ERISA and Modern Portfolio Theory – Prudence Per Footnote 8

Posted on August 5, 2016 by jwatkins

As an ERISA attorney and compliance consultant, I often hear plan sponsors and service providers attempt to justify an imprudent investment option by claiming that they are simply complying with the DOL’s and the courts’ adoption of Modern Portfolio Theory (MPT) as the applicable standard for assessing the prudence of investments. Now that latter point is true. But there’s just one little detail that was addressed in a key ERISA decision, DiFelice v. U.S. Airways(1), one little, yet significant, detail that was in footnote 8 of that decision that ERISA attorneys, plans sponsors and other plan fiduciaries should consider to avoid potential fiduciary liability issues

In footnote 8, the court distinguished between the reliance on MPT in choosing investment options for defined benefit plans and choosing investment options for a defined contribution plan.

Laborers Nat’l Pension Fund v. Northern Trust Quantitative Advisors, Inc.,173 F.3d 313, 315 (5th Cir.1999), 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 within a monolithic, fiduciary-selected portfolio. The court there determined that the defendant fiduciary could properly rely on modern portfolio theory because the fiduciary himself consciously coupled risky securities with safer ones to construct one ready-made portfolio for participants…. Here, in contrast, modern portfolio theory alone cannot protect U.S. Airways, which offered the Company Fund — an undiversified investment alternative — just because it also offered other investment choices that made a diversified portfolio theoretically possible.

So, essentially, the court draws the distinction between one person putting together one investment portfolio, who can ensure that the investment options are put together in such a way as to take advantage of MPT’s cornerstone principle – effective diversification by factoring the correlation of returns of the investments chosen – as opposed to including an otherwise imprudent investment option in a menu of investment options for a defined contribution plan , where the plan participants may, or may not, understand MPT and how to properly design an effectively diversified investment portfolio. Since ERISA does not even require that 401(k)/404(c) participants be provided with correlation of returns data for the investment options offered by their plan, the danger of inclusion of otherwise imprudent investment options is even easier to understand.

Most non-attorneys reading the DiFelice would probably not even bother to read a decision’s footnotes.  A lot of attorneys also neglect to read the footnotes in a decision, figuring that the key information is in the body of the decision. There are some who, when faced with the rationale of footnote, point out that footnotes are arguably not part of a decision.

Others will argue that even if footnotes are part of a legal decision, the DiFelice decision is only binding on the 4th Circuit Court Appeals. While DiFelice is technically binding on the the 4th Circuit, history has shown on more than one occasion that other courts are quick to adopt the logic of a well-reasoned decision by a sister court, including any footnotes within the decision.

Attorneys, financial advisers, plan sponsors and others involved in the financial services/investment industry are well aware of the controversial issues associated with MPT. Nevertheless, MPT is still the standard used by the DOL and the courts in assessing fiduciary prudence. And trust me, an experienced ERISA or securities attorney is going to have the correlation of returns data on a plan’s investment options in his file.

And trust me, the attorney is going to ask the plan sponsor and the other plan fiduciaries if they included a review of such data as part of their fiduciary duty of prudence and their fiduciary duty to conduct an independent investigation and evaluation of the funds chosen as the investment options for their plans. If the plan fiduciaries indicate that they did review the correlation of returns, they had better be telling the truth and be able to answer the questions correctly or hello breach of fiduciary duty. The again, if the plan fiduciaries admit that they did not review and factor in such correlation of returns data, that’s an admission of a breach of their fiduciary duties as well.

Bottom line, a prudent ERISA attorney or consultant will prove their value to a plan sponsor or other plan fiduciary by making sure the plan does review and factor in correlation of returns data on all funds being considered by a plan to ensure that the investments ultimately chosen are prudent on all counts, including cost efficiency, performance and risk-related performance, and diversification/risk management criteria. As the DiFelice court and other court have pointed out, with regard to defined contribution plans, each individual investment option must be deemed to be prudent for a plan’s sponsor and other plan fiduciaries to avoid any potential fiduciary liability.

Notes
(1) 497 F.3d 410 (4th Cir. 2007)

© 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, 404c, 404c compliance, compliance, DOL fiduciary standard, evidence based investing, fiduciary compliance, fiduciary law, investment advisers, investments, pension plans, retirement plans, wealth management | Tagged , , , , , , , , , , , , , , | Leave a comment

401(k) Alert: Protecting Plan Sponsors and Plan Participants Under the BICE Exemption

Posted on July 27, 2016 by jwatkins

Most of the litigation against 401(k) plans has focused on excessive fees and/or the poor quality of investment options within a plan. With the effective date of DOL’s new fiduciary standard and the Best Interests Contract exemption (BICE) coming in less than a  year, a question that has been raised in some legal circles is whether BICE will provide yet another basis for actions against both plan sponsors and plans.

One of the reasons cited in support of the DOL’s fiduciary standard was the need to need the conflict of interest issue that allowed plan advisers to put their own financial interests first when dealing with a 401(k) and its participants. Various studies were cited reporting the adverse financial impact of such conflicts of interest on plan participants.

When the DOL introduced the new fiduciary standard, they also introduced the BICE concept. BICE focuses on the provision of investment advice to retiring plan participants with regard to potential rollover of their 401(k) funds to an individual retirement account (IRA). Advisers who can get potential clients to enter in a BICE agreement will then be allowed to offer investment recommendations that may provide the financial adviser greater financial incentives than other comparable investment options.

In principle, BICE would still require a financial adviser to put the client’s best interests first. From a legal perspective, a couple of obvious questions beg valid response. First. why would a plan participant agree to such an agreement that allows a financial to potentially engage in the same sort of abuse marketing and sales tactics that was the motivating factor behind the DOL’s new fiduciary standard? Why would a plan sponsor not protect their plan participants, many of whom may not be knowledgeable enough to protect themselves against such abusive marketing and sales practices, making the prohibition of soliciting such BICE agreements an express condition for any and contracts with third-party service providers?

It is the second question that may form the basis for new allegations of a plan sponsors’s breach of their ERISA fiduciary duties of loyalty and prudence. While some many may argue that a decision to enter into a BICE agreement is a private matter between a plan participant and a financial adviser and does not involve a plan, it is highly doubtful that the DOL and the courts will see the issue as that cut and dried given the stated importance of protecting workers as they try to provide for a meaningful retirement.

The potential liability issues become arguably even stronger given the relative ease with which protective measures could be implemented by plans and plan sponsors as part of the negotiating process with third-party vendors. There are those that will argue that given the strong penalties imposed for violating a BICE agreement, the chance of abusive sales and marketing is minimal.

With over twenty years of experience as a compliance attorney, I would suggest that that argument is extremely shortsighted. When BICE was first announced, my immediate reaction was variable annuities (VAs) and equity indexed/fixed indexed annuities (EIAs/FIAs).

According to the SEC and FINRA,  variable annuities are among the leading grounds for customer complaints. In too many cases, VAs are structured to ensure a windfall for the issuing company at the VA owner’s expense, most notably by the use of a practice known as “inverse pricing” to assess the VAs annual M&E, or death benefit” fee. Moshe Milevsky’s landmark study of VA fees clearly established the abusive nature of such fees.  Such conditions are a blatant violation of fiduciary law’s basic tenets of loyalty, prudence and equitable treatment, as “equity abhors a windfall.”

EIAs/FIAs are fixed income annuities that generally use a stock market index’s return to calculate the fixed annuity’s annual return. EIAs/FIs actually involve a solid and simple concept, were it not for the various restrictions and conditions that severely limit the actual returns an investor can receive.

Those restrictions and conditions are potentially confusing to investors since the marketing of such products usually relies on the potentially higher returns possible by using market returns to calculate the returns on EIAs/FIAs. BICE situations will also be susceptible to the same excessive fees and imprudent charges that the lawsuits typically allege today.

Greed has, and always be a motivating factor to some in any business. Given the chance that most investors are unfamiliar with securities law and ERISA standards, and that regulatory sanctions for BICE violations will require consumer complaints, unethical financial advisers may engage in abusive practices based on their belief that the odds of being exposed are low, especially since the repercussions for such violations would impact their broker-dealer on a far greater scale.

The legal community silently nodded their collective heads recently when the DOL publicly clarified that BICE would be available for insurance agent and insurance products. for many attorneys, this just reinforced their positions to focus on VAs and EIAs/FIAs as the primary product source of BICE related litigation. The question now is whether plans, plan sponsors and other plan fiduciaries will take an inexpensive, proactive stance to reduce their potential liability,  namely conditioning their contractual relationships with all third parties on their agreement on an absolute prohibition on such third parties entering into BICE agreements with any of their employees, or whether plans, plan sponsors and other plan fiduciaries are willing to risk more multi-million dollar suits and settlements based on BICE issues. This should be interesting.

© 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, 404c, 404c compliance, BICE, compliance, DOL fiduciary standard, ERISA, fiduciary compliance, fiduciary law, investment advisers, investments, IRAs, pension plans, retirement plans, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , , , , | Leave a comment

The Two Minute ERISA Fiduciary Liability Risk Management Challenge

Posted on July 20, 2016 by jwatkins

I love fiduciary law. In a world with so many legal uncertainties, indecision and “weasel words,” fiduciary law is demanding and direct. The Restatement (Third) of Trusts, specifically Section 90, the Prudent Investor Rule, sets out the basic fiduciary requirements. Good faith beliefs and/or lack of knowledge are not accepted as defenses to breaches of the fiduciary duties set out in the Restatement, or as the courts like to say, “a pure heart and an empty head are no defense” to breach of fiduciary duty claims.

I first became interested in fiduciary law in the early 1990’s and became even more interested in the subject when I took a job as an RIA specialist at FSC Securities in Atlanta in 1995. It has been interesting to see the fiduciary developments in the securities industry, as more and more commission-based stockbrokers are making the move  to the RIA side and the move to a fee-based, fiduciary practice.

Even now, there are those that want to argue that the “best interests” requirement of fiduciary law is ambiguous and therefore leaves investment fiduciaries unfairly exposed to potential legal liability. The Restatement defines one’s fiduciary duties in terms of the Prudent Person Standard, which requires a trustee or other fiduciary to use the same “care, skill, prudence, and diligence under the circumstances then prevailing” that a prudent person would use considering all of the relevant facts that the fiduciary knew or should have known based on their independent investigation and evaluation of the situation.

One of my favorite quotes is from the late General Norman Schwarzkopf, who said “the truth of the matter is that you always know the right thing to do. The hard part is doing it.” In the world of financial/investment advice, fiduciaries must make sure that personal conflicts do not overtake one’s recognized legal duties. An objective analytical tool can help them do that

In my legal practice, I provide consulting services to RIA firms and ERISA plan sponsors. Many of my clients originally complained that they had a hard time understanding and acting in accordance with the Restatement’s fiduciary standard and “best interest” requirement.

After considerable frustration with both the genuine and the bogus complaints, I decided to create a metric to help clarify the concepts of the prudence and “best interests” required of fiduciaries under the Prudent Person Rule. Today, I am proud to say that I am learning that fiduciaries and attorneys are increasingly using my metric. the Active Management Value Ratio™ 2.0 (AMVR) in their practices to determine the prudence, or lack thereof, of the decisions of RIAs and ERISA fiduciaries.

The strength of the AMVR is its simplicity, both in terms of calculation and interpretation. The AMVR is the same simple cost/benefit metric many of us learned in our college Econ 101 class. The AMVR calculates the cost efficiency of an actively managed mutual funds relative to a comparable passively managed, or index, fund based on the incremental cost incurred and incremental return, if any, produced by an actively managed mutual fund.

The AMVR is based on the studies of investment icons Charles Ellis and Burton Malkiel. Ellis introduced the concept of analyzing mutual funds based on their incremental costs and incremental returns. His argument is that index mutual funds have become, in essence, commodities,  and that the proper way to evaluate any commodity is in terms of their incremental, or added, costs and returns. Malkiel’s contribution to the AMVR is his research finding that the two most reliable indicators of a mutual fund’s future performance are the fund’s annual expense ratio and its trading costs.

Calculating an actively managed mutual fund’s incremental returns only requires that the annualized return of a benchmark/index fund is subtracted from the annualized return of the actively managed mutual fund. I prefer to use the funds’ five year annualized returns in order to get at least one period of down or negative returns and, thus,  a better picture of the funds performance patterns. In some cases I will also analyze rolling five-year returns to verify the funds’ historical trends.

In calculating the funds’ incremental returns, I rely on Malkiel’s findings and combine a fund’s stated annual expense ratio with its trading costs. Since mutual funds are not required to disclose their actual trading costs, I use a proxy developed by John Bogle, former chairman of the Vanguard family of funds. Bogle simply doubles a fund’s stated turnover ratio and then multiples that number by 0.60 based on historical data re trading costs. While the trading cost number may not exactly match a fund’s actual trading costs, the application of a uniform factor to get a proxy number is acceptable and helpful in getting a better picture of a fund, as trading costs for an actively managed mutual fund are often higher than a fund’s annual expense ratio and both reduce an investor’s end return.

The calculation process only require a couple of pieces of data, all of which are freely available online at sites such as morningstar.com and yahoo.finance.com. As an investor, fiduciary or attorney becomes more familiar with the calculation process, the entire calculation process takes two minutes or less per fund.

As I mentioned earlier, the simplicity of interpreting a fund’s AMVR score in terms of prudence and “best interests” is one of the metric’s strengths. An example will help demonstrate this fact.

Assume two funds, Fund A being the actively managed fund and Fund B being the benchmark/index fund. Fund A has a five-year annualized return of  10 percent, an annual expense ratio of 1.00 percent and a turnover ratio of 50 percent. Fund B has a five-year annualized return of 9 percent, an annual expense ratio of  0.16 percent and a turnover ratio of 3 percent.

Fund A produces  1 percent, or 100 basis points, of incremental return (10-9) and incremental costs of  1.40 (1.60-0.20). (A basis point equals .01 percent of 1 percent) AMVR calculates a fund’s cost efficiency, so AMVR is calculated by dividing the fund’s incremental costs by its incremental returns. Funds that fail to provide any positive incremental returns do not qualify for an AMVR score, as they clearly do not qualify as prudent investment choices relative to the benchmark/index investment option.

In our example, Fund A’s AMVR score would be 1.4 divided by 1.0, for an AMVR score of 1.4. The optimum AMVR score will fall between one and zero. An AMVR score greater than one indicates that the fund’s incremental costs exceeds its incremental return, resulting in a loss for an investor relative to the less expensive benchmark/index fund.

The costs and returns issues becomes even more important when one considers that each additional 1 percent in costs and expenses reduces an investor’s end return by approximately 17 percent over a twenty year period. The impact of theses costs was noted in a recent article in the Wall Street Journal, which cited a study that estimated that a working couple loses approximately a combined $155,000 over a twenty year period as a result of 401(k) fees and costs alone.

Each year I do a forensic analysis of the top ten mutual funds in 401(k) defined contribution plans, as reported by “Pensions and Investments” magazine. Using the AMVR as my primary analytical tool, the results provide a good explanation as to why so many 401(k) plans, of all sizes, could be susceptible to successful legal challenges. To view my 2016 analysis, click here.

Fidelity Contrafund is a well-known actively managed fund whose K shares appear in many 401(k), 457(b) and 403(b) plans . In fact, the fund was the number one fund in the “Pensions and Investments” article. Will Danoff, the fund’s manager has a stellar performance record and is often mentioned as one of the mutual fund industry’s best all-time managers. But does it currently pass the fiduciary prudence and “best interests” test?

Morningstar classifies Fidelity Contrafund K (FCNKX) as a large cap growth fund. For comparative purposes, we will use one of Vanguard’s leading large cap growth funds, the Value Growth Index fund. Using the same process as before, the analysis shows Contrafund has incremental costs of 86 basis points . Based on the funds’ stated annualized five-year returns, Contrafund does not produce any positive incremental returns (12.80 percent vs. Value Growth Index’s 13.14 percent) or other benefits to an investor above and beyond those provided by the comparable, and less expensive, index fund.

I deliberately chose Contrafund as an example to demonstrate another way to use the AMVR. Ellis originally suggested that in calculating incremental returns, the risk adjusted returns of funds should be used. If we substitute the two funds’ risk adjusted returns in the calculation process, Contrafund actually produces a positive incremental return of 0.69 percent, or 69 basis points (12.85 percent versus Value Growth Index’s 12.16 percent). However this would still not allow Contrafund to pass the prudence or “best interests” test since an investor would lose money by investing in the fund since Contrafund’s incremental costs exceed it’s risk-adjusted incremental returns.

A third way of interpreting the cost effectiveness of a fund’s AMVR score is by comparing the percentage of returns produced by a fund to the fund’s incremental costs as a percentage of the fund’s total costs. In the immediate example, the incremental. or added costs, of the actively managed fund equal 87.5 percent of the fund’s cost (1.40/1.60), yet such costs are only adding an additional 1 percent of return. Again, hard to argue that such results indicate a prudent investment that is in the client’s “best interests,” especially given the other findings that indicate that the comparable index fund is a better investment choice.

Based on my experience in running forensic analyses for investors, retirement plans and investment fiduciaries, I would estimate that approximately 70 percent of actively managed mutual funds would not qualify as prudent or in an investor’s “best interests” under my prudent/”best interests” analysis. When I run an analysis I actually use a progressive system that uses five qualitative screens. Three of the five screens are based on the AMVR, including the positive incremental returns and incremental returns greater than incremental costs screens. Those two screens will effectively eliminate a significant number of actively managed mutual funds from consideration, making the investor’s or fiduciary’s job that much easier and less time-consuming.

I think it is worth noting that the DOL adopted a prudence standard in defining “best interests” in connection with their recently adopted fiduciary standard. The SEC has recently stated that it too will consider implementing a fiduciary standard for the investment industry as a whole. When, and if, that does actually happen, I think it is safe to assume that the SEC’s fiduciary standard will adopt the same prudence and “best interest” standards that the DOL chose since it is consistent with the Restatement’s position.

The AMVR helps avoid the confusion over one’s fiduciary duties and “best interests” obligations by providing a quick and simple means of quantifying prudence and “best interests,” one that is based on the sound, proven findings of two of the investment industry’s most respected icons. As the use of the AMVR continues to grow,  plan sponsors and other investment fiduciaries will hopefully incorporate the metric into their required ERISA due diligence process in selecting and monitoring their plan’s investment options in order to reduce their risk of potential personal liability.

© 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, 404c, 404c compliance, compliance, ERISA, evidence based investing, fiduciary compliance, fiduciary law, investment advisers, investments, pension plans, retirement plans, RIA, RIA Compliance, securities compliance, wealth management | Tagged , , , , , , , , , , , , , , , , , , , | Leave a comment

The Liability Needle in the RIA Haystack

Posted on July 13, 2016 by jwatkins

I have always enjoyed working with registered investment advisers (RIAs) and their representatives (IARs). I first got into the investment industry in 1995, shortly after the NASD issued Notice to Members 94-44. NTM 94-44 clearly stated that BDs had a duty to monitor the trading activity of both independent RIAs owned by the BDs registered representatives and the BD’s own proprietary RIA.

I was one of the few attorneys in Atlanta who had an understanding of the Investment Advisers Act of 1940, so I responded to an  for a RIA Specialist with FSC Securities here in Atlanta. Met some incredible people like Jim Wisner, FSC’s President, Tom Wells, FSC’s general counsel. and Carolyn Maloney, who actually ran the RIA Compliance department for me.

One of the most frustrating aspects of my job as manager of RIA compliance department was that I knew I could offer more advice to the RIA firms than we were providing. At the same time, I understood FSC’s position with regard to the potential liability issues involved with providing such information.

BDs have no legal obligation to provide compliance advice to independently owned RIA firms. I do not think that most independent RIA firms believe that their BD will tell them anything they need to know with regard to RIA legal and compliance issues. Just as I tell my RIA compliance clients, if you do not have a legal obligation to provide a service, either by laws/regulations or based on your contract with a client, do not provide such service. If you do, a good attorney will argue that you voluntarily provided said service, so why did you not provide other additional services.

I believe that most RIAs and IARs are basically honest and want to provide their clients with valuable services.  That’s why I try to provide information on this blog that will educate RIAs and IARs and allow them to better protect themselves and their practices with regard to best practices and some little known legal nuances, or as I like to call them, liability needles in the RIA haystack.

Grab your master agreement with the custodian(s) that you use for your RIA practice. Somewhere in the agreement you will find language such as

You represent and warrant that you have necessary authority to enter into this agreement.

You represent and warrant that you have necessary documentation and authority to enter into this agreement.

You agree to indemnify and hold harmless XYZ and its affiliates, and its and their directors, officers, employees and agents from and against any and all claims, actions, costs, and liabilities, including attorneys’ fees, arising out of or relating to XYZ acting in accordance with any instructions that you may give.

Trust me, it’s somewhere in the master agreement, usually in a section entitled “Legal Authority” and/or Indemnification.” My experience is that too many RIA firms simply sign the master agreement without actually reading, considering and understanding the actual terms of the master agreement. In some cases, the failure to do so can have some serious adverse, and expensive, consequences.

The investment industry generally relies on a document known as a trading authorization in taking orders and trading. While the industry does business relying on such trading authorizations, no questions asked, the fact of the matter is that legally, a person needs to have a power of attorney in order to legally act on behalf of another person. Two of the most common power of attorney forms, also referred to as “directives” in some cases, are a durable power of attorney for health care and a financial durable power of attorney.

When a securities attorney is reviewing a potential case involving a discretionary account, they should always determine whether the RIA trading in the account had a power of attorney or just a trading authorization. If the attorney decides to proceed with the case and the RIA only had a trading authorization, the attorney is probably going to add an unauthorized trading claim.

RIA should always obtain a properly executed power of attorney from a client prior to trading in the client’s account. While in most cases a short and simple power of attorney will suffice to convey the necessary authority to the RIA, an RIA should always check the applicable state law for each jurisdiction in which they do business, as some state are well-known for having different rules and regulations. Do  not even get me started about Louisiana, where they still basically use the old Napoleonic Code. Yes, that Napoleon.

In an increasingly litigious society, an RIA can find itself and its officers facing not only their legal fees and costs, but having to potentially pick up the legal fees and associated costs of their custodian, since they may be named as a party as well for having executed the trades without the RIA having all the legally required documents.

I know that some BDs do have sample powers of attorneys that they provide to their registered representatives who manage discretionary accounts. As a registered representative of the BD, they should be more than willing to provide such form to IARs of independent RIAs owned by their registered representatives.

Truly independent may be able to find other RIAs that are willing to share the power of attorney form they use, but the prudent RIA will verify that any such form is legally acceptable in their jurisdiction. Some jurisdictions have very strict requirements as to certain required language and disclosures that must be included in certain types of powers of attorney.

Some attorneys and RIAs claim that a trading authorization is sufficient, as they will simply argues that a customer ratified any trades if they did not object to same. Ratification may in fact work, but courts and regulators have increasingly rejected such defenses, as both have adopted even stronger consumer-centric position.

If you own or are affiliated with a privately owned RIA, understand that it is your business and you have the responsibility for knowing and complying with any and all federal, state and local regulations. While RIA compliance has become increasingly more difficult and time-consuming, especially with the new emphasis on cybersecurity and client confidentiality, a RIA may not have to worry about such issues for long it if the required compliance is not done properly.

 

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James W. Watkins, III Quoted in 401(k) “Best Practices” Article

Posted on July 6, 2016 by jwatkins

I was recently quoted in an article addressing best practices of leading 401(k) plans. The article raises a number of relevant issues regarding providing a meaningful plan to help plan participants accomplish their financial goals.

The article, “Is your 401(k) helping or hurting your retirement savings,” is available at the MarketWatch web site:

http://www.marketwatch.com/story/is-your-401k-helping-or-hurting-your-retirement-savings-2016-07-06

Posted in 401k, 401k investments, 404c, ERISA, investments, pension plans, retirement plans, wealth management | Tagged , , , , , , , | Leave a comment

The End of Human Investment Advisors Exaggeration

Posted on July 5, 2016 by jwatkins

Only when the tide goes out do you discover who’s been swimming naked.
Warren Buffett

This weekend I saw yet another story on the predicted end of the human investment advisors and the takeover of the robo-advisors. Whenever I see such stories, I just shake my head. I guess that as an attorney and someone who has been in the investment advisory business arena since 1995, I just see a different picture than a lot of other people.

Yes, robo-advisors can offer beneficial economies of scale in the provision of personal investment advice, but the quality of the services provided by robo-advisors has yet to be really tested by a significant downturn in the stock market. And there are many who believe that when “the tide does go out,” and the market does experience a significant downturn, a number of suspected issues involving robo-advisors will be exposed, resulting in a wave of litigation.

People who know me know that I like to tell the story about the computerized asset allocation proposal that was prepared for a recently widowed wife. Her husband had carefully created an investment portfolio that provided significant income through interest and dividend payments, more than enough for them to live comfortably for the rest of their lives.

An investment advisor asked her to fill out a risk tolerance questionnaire so that he could prepare a financial plan for her, including an asset allocation proposal. One of the questions on the risk tolerance questionnaire asked her if she had any needs for income. Naturally, she answered “no,” as her current investment portfolio provided more than a sufficient amount of income.

However, the computer program did not, and could not, realize that her answer was based on the income produced by her portfolio. As a result, the asset allocation software program recommended a re-allocation that was totally unsuitable, replacing most of the income-oriented investments with equity-based products, some of which were grossly unsuitable.

Worse yet, the advisor actually presented the proposal to the widow. Fortunately, she did not implement the proposed re-allocation, as she sought the advice of her counsel and her children before making any changes in her portfolio.

As we all know, any computer based financial planning/investment program is subject the to the familiar “garbage in/garbage out” trap. In the case of the widow, her answer was totally accurate, but the inherent limitations of any computer program needed to be recognized and addressed.

I have read that at least one of the major robo-advisor firms has now partnered with an investment advisory firm to add the human element to their services, apparently in recognition of the potential legal issues that may result from a totally computer-based program.

I still am unclear on exactly what services the human advisors provide in this new program, but hopefully it will include the ability to reduce potential legal liability by offering proactive wealth management services beyond  the simple re-balancing services which most robo-advisors offer. Re-balancing alone simply does not provide the downside protection contemplated and endorsed by the Prudent Investor Rule, as set out in Section 90 the Restatement (Third) of Trusts.

Asset allocation decisions are a fundamental aspect of an investment strategy and a starting point in formulating a plan of diversification….These decisions are subject to adjustment from time to time as changes occur in economic conditions or expectations or in the needs or the investment objectives of the trust.

I believe that while some litigation will be based on basic unsuitability claims based on the investments within some investment portfolios, the major litigation claims will be based on the positions set forth in the Restatement, including the Prudent Investor Rule. I always advise new clients to take a weekend and visit a local law school library and read the entire volume on the Prudent Investor Rule, as the courts and the regulators routinely rely on the Restatement in deciding investment and fiduciary related cases.

Another reason that I believe that the human element will always be needed in the financial planning and investment advisory businesses is that clients will always need additional wealth management services that can only properly be provided by human advisors. For instance, recent studies are consistently showing that high net worth clients are inquiring more about asset protection and wealth preservation strategies.

In the legal community, this concept of “integrated estate planning” is growing, especially since the new higher estate tax exemptions and the new portability laws are reducing the need for  many of the more traditional estate planning techniques. Integrated estate planning actually offers a good opportunity for investment advisors to form new collaborative relationships with attorneys.

Investment advisors can obviously seize on this concept of collateral services by developing other services that the public often seeks , such as college tuition planning, divorce planning, and retirement income/retirement distribution planning. In most cases there are programs, in most cases conferring designations. to help an advisor acquire the knowledge necessary to properly provide such services.

Just as Mark Twain noted that reports of his death had been greatly exaggerated, I believe that there will always be a need for the human element in the investment advisory and financial planning businesses.

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A Little More Knowledge on Reducing 401(k) Plan Sponsor Liability

Posted on June 24, 2016 by jwatkins

As I have mentioned several times, I believe that the current environment presents investment advisors with a perfect opportunity to enter the 401(k) arena and prove the value added proposition that they can provide. The DOL’s recently announced fiduciary standard only increases the value of the opportunity.

In our experience, the fiduciaries of most [404(c)] plans believe they have [complied with 404(c)] but in most cases they have not.

Those words of warning come from Fred Reish, one of the nation’s leading ERISA attorneys. The relevance of the quote lies in the fact that ERISA plan sponsors face unlimited personal liability if they fail to comply with all of Section 404(c)’s requirements.

As I read various financial publications, I see a large number of articles trumpeting the goal of “retirement readiness.” Toward that goal, the articles usually stress the value of increasing participation in a company’s 401(k) plan by automatic enrollment and automatic contribution programs.

As an ERISA attorney who regularly performs forensic portfolio analyses of 401(k), 457(b) and 403(b) plans, I’m not sure that plan sponsors realize the personal liability exposure that they may be creating for themselves by forcing employees into non-compliant and imprudent plans and forcing such employees into plans whose investment options are actually costing the plan participants to lose money.

I believe that an area that is going to be receiving more attention in the excessive fees and imprudent investments litigation arena is private colleges and universities. Private colleges and universities do not enjoy the same protection from ERISA that government-run colleges and universities do.

I recently completed a forensic investment analysis on the 403(b), 457(b) and Optional Retirement Program of a major Southern university. Of the 126 mutual funds I reviewed, only 16 of the funds passed my prudence analysis based on their nominal returns, and only 6 passed my prudence analysis based on their risk-adjusted returns.

My analysis did not include an analysis of the sub-accounts within the variable annuities which were offered as part of the plans. However given the fact that the sub-accounts were basically higher priced versions of some of the same company’s mutual funds that failed my forensic analysis, inclusion of the sub-accounts would have assuredly resulted in even more discouraging results.

In performing my forensic analyses, I rely on several proprietary metrics, most notably the active Management Value Ratio™ 2.0 (AMVR) and the Fiduciary Prudence Compliance Score. A list of the metrics I use in preparing my forensic fiduciary prudence analyses is available here.

To be honest, the AMVR is usually enough alone to expose mutual funds that are imprudent due to failing to provide a positive incremental return for a plan participant and/or being cost inefficient, both of which actually cost plan participants money. I am not sure how a plan sponsor would successfully argue the prudence of either situation.

And that presents yet another opportunity for fee-only investment advisors to prove their value added proposition to ERISA plan sponsors. Most plan sponsors blindly rely entirely on service providers who are either stockbrokers, broker-dealers, insurance agents or insurance companies.

However, the courts have repeatedly stated that plan sponsors cannot blindly rely on such parties given their inherent conflicts of interest. In order for plan sponsors to justifiably rely on the advice of third parties, such third parties must be independent and unbiased. As one court stated in denouncing blind reliance on service providers and stressing a plan sponsor’s duty to perform an independent investigation and evaluation of a plan’s investment options,

blind reliance on a broker whose livelihood [is] derived from the commissions he [is] able to garner — is the antithesis of such independent investigation.

Liss v. Smith, 991 F. Supp 278, 299 (S.D.N.Y. 1998)

So truly objective and independent investment advisors can both educate plan sponsors and provide such sponsors with the valuable advice that they need in attempting to be 404(c) compliant and attempting to promote their goal of “retirement readiness” for their plan participants. Plan sponsors will then need to consult with ERISA attorneys or consultants to ensure compliance with the other non-investment related 404(c) requirements.

Carpe diem!

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To BICE Or Not To BICE, That Is the Question.

Posted on June 7, 2016 by jwatkins

I read an interesting article today on LinkedIn Pulse entitled “401(k) Opportunity, Is That You ?” by Rebecca Hourihan. https://www.linkedin.com/pulse/401k-fiduciary-opportunity-you-rebecca-hourihan-aif-ppc-?trk=mp-reader-card Ms. Hourihan addressed the same question that several of my plan sponsor fiduciary clients have asked me – what are the potential legal liability issues with allowing a plan service provider to enter into BICE agreements with a plan’s participants?

With all the articles and discussions regarding the DOL’s new fiduciary rule and BICE, I have not seen anything discussing the worst case scenario in a BICE situation. While one would like to think that the severe penalties for violating the rule and/or a BICE agreement would reduce the likelihood of same, it would be foolish not to recognize that there will undoubtedly be some violations of the rule and BICE.

There have numerous references made suggesting that the real parties that will benefit from the rule and BICE are class action attorneys since BICE preserves the right of an individual plan participant to participate in a class action based on a violation of the rule and/or BICE. I am among those who believe that there will also be legal actions against plan sponsors in cases of BICE violations based on breach of fiduciary claims, based on the argument that but for the plan sponsor hiring the service provider and allowing them to have access to the plan participants, resulting in the opportunity to obtain BICE agreements from plan participants, the damages suffered from the BICE violation would not have occurred.

Under the new fiduciary rule, plan sponsors have an opportunity for significant power in vetting potential service providers and establishing the terms of any engagement. They also have an increased liability exposure in connection with same. A potential violation of both the rule and BICE are certainly foreseeable. Therefore, one can legitimately ask why a plan sponsor would not require that a potential service provider agree not to ask plan participants to enter into a BICE agreement, since a BICE agreement essentially asks a plan participant to allow the service provider to engage in the very sort of abusive conflict-of-interest conduct that drove the passage of the rule and BICE.

Ms. Hourihan’s article made the point very clear with her simulated discussion:

Plan Sponsor: Are you working in my best interest?”
Advisor: “No, I’m using an exemption.”

And it’s just that simple. If a plan sponsor allows a service provider to seek BICE agreements from the plan’s participants and the service provider violates the BICE agreement, the individual will probably have to submit to arbitration with regard to any individual claim. Given the questions regarding the fairness of arbitration, it is highly unlikely that the plan participant will recover 100 percent of their loss, especially since attorneys fees will probably not be awarded, further reducing any recovery. Throw in possible discovery costs and other legally related expenses, and the seriousness in both the wrongful act and the plan sponsor’s culpability in not preventing same by prohibiting BICE agreement with the plan’s participants, and I believe you have the potential for a valid action against the plan sponsor.

Since most plan participants likely do not understand the implications of the new rule and BICE, a collateral issue is whether a plan sponsor has a fiduciary duty to explain both to plan participants so that they understand what their rights are with regard to both and the full implications of entering into a BICE agreement, that essentially they are giving the service provider/advisor the right engage in providing advice and recommendations that would otherwise be legally prohibited. Even if a plan sponsor attempts to educate plan participants on all of these issues, it is still possible that some plan participants still do not fully understand the issues and how they can protect themselves. In such cases, it can be anticipated that plan sponsors will be asked why they just did not take the proactive step of just conditioning the hiring of a service provider on their agreement not to seek BICE agreements from the plan’s participants.

I’m sure some will respond to this post with more negative comments about me and my fellow attorneys. Hopefully, some will seriously consider the points I’ve made, and other attorneys have already discussed nationally, and use them as potential “value added” ideas in marketing to plan sponsors and building their practices.

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

Posted on May 28, 2016 by jwatkins

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.

 

 

 

 

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“Best Interest,” BICE and Class Action Targets, Part II

Posted on May 18, 2016 by jwatkins

Much has been written about the Department of Labor’s (DOL) new fiduciary rule and the accompanying Best Interest Contract Exemption (BICE). Several writers have suggested that the group that will benefit the most from the rule and BICE are class action attorneys.

Unless Financial Institutions and their Advisers understand and successfully adapt to the shift from a culture of “suitability” to the more demanding “fiduciary/’best interest’/prudence” culture required under the DOL’s new fiduciary rule and BICE, the likelihood of successful class actions against them will definitely increase.

In Part I of this article, we discussed the fiduciary issues that exist for Financial Institutions and their Advisers with regard to actively managed mutual fund, including so-called “closet index” funds and the popular “preferred provider” programs that many Financial Institutions have adopted. In Part II, we will address the issue of 401(k) Rollovers and IRAs, variable annuities and equity/fixed index annuities.

401(k) Rollover and IRAs Accounts

The abusive marketing and sales strategies directed toward Retirement Investors in connection with 401(k) rollovers and individual retirement accounts (IRAs) were one of the primary reasons for the DOL’s new fiduciary rule and BICE. In many cases, a 401(k) rollover into an IRA is a prudent move, as it often provides a Retirement Investor with a wider selection of investment options that provide better returns and lower fees.

However, experience has shown that far too often unethical financial advisers were recommending that Retirement Investors execute 401(k) rollovers into actively managed mutual funds with historically poorly performing mutual funds and with excessively higher fees. In other cases, financial advisers were recommending questionable products such as variable annuities and fixed/equity indexed annuities in order to receive the high commissions associated with such products, despite the fact that such products raise obvious “best interest” issues for a Retirement Investor.

Under the new fiduciary rule and BICE, making recommendations with regard to 401(k) rollovers and IRA investments is classified as a fiduciary act. Under the new rule and BICE, a financial adviser must determine whether a rollover would be in the “best interest” and prudent of a Retirement Investor. In making such decisions, Financial Institutions and their advisers are required to consider such factors as

  1. the costs associated with the plan versus the costs associated with the IRA;
  2. the Retirement Investor’s available alternatives to a rollover; and
  3. the different levels of services and investments available under each option.

One question that I have received in connection with a financial adviser’s duty to perform a “best interest” analysis in connection with rollover and IRA advice is whether an adviser will be required to perform an analysis similar to that provided by the AMVR metric. Given the continuing legal actions and settlements involving the quality of current 401(k) plans, is it prudent for a Financial Institution and their Advisers to simply assume that a Retirement Investor’s 401(k) plan is prudent with regard to its investment options, both in the quality of the investment options and their fees.

I do not know the answer to the question, but it would seem to be an area that needs to be addressed to further the goals of the new rule and BICE, namely to ensure that Retirement Investors are protected and receiving investment advice that is prudent and in their “best interest.” The question becomes even more relevant if the financial adviser proving the rollover and IRA advice is the same adviser who advised the 401(k) plan as to its investment options, as there would definitely be, at a minimum, a potential conflict of interest since the adviser would be unlikely to admit to making poor investment recommendation for the 401(k) plan. My guess is that someone will eventually raise these questions, again in furtherance of the goals of the rule and BICE.

Variable Annuities

Variable annuities are among the leading grounds for customer complaints each year. The abusive sales strategies, as well as the issues regarding the excessive fees and quality of investment options offered by such products, makes such products imprudent for most investors. Given the fact that most variable annuities charge cumulative annual fees of 2-3 percent, and that each additional 1 percent in fees and expenses reduces an investor’s end return by approximately 17 percent over a twenty year period, it is easy how a variable annuity could reduce an investor’s end return by over 50 percent. Hardly prudent or in an investor’s “best interest.”

The impact of excessive fees and the poor quality of investment subaccounts within variable annuities is  the reason why smart investment advisers have avoided variable annuities since investment advisers have always been held to a fiduciary standard. Smart investment advisers have also realized that the method used by most variable annuity issuers to calculate the annuity’s annual M&E, commonly known as “inverse pricing,” is inherently inequitable. Using “inverse pricing,” the variable annuity issuer bases the annuity’s annual M&E on the accumulated value of the variable annuity, even though the variable annuity issuer’s legal obligation under the death benefit is usually limited to the amount of the variable annuity owner’s actual contributions, which are usually far les than the annuity’s accumulated value.

Experience has shown that in most cases, the variable annuity issuer does not even have to pay a death benefit, as the accumulated value of the annuity at the owner’s death is greater that the death benefit. This makes the inequitable nature of the choice of “inverse pricing” to calculate annual M&E fees even more inequitable and egregious, as it guarantees a windfall at the variable annuity owner’s expense. This results in a situation that is clearly imprudent and not in the variable annuity owner’s “best interest,” as the law clearly states that “equity abhors a windfall.”

Equity/Fixed Indexed Annuities 

A relatively newcomer to the financial services industry, equity/fixed indexed annuities (EIAs) are marketed in such as way as to entice investors to invest in a product that will allow them to benefit from the returns of the stock market without all of the risk associated with the stock market. However, it is the various restrictions and other limitations on an investor’s returns that may result in class action suits involving these products.

EIAs are not technically securities. They are an insurance product that uses the returns on a stock market index or other benchmark to calculate the interest rate earned by the annuity. Given the popularity of EIAs and the confusion and complaints resulting from the restrictions on interest earned by investors, the DOL obviously chose to take steps to protect investors and ensure that Retirement Investors are treated fairly.

The issue with EIAs has to do with the fact that EIAs usually contain various “caps” and restrictions and limitations that result in an investor receiving a level of interest that is far below the return of the applicable market index. Two of the most common restrictions are the “cap rate” and the “participation rate.”  The “cap rate” is just that, a cap on the amount of interest an investor can receive, regardless of the actual return of the applicable market index. Based upon my experience, most EIAs use a cap rate of approximately 10 percent.

The “participation rate” is then applied to further reduce the rate of return actually received by an investor. Again, based on my experience, 2 percent is a popular “participation rate.” Therefore, for example, assume an EIA based its interest rate payable on the S&P 500, with a “cap rate” of 10 percent and a “participation rate” of 2 percent. If the  S&P 500 had an annual return of 30 percent, the investor would only be credited with an interest rate of 8 percent (10 percent “cap rate”) minus 2 percent “participation rate’).

These various restriction and limitations can be confusing to an investor when combined with the marketing materials that tout an interest rate based on the enticing returns of the stock market. Under BICE’s new Impartial Conduct Standards, Financial Institutions and their Advisers are prohibited from making misleading statements about investment transactions, compensation and conflicts of interest. The combination of marketing discussing interest based on market gains with the restrictions on interest actually earned by an investor can obviously raise issues as to misleading statements. Fortunately for Financial Institutions and their Advisers, this is an issue that should be easily resolved through better disclosure , both in terms of the disclosure language itself and the prominence of same.

Conclusion

The bad news – the DOL’s new fiduciary rule and BICE impose strong requirements on Financial Institutions and their Advisers in connection with the provision of investment advice to Retirement Investors. The good news – the requirements, while demanding, can and must be complied with to avoid the potentially severe legal penalties, both from regulators and class actions. The shift from a culture of “suitability” to a much more demanding “fiduciary/”best interest”/prudence culture definite change, but one that can actually help increase business for Financial Institutions and their Advisers by regaining the trust of Retirement Investors by promoting a system that produces win-win situations for all parties. For those unwilling to comply with the DOL’s new fiduciary rule and BICE to produce such result, the guarantee of successful class actions should come as no surprise.

© Copyright 2016 The Watkins Law Firm, 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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