s investment options, the inclusion of overpriced and underperforming proprietary products has become even more difficult to justify.

Excessive fees will continue to be a primary focus of these actions against 401(k), 403(b) and 457(b) plans. The reason is that they are simple to prove, as most plans are loaded with overpriced and underperforming investment options. That fact, combined with the fact that most plan sponsors either do not perform the legally required independent investigation at all, or do so improperly, make cases against plans the proverbial “low hanging fruit” for attorneys and regulators.

Several years ago I created a simple cost/benefit metric, the Active Management Value Ratio™ (AMVR) that allows plan sponsors, attorneys, regulators and investors to quickly assess the cost-efficiency of a mutual fund. Interestingly, the legal community has openly embraced the AMVR and I have given presentations to various legal groups on how to use the AMVR effectively. Some investment advisers have also embraced the AMVR as well, as it can be used as a risk management tool for both their clients and their practice. For more information about the AMVR, click here.

Conclusion
The actions against 401(k), 403(b) and 457(b) is not going to end anytime soon. In most cases, the violations are blatant and, therefore, easy to prove. The easy availability of a plan’s information from its annual Form 5500 makes the task that much easier.

I tell all my fiduciary consulting clients that there are two legal decisions that they need to remember and/or print out and frame in their offices. The first decision is Meinhard v. Salmon, in which Judge Cardozo made his historic statement that

A [fiduciary] is held to something stricter that the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.”1

The second decision is Donovan v. Cunningham in which the court admonished all fiduciaries that subjective good faith and/or ignorance are not relevant in cases involving breach of fiduciary duty claims, as

a pure heart and an empty head are not enough.2

Under the fiduciary duty of prudence, fiduciaries like plan sponsors are held to the “prudent man” standard. More specifically, the courts assess a fiduciary’s prudence based on an “objectively prudent” standard, with no consideration of any alleged subjective considerations. In defining “objective prudence,” the courts have held that

A decision is ‘objectively prudent’ if ‘a hypothetical prudent fiduciary would have made the same decision anyway…Put another way, the fiduciary would have made the same decision if a proper investigation had been made.3

The court then went on to dismiss the fiduciary’s argument that the applicable standard was whether a fiduciary “could have” made the same decision, not the “would have” made the same decision standard. The court pointed out that the difference in the two terms was more than semantics, as “would have” is more demanding, meaning probable, while “could have” simply means possible, which falls far short of the duties required of fiduciaries.

Mr. Schlichter’s newly filed actions against private colleges and universities sends a clear message and warning to all investment fiduciaries. Take the time to truly understand your duties as a fiduciary and take the time to perform them properly. Retain the services of an expert that is knowledgeable and experienced in ERISA and fiduciary law to help protect the plan sponsor. While it is too late now for plans and plans sponsors to protect against a breach of fiduciary action for past decisions, plans and plans sponsors can create a win-win situation for the plan, plan sponsor and plan participants by being proactive and making the changes necessary to bring a plan into compliance with applicable rules and regulations.

Notes
1. 249 N.Y. 458, 164 N.E. 545 (1928)
2. 716 F.2d 1455, 1467 (5th Cir. 1983)
3. Tatum v. RJR Pension Investment Committee, 761 F.3d 346 (4th Cir. 2014)

© Copyright 2016 InvestSense, LLC. All rights reserved.

This article is for informational purposes only, and is not designed or intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

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“Tipping Off” Potential ERISA Fiduciary Violations – Part 1

Posted on August 11, 2016 by jwatkins

As a former catcher, I always enjoyed watching a pitcher to see if he was “tipping off” his pitches so our team could gain an advantage. As an ERISA attorney, one of the services I provide to ERISA consulting clients is forensic analyses of plans to determine if they are “tipping off” potential breaches of their ERISA fiduciary duties. In far too many cases, I find that plans and plan sponsors are “tipping off” potential ERISA violations, exposing themselves to unnecessary fiduciary liability.

I bring this up because of the news that Jerome Schlichter has reportedly filed actions against M.I.T, N.Y.U. and Yale alleging various violations of ERISA. Having analyzed the 403(b) and 457(b) plans of several American universities and colleges, I figured that it would only be a matter of time before someone decided to address many of the same fiduciary issues that plague 401(k) plans, as many of the leading private colleges and universities have plans with assets in the trillions of dollars.

I expect private colleges and universities to draw most of the attention as to ERISA violations since state-run colleges and universities are not covered by ERISA. However, state-run colleges and universities are arguably subject to similar actions based on common law grounds such as agency, negligence and breach of contract, so state universities and colleges should not assume that their 403(b) and 457(b) plans are safe from future litigation.

I have not read the actual complaints that Mr. Schlichter reportedly filed against the three schools. However, based on the stories that I have read in both the Wall Street Journal and the New York Times, Mr. Schlichter has identified some of the same potential violations that I often see with plans, violations that plans often unknowingly “tip-off” to plaintiff’s attorneys and regulators.

By far, the easiest “tip-off” has to do with the number of investment options that a plan offers. Plans often attempt to justify a large number of investment options within the plan by claiming that it benefits plan participants by providing more choices and allows them to reduce the overall investment risk of their plan account.

Such arguments fail to consider a number of factors. First, studies have shown that the more investment options that investors are provided with, the higher the potential of investors suffering “paralysis by analysis,” with investors choosing to do nothing at all or opting for the simplest perceived option, e.g., the 50% S&P 500/50% Bond portfolio (which might actually be both the simplest and best option anyway.)

The articles I read on the Schlichter filings indicated that he stated that at least one of the plans has offered well over 300 investment options at one point in time. Schlichter reportedly argues that such a large number of investment options could impair a plan’s opportunity to negotiate lower investment related fees for the plan and its participants, thereby violating the plan sponsor’s fiduciary duty of prudence.

I would suggest that having so many options within a plan is a “tip-off” that the plan sponsor has not properly performed their fiduciary duty to conduct an independent and thorough investigation and analysis of the investment options within their plan. The legal decisions on this topic make it very clear that the failure of a plan sponsor or other plan fiduciary to properly conduct the required independent investigation and evaluation of each investment option within a plan is a blatant violation of the plan sponsor’s fiduciary duties. The sheer number of funds raises obvious questions as to whether the required investigation was done properly, if at all. A good plaintiff’s attorney will obviously ask for documentation verifying both the investigation and its findings establishing fiduciary prudence

Plans with a large number of investment options may also “tip-off” potential ERISA fiduciary violations based on the types of funds offered as investment options within a plan. According to the two stories referenced earlier, Schlichter reportedly cites similarities between many of the funds as a breach of the plan sponsor’s fiduciary duties.

The larger the number of available investment options within a plan. the greater the likelihood of overlap of funds with similar investment objectives, but with varying levels of fees and other costs. This overlap provides an opportunity to raise questions regarding  the fiduciary duty of prudence – why offer six funds with the stated investment objective of capital appreciation, but with varying fees, instead of the one or two with the best cost/benefit results? Again, other than possibly confusing plan participants, what benefit do plan participants receive from having to consider ten, fifteen or more funds with a similar investment objective? Plan sponsors should anticipate that question at deposition and at trial.

The number of investment alternatives offered by a plan also raises an issue regarding a fiduciary’s fiduciary duty to minimize the risk of large losses by properly diversifying a plan’s investment options. Some plan sponsors apparently mistakenly believe that proper diversification can be achieved by the sheer number of investment options that their plan offers. Anyone familiar with diversification knows that effective diversification depends not on the number of investment in a portfolio, but rather on how the various investments react under various economic and market conditions. In a perfect world, the investor could combine investment in such a way that the portfolio’s investments would react in such a way as to balance each other out, thereby preventing significant financial losses.

Unfortunately, the evidence has increasingly shown that the correlations of returns for equity-based investments, both domestic and international investments, have increased over the past decade or so. At the same time, 401(k) and 403(b) plans have shown a definite patterns of offering a high percentage of funds with similar investment objectives, e.g., large cap growth, and/or a menu of investment options that have a high correlation of returns. Either scenario raises obvious potential breach of fiduciary issues.

One final point with regard to “tipping off” potential ERISA fiduciary violations with regard to product selection. The two stories I read mentioned that Schlichter’s complaints included allegations involving annuities offered by the plans, both variable annuities and TIAA’s Traditional Annuity.

The high costs associated with many annuities, combined with the poor relative performance of many of the sub-accounts offered within variable annuities, make these an easy target for breach of fiduciary claims, both in ERISA related and non-ERISA related cases. Given the fact that the two of the three largest service providers for colleges and universities plans are known for their annuity products, the introduction of this new fiduciary issue may result in even more fiduciary litigation in the 403(b) and 457(b) arena, including state colleges and universities.

© Copyright 2016 InvestSense, LLC. All rights reserved.

This article is for informational purposes only, and is not designed or intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

Posted in 403b, Annuities, compliance, DOL fiduciary standard, ERISA, evidence based investing, fiduciary compliance, fiduciary law, pension plans, retirement plans, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , | Leave a comment