Excellent discussion and analysis on a subject that is gaining increasing attention by both financial planners, financial advisers and attorneys, as the need for such services continues to grow as people realize the significant benefits, and protection, that experienced professionals can provide.
https://www.northerntrust.com/insights-research/detail?c=19b7b5a72911c23faea5bc4f586a21ad
There is currently a lot of speculation on how and if the new Trump administration will attempt to undo the DOL’s new fiduciary rule. Opinions range from an attempt to delay the effective date of the new rule to a complete repeal of the new rule. From a procedural standpoint, a complete repeal would appear to be unlikely, as pointed out in this article.
While the DOL’s new fiduciary rule arguably helps define the duties owed by financial advisers who provide investment advice to retirement plans and their participants, from a purely legal standpoint, those duties may already be sufficiently defined regardless of the actions the Trump administration may take.
Fiduciary is basically derived from a combination of the common law of trusts and agency, as set forth in the Restatements for both areas of the law. Certain types of financial advisers are already held to the high standards required under fiduciary law, namely that they always put a customer’s best interests first. Registered investment advisers and ERISA fiduciaries are legally held to a fiduciary standard. In addition, some states impose a fiduciary duty on stockbrokers, who are generally not held to a fiduciary standard unless they have contractually agreed to such status, they are managing a customer’s account on a discretionary basis, or the courts have imposed such a standard on them.
Stockbrokers are generally held to a much lower standard which simply requires that any investment recommendations they provide to a customer be “suitable” for that customer given the customer’s personal investment parameters, including their financial goals and needs. From a regulatory standpoint, “suitability” is evaluated in terms of both the suitability of the investment recommendations vis-a-vis both the specific customer and the investing public in general.
While there are those that try to confuse the issues with regard to fiduciary prudence and/or suitability, I would suggest that two simple questions help to clarify the issues for both financial/investment advisers and securities attorneys.
(1) Is an investment that has consistently failed to produce a positive incremental return for an investor a prudent investment and/or suitable for any investor, given the opportunity costs it produces relative to comparable investment options?
(2) Is an investment whose incremental costs have consistently exceeded the investment’s incremental returns a prudent investment and/or suitable for any investor, given the financial losses it produces relative to comparable investment options?
Common sense tells you that any investment that consistently fails to provide a positive incremental return, or whose positive incremental returns are consistently exceeded by the fund’s incremental costs, is neither prudent nor suitable for any investor, as both situations ensure unnecessary financial losses for an investor. This is an argument that financial advisers and financial fiduciaries can expect to see on a more regular basis in securities and ERISA litigation due to both the simplicity of the argument itself and the simplicity in performing the calculations needed to prove such incremental costs and returns.
Various studies, including Standard & Poor’s well-known SPIVA reports, have shown that most funds fail to outperform their relative benchmark index fund. In some cases, the fund underperformance can be attributed to the fund’s higher incremental costs relative to the benchmark’s fees. In fact, a recent study concluded that a large percentage of actively managed mutual funds are priced to fail, as their fees and other costs sometimes negate their actual outperformance of their benchmarks based purely on returns.
Litigation against 401(k) plans has been a trend for several years now. 2016 saw the first fiduciary cases filed against private 403(b) plans. 2017 may well see the first fiduciary cases files against public 403(b) plans and non-profit plans. In many cases, the fiduciary breaches are so obvious that a simple incremental costs/returns analysis basically ensures that a settlement is the best option for resolving the action.
Stockbrokers and broker-dealers can expect to see an increased use of incremental costs/returns analysis to prove suitability violations as well. Investments that basically ensure a loss for investors, whether due to negative incremental returns or positive incremental returns negated by a fund’s incremental costs, will face an extremely difficult challenge in withstanding legal and/or regulatory challenges under even the suitability standard.
One trend in the investment industry has been the increase in dually registered financial advisers, those that are registered as as both registered representatives of their broker-dealer and as investment advisory representatives of a registered investment adviser. The challenge for dually registered financial advisers may be even more daunting, as the courts have undercut the popular “two hats” theory and clearly warned of the liability standard implications for such advisers:
The record shows clearly that, except for a few isolated instances, petitioner acted simultaneously in the dual capacity of investment adviser and of broker and dealer. In such capacity, conflicting interests must necessarily arise. When they arise, the law has consistently stepped in to provide safeguards in the form of prescribed and stringent standards of conduct on the part of the fiduciary.
(Hughes v. SEC, 174 F.2d 969 (1949)
© 2017 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.
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.
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.
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.
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.
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
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.
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).
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.
The Prudent Investment Fiduciary Rules 
You must be logged in to post a comment.