Robo-advisors: Much Ado About Nothing?

Posted on January 29, 2015 by jwatkins

I just finished reading an article about a recent debate between noted financial advisor Ric Edelman and Adam Nash, CEO of robo-advisor Wealthfront. Interestingly, Edelman suggested that robo-advisors would put many financial advisors out of business.

My position is simple. If you are truly a wealth manage, providing more than just asset allocation/money management services, you should not have a reason to worry. The high net worth sector needs, and wants, more than just money management services. Studies have consistently shown that the HNW sector wants integrated wealth management, including wealth preservation services such as estate planning, asset protection and retirement distribution planning. That’s one of the main reasons I hold myself out as a wealth preservation attorney, as I offer that package of services.

If you hold yourself as a wealth manager, but only provide portfolio management services, then you may have reason to worry. If robo-advisors can prove that they provide meaningful and consistent money management services at a significantly lower rate, then they may in fact have created a better mousetrap for those who only need such services.

Just as the bear market of 2008 was a true test for many financial advisors, I think the true test of the robo-advisors will be when the market encounters it next significant downturn, or “black swan.” Given the length of the current bull market, the recent volatility in the markets, and the suggestion of a pending increase in interest rates, that test may be sooner than later.

I’m not sure what algorithms and concepts robo-advisors use, but the fact that they are computer driven means the potential for “garbage in, garbage out” issues remains real. The same issues that plague current commercial asset allocation/portfolio optimization software programs may well affect robo-advisors.

One of the services that I provide is a forensic analysis of computer prepared asset allocation/portfolio optimization reports. During one of my former positions, we worked with a well-known company to create a proprietary asset allocation program for the company. Based on what I learned during that time, I realized that such programs will always have an inherent instability and a propensity to often make recommendations that are either counter-intuitive at best, or simply flat out improper.

When I prepare a forensic analysis, I use four proprietary metrics, including the Active Management Value Ratio™, which I have made publicly available through posts on this web site. But in many cases, one does not need metrics to detect errors in asset allocation/portfolio optimization recommendation.

One of the best cases of this was a situation where a widow had a plan prepared. One of the questions on a questionnaire she was asked to complete asked if she had a need for current income. She properly marked “no,” as her current portfolio provided a nice stream of income. However, the computer program misunderstood her answer and essentially recommended that she significantly increase her holdings in growth-oriented equity mutual funds with little or no income. Fortunately, I was able to point out these problems to the widow and her attorney before any changes were made to her portfolio.

So, I am suggesting that financial advisors may take advantage of the robo-advisor buzz and offer to review the robo-advisors recommendations and performance and use it as a marketing opportunity. I know a couple of financial advisors who have already offered such services to former clients for free in hopes of demonstrating the worth of their services in comparison to robo-advisors. Since most robo-advisors are offering their services at significantly reduced rates, e.g. 25 basis points, the financial advisor will still have to deal with that issue.

The point is that robo-advisors have yet to be time tested, so their true worth is still suspect. Just like so many 401(k) plans that offer investment options that are far from prudent, both in terms of fees and performance, robo-advisors who provide imprudent investment management, albeit at a reduced price, are worthless and clearly not in the best interests of their clients. Only time will tell.

 

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The Fiduciary Standard – It’s “Best Interests,” Not “Like Everyone Else”

Posted on January 5, 2015 by jwatkins

During a recent deposition of an investment adviser, the adviser told me that was doing the exact same thing as everyone else in the  industry and asked me why I was “targeting” him. Not the first time I have heard this argument, nor probably the last time I will hear it.

I do sue investment advisers and stockbrokers on behalf of investor. I also serve as a consultant to RIA firms and show them how to “bulletproof” their practices. This blog is part of my educational efforts for RIA firms.

Fiduciary law is derived from both trust and agency law. The core principle is that a fiduciary must always show undivided loyalty, must always act in the customer’s/client’s “best interests.” Just remember this statement and you should be OK:

Fiduciary law defines loyalty in terms of the customer’s/client’s “best interests,” not in terms of what the financial services industry or other investment professionals are doing.

I remember the old saying, “well, would you jump off the Golden Gate bridge just because everyone else did?” Same concept. I’ll let you in on a little secret – the law is not going to change anytime soon. Focus on a customer’s/client’s best interests, not what everyone else is doing.

What securities attorneys now realize is that through the use of forensic analysis and tools such my metric, the Active Management Value Ratio™, it is becoming much easier to document both fiduciary prudence and the lack thereof. Therefo0re, it is incumbent on prudent investment advisers and financial advisers to learn and use the same tools and processes in order to protect their practices and better serve their clients.

Stockbrokers who think they are never fiduciaries and can do whatever they want might be interested in the following quotes:

The suitability requirement that a broker make only those recommendations that are consistent with the customer’s best interests prohibits a broker from placing his or her interests ahead of the customer’s interests. (from “FINRA Regulatory Notice 12-25)

As we have frequently pointed out, a broker’s recommendations must be consistent with his customer’s best interests. (Wendell D. Belden enforcement decision)

In interpreting the suitability rule, we have stated that a [broker’s] ‘recommendations must be consistent with his customer’s best interests. (Scott Epstein enforcement decision)

Brokers should also be aware that the courts are showing an increased willingness to impose a fiduciary standard on brokers when customers lack the knowledge and/or experience to independently evaluate their broker’s recommendations. I would suggest that this could potentially cover a third to a half of brokerage accounts. Therefore, both investment advisers and stockbrokers wo0uld do well to remember the following:

Fiduciary law defines loyalty in terms of the customer’s/client’s “best interests,” not in terms of what the financial services industry or other investment professionals are doing.

 

 

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Whoomp, There It is! – The New Prudent Fee Fiduciary Standard

Posted on December 18, 2014 by jwatkins

“Essential to the plausibility of plaintiffs’ claims was the allegation that the Affiliated Funds ‘charged higher fees than those charged by comparable Vanguard funds-in some instances fees were more than 200 percent higher than those comparable funds'”.

With those words the United States District Court for Southern District of New York, provided the long-anticipated introduction, or more specifically the judicial verification, of Vanguard’s funds’ fees as a comparative basis for assessing excessive of fund fees was established. While the case is not binding on other courts, the rationale used by the court is persuasive and will undoubtedly be referenced by plaintiffs’ attorneys in both 401(k) and other cases where breach of fiduciary issues involving fee issues are involved.

The case involved is Marya J. Leber, et al. v. The Citigroup 401(k) Plan Investment Committee et. al., otherwise known as the Citigroup 401(k) action. The court’s decision is yet another in the continuing pro-plan participant decision s that have been handed down since the Supreme Court’s LaRue decision, recognizing that plan participant’s bear the risk in defined contribution pension plans.

More importantly, the court’s decision provides further support for the relevance of intrinsic costs and returns in analyzing both investment recommendations made by financial advisors and investment options offered by 401(k) plans and other retirement plans. I introduced a proprietary metric, the Active Management Value Ratio™ (AMVR™), as a means of assessing the prudence of actively managed investment products. The AMVR™ is a simple, straightforward metric that requires nothing more than simple subtraction and division. By using the incremental costs and incremental returns of an investment in the calculation process, the AMVR™ provides a truer evaluation of an investments benefits, or lack thereof.

Investment advisers and investment adviser representatives are fiduciaries by law. Many stockbrokers have told me that they do not have to worry about fiduciary issues since they do not manage customer accounts on a fiduciary basis and the law clearly states that a broker does not have any fiduciary duties with regard to non-discretionary customer accounts.

Those same brokers are surprised when I tell them about the cases of Follansbee v. Davis, Skaggs & Co. Inc. and Carras v. Burns. In both cases, the courts ruled that a broker can be held to owe a fiduciary to their customers, even in cases involving purely non-discretionary accounts. As the Follansbee court stated

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

The Carras court reiterated the Follansbee standard, stating that

the issue is whether or not the customer, based on the information available to him, and his ability to interpret it, can independently evaluate his broker’s suggestions.

As a result, I would suggest that broker’s may face imposition of a fiduciary standard more often than they believe. Therefore, all financial advisers, might find it beneficial to consider the impact of the Citigroup decision and the usefulness of the AMVR™ in both providing valuable services to their clients while reducing unwanted  and unnecessary liability exposure.

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Citigroup Decision’s Warning for 401(k) Fiduciaries

Posted on October 23, 2014 by jwatkins

U.S. District Judge Sidney H. Stein recently ruled that the participants in the Citigroup 401(k) excessive fees case had filed their action within the required time period. Judge Stein’s opinion was based primarily on a finding that absent “actual knowledge” of a fiduciary breach,” the time period for filing is six years after a fiduciary’s breach.

As an attorney, I always want to read the actual decision in a case. Judge Stein’s discussion of what is required for “actual knowledge of a fiduciary’s breach is what 401(k) fiduciaries and plan sponsors should review.

The main issue in the Citigroup case is the decision to replace ten funds in the Citigroup plan with other funds, including three Citigroup affiliated funds. As the court noted, the Citigroup funds all “charged higher fees and performed less well  than comparable unaffiliated funds.”

Citing Caputo v. Pfizer, the court stated that

[A] plaintiff has ‘actual knowledge of the breach or violation’ within the meaning of [the statute] when he has knowledge of all material facts necessary to understand that an ERISA fiduciary has breached his or her duty or otherwise violated the Act…one of ‘facts necessary to constitute [the] claim.

The court rejected Citigroup’s argument that by providing plan participants with documents disclosing both the affiliated funds’ fee and the fact that the funds’ affiliated status, the participants’ had actual notice of any breach of fiduciary duties.  In evaluating “actual knowledge” with regard to excessive fees, the court stated that

to demonstrate plaintiff’s actual knowledge of the breach. defendant must show either that plaintiffs possessed, through Plan communications or otherwise, comparisons of the Affiliated funds to the alternatives or knew in some way that the fees were excessive.

The court noted that Citigroup had not even attempted to offer any evidence that the plan participants had been provided with or possessed the necessary fee data Without such data, the court held that the plan participants “could not have known that the fees were excessive, and thus a basis for an ERISA claim.”

After reviewing the court’s decision, two points came immediately to mind. First, few, if any, 401(k) plans provide the type of fee comparison data mandated by the court’s decision. The court seems to suggest that the required fee comparison data includes comparison data on both the unaffiliated funds with a plan, but also on comparable alternative funds with similar types of assets and equivalent performance available in the marketplace.

Essential to the plausibility of plaintiff’s claims was the allegation that the Affiliated Funds ‘charged higher fees than those charged by comparable Vanguard funds-in some instances fees that were more than 200 percent higher than those comparable funds.’

There are going to be very few actively managed retirement funds that can match Vanguard’s low fee structure. Furthermore, my experience with forensic investment analysis has shown that only about fifty percent of actively managed funds provide investors with any incremental benefit at all. Even in cases when a fund provides investors with any incremental benefit, the incremental costs incurred far exceed the incremental benefit provided, raising obvious fiduciary issues.

I am a member of the Paladin Registry. I recently posted an article on the issue of retirement funds having various fee options, including various 12b-1 fee payouts. Now I realize that in some cases the higher fees reflect the costs of various 401(k) services. When people responded to point this out, even they admitted that despite new requirements for greater transparency in fee reporting, most mutual funds and service providers do not provide plan participants and,  in some cases, plan sponsors and fiduciaries with a proper breakdown to allow for an accurate evaluation of plan management fees. The reference to 12b-1 fees is especially troublesome, as ERISA prohibits such payments from third parties to those serving as consultants to pension plans.

The second point that came to mind was the court’s discussion of the requirements for “actual  knowledge,” more specifically the requirement that participants had to know “all facts necessary to constitute a claim.” As many people know, I have long been a proponent of requiring that plans provide plan participants with correlation of return data for each of the investment options within a plan.

ERISA does not currently require disclosure of such information. However, such information is obviously material to the goals of ERISA, providing plan participants with “sufficient information to make informed investment decisions” and to ensure that participants “are afforded a reasonable opportunity to materially affect the potential risk and return on amounts in their accounts…” Without such information, plan participants cannot effectively provide the downside protection that their portfolios need to protect against significant investment losses, a stated goal of ERISA.

The importance of correlation of return data is reinforced by the fat that both the Department of Labor and the courts have clearly and consistently stated that Modern Portfolio (MPT) is the applicable standard in determining whether a fiduciary has acted prudently. The cornerstone of MPT…factoring in the correlation of returns among investments options as part of the portfolio construction process.

If both the Department of Labor and the courts consider correlation of returns data to be material information with regard to an ERISA fiduciary’s duty of prudence, and “actual knowledge” requires “knowledge of all material facts necessary to understand that an ERISA fiduciary has breached his or her duty or otherwise violated the act….[knowledge] of all facts necessary to constitute a claim,” then it can be argued that the failure to provide plan participants with fee comparison data and/or correlation of return data constitutes a continuing breach of fiduciary duty by an ERISA plan sponsor and plan fiduciary, effectively preventing the application of the “actual knowledge” three-year statute of limitations.

The Citigroup decision represents the continuing trend of courts to recognize the need to protect 401(k) participants from the pre-Larue abusive practices that denied plan participants the protection guaranteed by ERISA. The sooner that plan sponsors and other plan fiduciaries realize that “a pure heart and an empty head” are no defense to ERISA breach of fiduciary claims, the better for both plan participants and plan sponsors and fiduciaries.

Note: You can review the entire Citigroup decision at http://www.planadviser.com/uploadedFiles/LebervCitigroup.pdf

 

 

 

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Three Investment Adviser Fiduciary Traps to Avoid

Posted on September 30, 2014 by jwatkins

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Selah.

 

 

 

 

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Financial Plans v. Investment Policy Statements: One, None or Both?

Posted on August 25, 2014 by jwatkins

As an investment adviser consultant, one of the first things I ask new adviser clients is whether they prepare financial plans for clients. If so, I advise them not to do so going forward. Simply put, a financial plan in the hands of a knowledgeable securities attorney is an accident waiting to happen.

Dually registered advisers often counter by saying that their advisory activity is separate from their brokerage activity under the “dual hats” theory. Having been a compliance executive in the brokerage industry, I am aware of such arguments. However, I do not believe that argument is valid.

The “two hats” theory is derived from legal decisions involving ERISA and the separation of purely administrative duties from fiduciary duties under ERISA.  While a clear division can be established under ERISA, the courts have generally held that the functions of advisers and brokers are so intertwined that they cannot be clearly separated. As the court stated in the 1949 decision in Hughes v. Securities and Exchange Commission,

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. More than 100 years ago the Supreme Court set forth this principle as follows:

“In this conflict of interest, the law wisely interposes. It acts not on the possibility, that, in some cases, the sense of that duty may prevail over the motives of self-interest, but it provides against the probability in many cases, and the danger in all cases, that the dictates of self-interest will exercise a predominant influence, and supersede that of duty.” (Michoud et al. v. Girod et al., 1846, 4 How. 503, 554-555, 45 U.S. 503, 554-555, 11 L.Ed. 1076.

The cornerstone of most financial plans is some sort of asset allocation or portfolio optimization recommendations generated by a commercial software program. Such programs usually rely on past performance data, even though advisers and investment product ads are required to disclose that past performance does not guarantee future performance. Some plans use projections of future performance, or “guesstimates,” which pose obvious potential liability problems.

Financial plans generally make use of various spreadsheets to make projections regarding financial goals and future financial needs. The software typically used in generating such projections is often highly unstable, often resulting in dubious projections. A careful review of such spreadsheet calculations will generally point out calculation errors, errors which invalidate all or a significant portion of such calculations.

A well-known saying  is that “trees don’t grow to the sky.” History shows that the performance of the stock market is cyclical, alternating between secular bull and bear markets. And yet, financial plans calculations are usually based on assumptions of constant growth , with no allowance for downturns in the market. From a liability standpoint, this flawed premise can result in serious miscalculations regarding a client’s future needs.

Financial plans and their components also pose potential issues under  with regard to the anti-fraud provisions of Rule 10b-5 under the ’34 Exchange Act and/or Section 206 of the ’40 Adviser Act. These issues often arise when an adviser’s implementation recommendations differ significantly from the scenarios and assumptions used within a financial plan.

Some advisers use disclaimers in an attempt to protect against potential liability for plan/implementation variances. However, the extent and language of such disclaimers may create liability issues under the legal concept of quantum meruit. Quantum meruit stands for the proposition that clients who pay for a financial plan have a legal right to receive something of equal value in return. Financial plans with disclaimers may effectively diminishes or totally destroys any inherent value of the financial plan.

The various quality-of-advice issues presented by most financial plans provided by financial advisers has led Nobel laureate Dr. William F. Sharpe to refer to such practices as “Financial Planning in Fantasyland. http://web.stanford.edu/~wfsharpe/art/fantasy/fantasy.htm. Those who do offer financial plans to clients would be well advised to consider Dr. Sharpe’s analysis, especially in terms of potential liability issues.

Based on my experience, many financial advisers prepare financial plans, yet few take advantage of the benefits available from investment policy statements. (IPS) From a risk management perspective, an IPS avoids all the subjective elements of a financial plan and allows a financial adviser to clearly define the terms of the adviser-client relationship. In the event that a dispute should arise, the value of such an agreement cannot be overstated.

Another advantage of an IPS is that it demonstrates to a client that the financial adviser is interested in truly understanding a client and the client’s goal and need, not just using a client as a means to an end, selling product. In this regard, an IPS serves to address the old saying that “people do not care how much you know until they know how much you care.” Prudent financial advisers will take the time to sit down with a client and create a mutually agreeable IPS.

 

 

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Death, Divorce and LaRue: 401(k) Breach of Fiduciary Duty Claims as Assets In Divorce and Probate Cases

Posted on July 22, 2014 by jwatkins

In 2008, the Supreme Court of the United States handed down their landmark decision in LaRue v. DeWolff, Boberg and Associates, Inc.(1) In LaRue, the Court finally recognized the fundamental difference between defined benefit pension plans and defined contribution pension plans. Recognizing that plan participants bear the risk of investment losses in defined contribution plans, the Court ruled that individual participants in defined contribution plans could recover for losses in their accounts that were due to breaches of fiduciary duties by plans and/or plan fiduciaries.

While ERISA lawyers and others involved in the ERISA arena recognized the significance of the LaRue decision, attorneys practicing in other areas of the law have failed to recognize LaRue’s potential impact on their practices, particularly potential malpractice issues. This white paper will discuss the potential implications of LaRue for divorce attorneys, probate attorneys, other ERISA practitioners, and their clients.

Causes of Action As Property
From a legal perspective, “property includes all rights which are of value, including claims against third parties.”(2) A cause of action is a “chose in action,” or claim of one party against another for the rendering of something of value.(3) The Supreme Court and other courts have ruled that causes of action are rights of property.(4)

The Supreme Court’s LaRue decision recognizing the right of individual participants in defined contribution plans to bring an action for individual losses creates a potential cause of action for such plan participants and their beneficiaries. The creation of a cause of action also creates a property right, an asset, for participants and beneficiaries in defined contribution plans.

Compliance Issues in Defined Contribution Plans
ERISA Section 404(a) and the accompanying regulations set out a number of fiduciary duties for plan fiduciaries, including the duty of prudence-the duty to act with the care, skill, prudence and diligence that a prudent man would in a like capacity and familiar with such matters. In meeting the prudent man standard of care, Section 404 states that

a fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and-
(A) for the exclusive purpose of:
(i) providing benefits to participants and their beneficiaries; and
(ii) defraying reasonable expenses of administering the plan;
(B) with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims;
(C) by diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so;(5)

Recent ERISA settlements and legal decisions since LaRue suggest that defined contribution plans and fiduciaries are not complying with said 404(a) requirements. (6) Most of the ERISA-based breach of fiduciary duty claims to date have focused on the fees of the investment options available within a plan.

A future basis for ERISA-based breach of fiduciary may be the failure to meet the fiduciary duty to effectively diversify a plan’s investment options. Effective diversification is a two-step process requiring both vertical and horizontal diversification.

Most plans perform vertical diversification, i.e., diversifying among various asset classes. Few plans properly perform horizontal diversification, i.e., diversifying within asset classes. As a result, the plan’s participants are not provided with the ERISA’s required ability to minimize the risk of significant investment losses within their plan accounts.

Some plans believe that they are immune from fiduciary liability under Section 404(a) by virtue of a “safe harbor” known as ERISA Section 404(c). However, experience suggests that few plan and plan fiduciaries actually qualify for the various requirements for Section 404(c) protection.(7) Consequently, the potential for successful ERISA-based breach of fiduciary duty claims may be much higher than many plans and plan fiduciaries believe.

The potential number of successful ERISA-based breach of fiduciary duty claims may also be higher than believed by plans and plan fiduciaries. ERISA does not require small defined contribution plans, defined as plans with less than 100 participants, to conduct annual audits of the plan. As a result, such small plans may not be aware of potential fiduciary liability exposure.

The Department of Labor compiles statistics on defined contribution plans and active participants. The most current statistics, covering plan years ending in 2011, show that

• out of a total of 638,390 plans, 536,069 (88%) had less than 100 participants;
• out of a total of 638,390 plans, 487,795 (76%) had less than 100 participants;
• out of a total of 487,795 plans in which participants direct all investments, 422,072 (86%) had less than 100 participants.(8)

Small plans are less likely to spend the money for expert ERISA advice. Small plans often choose to rely solely on the representations and advice of plan service providers and others parties, who may have no fiduciary duty or other legal obligation to provide a plan or its fiduciaries with complete and accurate ERISA compliance advice.

ERISA-based Breach of Fiduciary Claims and Divorce Actions
The division of marital property is usually a significant issue in divorce actions. In some case, pension plan accounts may be a couple’s major marital asset.

The division of pension plan accounts is usually accomplished by a document known as a qualified domestic relations order (QDRO). The QDRO usually addresses the manner in which a pension plan account will be divided. In most cases, the preferred option is to let the non-owner of the account transfer the money to a separate retirement account, such an individual retirement account (IRA), in order to provide greater flexibility in the management of the funds. However, in some cases the pension plan may impose restrictions on the timing and/or the manner of the non-owner’s payout from the plan.

Under ERISA, the non-owner of the plan account is designated as an “alternate payee” and has the same rights as a plan beneficiary would have. Under ERISA Section 502(b), a beneficiary has standing to sue a plan and plan fiduciaries for breaches of their fiduciary duties. Therefore, the non-owner spouse should be informed of the potential for such ERISA-based breach of fiduciary claims and the possible value of same, in order to calculate the value of marital property and the potential value of individual claims.

Divorce attorneys should determine whether there are possible ERISA-based breach of fiduciary duty claims before finalizing property settlements. The evaluation of such potential claims should be considered not only in determining the total value of the marital property to ensure a fair and appropriate property settlement for their clients, but also to avoid potential malpractice claims

ERISA-based Breach of Fiduciary Claims and Probate Proceedings
The proceeds in a defined contribution plan are usually distributed in accordance with the decedent’s beneficiary form. The Supreme Court has ruled that the beneficiary form, not a decedent’s will, controls the distribution of pension plan accounts.(9)

An executor or administrator has a legal duty to gather all of the decedent’s assets. As mentioned previously, LaRue established a defined contribution plan participant’s legal right to file ERISA-based breach of fiduciary claims, and thus established such claims as property rights and assets.

Consequently, it can be argued that executors and administrators have a fiduciary duty to determine whether the participant’s estate has a potential ERISA-based breach of fiduciary duty claim. Given the high rate of suspected non-compliance by defined contribution plans, this duty to evaluate becomes even more important to protect against a possible breach of fiduciary duty action against the executor or administrator themselves.

Practical Considerations Going Forward
While the ERISA world immediately realized the implications of the LaRue decision, attorneys practicing in other areas of the law, as well as non-attorneys in the ERISA arena, may not have considered the full implications of LaRue for their practices.

Evidence from recent cases support the widely-held belief that many plans are not ERISA compliant in terms of both ERISA Section 404(a) and 404(c). Therefore, it is important for both divorce attorneys and probate attorneys to evaluate their cases for the possibility of an ERISA-based breach of fiduciary claim and the potential value of same. The most likely bases for ERISA-based breaches of fiduciary duty claims include excessive fees issues and issues regarding the improper selection, monitoring and/or diversification of a plan’s investment options.

At a minimum, it is suggested that an attorney involved in divorce or probate proceedings should discuss the possibility of such claims with their clients, leaving the ultimate decision to pursue any such action to the client. While such claims should not be cost prohibitive in most cases, the size of the potential recovery and/or the time element may be an important factor for a client.

401(k) plans are receiving an increasing amount of attention the issue of fees and other fundamental issues. With the number of multi-million dollars settlements and high profile ERISA-based breach of fiduciary actions pending, e.g., Tussey v. ABB, Inc.,(10), with the expectation of more to follow, it is important for attorneys and other ERISA experts to understand the impact of the LaRue decision and its progeny. While employees may be reluctant to file breach of fiduciary duty claims against their employers, ex-spouses and heirs may not be so reluctant, especially when potentially significant amounts of money involved.

This article 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.

Notes
1. Larue v. DeWolff, Boberg and Associates, 552 U.S. 248 (2008)
2. Ray Andrews and Walter B. Raushenbush, “The Law of Personal Property,” 3d ed., (Callaghan & Co., Chicago. IL 1975)
3. Logan v. Zimmerman Brush Co., 455 U.S. 422, 428 (1982)
4. Logan
5. 29 U.S.C. § 1104(a)
6. Recent notable settlements include Bechtel ($18.5 million), Caterpillar ($16.5 million), General Dynamics ($15 million), Wal-mart ($13.5 million) and Kraft ($9.5 million). The Braden-Tibble-Trilogy provide a good overview of the LaRue progeny of cases – Braden v. Wal-Mart Stores, Inc., 588 F.3d 585 (8th Cir. 2009); Tibble v. Edison Int’l, 711 F.3d 1061 (9th Cir. 2013); and Tussey v. ABB, Inc., (8th Cir. 2014)(not reported)(available online at http://scholar.google.com/scholar_case?case= 201457323903537409&hl=en&as_sdt=6&as_vis=1&oi=scholarr.
7. Fred Reish, “The New Take on 404(c): Confusion in the Federal Courts,” available online at http://www.drinkerbiddle.com/resources/publications/2009/the-new-take-on-404c-confusion-in-the-federal-courts?Page=8&Section=SpeakingEngagements& Year=&Practice=0&Attorney=0
7. Department of Labor, “Private Pension Plan Bulletin:Abstract 8f 2011 Form 5500 Annual Reports,” Table 6, available online at http://www.dol.gov/ebsa/pdf/ 2011pension planbulletin.pdf
9. Kennedy v. Plan Adm. For DuPont Sav. And Inv. Plan, 129 S.Ct. 865 (2009)
10. Tussey

Posted in 401k, 401k compliance, 401k investments, 404c, 404c compliance, compliance, fiduciary compliance, fiduciary law, investments, pension plans, retirement plans, wealth management, wealth preservation | Tagged , , , , , , , , , , , , | Leave a comment

The Art of Fiduciary Investing: Controlling the Controllable

Posted on July 9, 2014 by jwatkins

“[I]nvesting intelligently is about controlling the controllable.”
Ben Graham, “The Intelligent Investor”

The world of fiduciary investing is going through a significant stage, as more attention is being focused on various issues such as advisory fees, annual fees charged by investments, disclosure of material information, and effective risk management. While many consider the rules of fiduciary investing complex and confusing, fiduciary investing can be relatively simple if one follows Ben Graham’s advice.

I am often asked to name the best books on investing. In my opinion, Graham’s “The Intelligent Investor,” and Charles Ellis’, “Winning the Loser’s Game,” should be required reading for all fiduciaries. Ellis’ discussions on risk management as the proper focus of wealth management and the use of incremental costs and returns as the proper basis for evaluating investments are invaluable in assessing compliance with the fiduciary duty of prudence.

Graham’s concept of controlling the controllable is equally sound. No fiduciary can control the performance of the markets. The law does not impose liability on fiduciaries based solely on an investment’s performance. The law does impose liability on fiduciaries for failing to meet their fiduciary duties of prudence and loyalty, particularly with regard to unnecessary/excessive costs and the failure to provide proper portfolio risk management through effective diversification, two of the controllable elements referenced by Graham

Graham actually references four controllable elements: costs (specifically funds with excessive annual fees); risk management (through effective diversification); taxes (through focusing on capital gain treatment), and the investor’s own behavior. With regard to costs, fiduciaries often mistakenly focus on fees on a relative basis. Even the judicial system makes this mistake.

Fiduciary law, ERISA included, requires a fiduciary to always act in the best interest of the client. Consequently, investment costs should be evaluated in terms of the incremental costs and incremental benefits to the client, the idea advanced by Ellis. I have written about my own metric, the Active Management Value Ratio™, which is a simple calculation requiring only subtraction and division. Another useful metric for evaluating investment costs is Ross Miller’s Active Expense Ratio, which is available online.

While excessive costs have been the focus of recent ERISA actions, I believe that the next wave of ERISA litigation will focus on the failure of plan sponsors to provide the “broad range” of investment options required under ERISA Section 404(c) in order to allow plan participants to effectively diversify their pension accounts so as to minimize the risk of significant investment losses. Based on my experience, the investment options offered by most defined contribution plans consist of mainly of unnecessarily expensive and highly correlated equity-based mutual funds.

Many defined contribution plans are electing 404(c) status, as it potentially allows them to shift investment risk to the plan participants. However, it is has been suggested by at least one prominent ERISA attorney that very few plan sponsors are actually in compliance with all of Section 404(c)’s requirements. Consequently, many plan sponsors and plan fiduciaries face unlimited personal liability for the performance of the plan participants’ investment accounts.

Graham’s inclusion of the need to control one’s behavior has special relevance to fiduciary investing. The issue of conflicts of interest is a key issue in today’s investment industry. Fiduciaries who fail to “control the controllable” can expect to see litigation alleging breach of their fiduciary duties due to conflicts of interest, particularly financial conflicts of interest. Fiduciaries in the ERISA arena should note the post-LaRue trend of courts to recognize and protect the rights and interests of plan participants, as evidenced by the decisions in the recent Braden-Tibble-Tussey trilogy.

Leonardo da Vinci once said that “simplicity is the ultimate sophistication.” Steve Jobs, Apple’s legendary leader also adopted this belief. Whether conducting a fiduciary audit or trying a breach of fiduciary action, I simplify the process by focusing on whether the fiduciary has controlled the controllable – costs, risk and their own behavior. Investment fiduciaries who adopt a similar focus and properly control these elements-while at the same time putting the client’s best interests first-greatly reduce the chance of being successfully being sued for a breach of fiduciary duty. claim.

 

Posted in 401k compliance, 401k investments, 404c, 404c compliance, compliance, fiduciary compliance, fiduciary law, investments, pension plans, retirement plans, wealth management, wealth preservation | Tagged , , , , , , , , , , , , , | 1 Comment

Fiduciary Standard and Selective Amnesia at the SEC

Posted on June 1, 2014 by jwatkins

I just finished reading Knut Rostad’s insightful post on ThinkAdvisor.com regarding the ongoing debate over a uniform fiduciary standard for both stockbrokers and investment advisers. For those unfamiliar with Knut, he is the President of The Institute for the Fiduciary Standard. He has been championing the need for a uniform fiduciary standard that would require that both stockbrokers and investment advisers would be required to always put a customer’s interests first. Currently, stockbrokers are allowed to put their own financial interests ahead of those of their customers.

Knut’s post discussed the financial services industry’s ongoing campaign of misinformation regarding both the need and impact of a uniform fiduciary standard. The industry claims there is no need for such a standard, that everything is fine. The industry claims that such a standard would cause harmful cost increases for the industry and would reduce the number of stockbrokers who would provide advice to the public.

The annual number of court actions and arbitration cases clearly shows that things are not fine. The SEC has reported that their request for information regarding the increased costs that would be associated with such a standard produced little response. This should not be surprising, as the claim has no merit. Most broker-dealers have proprietary investment adviser firms or they allow their brokers to maintain independent advisory firms. Therefore, they are already required to review trades by brokers under the fiduciary standard’s “best interests” criteria pursuant to either the Investment Advisers Act of 1940 or NASD Notice to Member 94-44. Consequently, there should be little or no additional costs to broker-dealers under a uniform fiduciary standard.

The industry’s claim of reduced financial advisers to serve the public is pure speculation. As a trial attorney, courts do not allow purely speculative to be considered. As a former compliance director, I seriously doubt that brokers are going to walk away from any sort of compensation, at least honest brokers. As for those brokers who would not be willing to provide investment advice to the public under a “customer’s best interests first” standard, they should not be providing advice in the first place. If the SEC stays true to its stated mission statement of protecting the public, then the emphasis should be on quality of advice, not quantity.

Another article regarding the debate over a uniform fiduciary standard involved comments attributed to SEC Commissioner Daniel Gallagher. Commissioner Gallagher reportedly stated that he was unconvinced of the need for such a standard. Commissioner Gallagher reportedly based his statements on a lack of evidence regarding abusive practices by the brokerage industry. Commissioner Gallagher reportedly stated his opinion that the brokerage industry was being unfairly targeted, that “advisors are always seen as pure and brokers are seen as miscreants.”

I’m not sure where Commissioner Gallagher is getting his information, but again, as both a former RIA Compliance Director at one of the nation’s largest indie broker-dealers and a securities attorney, the simple truth is as with most industries, there are honest and dishonest in both the financial service and investment advisory industries. Furthermore, Commissioner  Gallagher’s call for additional information is troubling, as he need do nothing more than visit the SEC’s enforcement division and Finra’s enforcement division to uncover whatever evidence he needs.

However, I do not believe Commissioner Gallagher or, for that matter, Chairwoman White or any of the other SEC commissioners, need any additional information of the history of abusive practices within the financial services industry. I do, however, believe that they should take a refresher course in the stated mission and purpose of the SEC.

While the SEC’s home page proudly proclaims to be “The Investor’s Advocate,” recent history would seem to indicate that the SEC has become more “The Investment Industry’s Advocate,” at least with regard to protecting investors. In 2004, the SEC enacted a controversial exemption allowing broker-dealers to effectively act as investment advisors without registering as required by law. The exemption would have allowed broker-dealers to act as investment advisers without requiring them to comply with the “best interests of the customer,” or fiduciary, standard. Fortunately, the Financial Planning Association successfully sued the SEC, with the federal courts revoking the exemption and ordering the SEC to enforce the law as written.

With the current debate over a uniform “best interests” fiduciary standard, perhaps Madame Chairwoman and the commissioners should review the commission’s home page.

The main purpose of the Securities Act of 1933 and the Securities and Exchange Act of 1934 can be reduced to two common-sense notions, [one of which is that] people who sell and trade securities-brokers, dealers, and exchanges must treat investors fairly and honestly, putting investors’ interests first.” (emphasis added.)

Commissioner Gallagher’s statements notwithstanding, the obvious disregard for both the commission’s stated purpose and mission is even more puzzling given the fact that Finra, the entity primarily responsible for overseeing broker-dealers, clearly stated in Notice 12-25 that broker-dealers and their representatives must always act in the “best interests” of their customers. Consequently, a uniform fiduciary standard would simply reinforce Finra’s position. Finra’s position also either weakens the industry’s ‘increased costs” and “reduced advisors” claims or indicates that such claims are an admission that broker-dealers and their representatives have not been in compliance with Finra’s regulations.

Commissioner Gallagher is correct when he references the problem with dishonest brokers and investment advisers. Enacting a uniform fiduciary standard is not going to stop such activity. However, a uniform fiduciary standard will avoid the confusion investors face over what duty, if any, is owed them. A universal fiduciary standard will make it easier for regulators and investors to successfully address the unethical and dishonest brokers and advisers. As Dr. Martin Luther King, Jr. pointed out,

[m]orality cannot be legislated but behavior can be regulated. Judicial decrees may not change the heart, but they can restrain the heartless.

Despite Commissioner Gallagher’s selective amnesia, the financial service’s abusive practices and the resulting need for a uniform fiduciary standard to better protect investors are well-documented. Commissioner Gallagher’s position is inconsistent with the common-sense positions set out on the commission’s home page. Common-sense says that having two standards for groups providing the same services is ludicrous. Common-sense indicates that adopting a uniform fiduciary standard is both fundamentally fair for investors and, in truth, imposes no hardship on broker-dealers and their representatives other than having to treat investors fairly, as guaranteed by securities laws.

In Knut’s post, he references a statement by Scott Curtis, Raymond James’ President, to the effect that a uniform fiduciary standard would not be healthy for the brokerage industry. However Chairwoman White and the other commissioners should remember the mandate announced in 1949 in the decision in Norris v. Hirshberg v. SEC, namely that the federal securities laws were meant to protect the public, not broker-dealers.

Common-sense dictates that the SEC adopt a uniform fiduciary standard in furtherance of its purpose, protecting the public. Here’s hoping the SEC listens to the wise words of former Supreme Court Justice William O. Douglas-“common-sense often makes good law.”

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Incredible Marketing Opportunity for RIAs

Posted on May 22, 2014 by jwatkins

I recently read an article in which SEC Commission Gallagher stated that he is not convinced that a universal fiduciary standard is needed. He also stated that he needed to see more evidence of the need for such a standard.

Commissioner Gallagher, perhaps you should read all the studied that the SEC has conducted and contact both the SEC’s and FINRA’s enforcement divisions. Everyone knows why the SEC is dragging its feet on this issue despite the clear need for same and your own agency’s recommendation for a universal fiduciary standard to protect investors. (See Financial Planning Association v. Securities Exchange Commission, where court ordered SEC to enforce the related RIA law against broker-dealers)

The Department of Labor’s pending fiduciary revisions and the SEC’s stall tactics provide an incredible opportunity for investment advisers, who are already subject to a fiduciary standard. Prudent investment advisers will focus their marketing on the inequitable dual standard that currently exists and the dangers that result from same.

As both a former securities compliance director and an RIA compliance director for major broker-dealers, I believe that most advisors, both brokers and investment advisers, are honest and truly want to help their customers. For these advisers, a universal fiduciary standard is a non-issue, as they already conduct their practices under the fiduciary “best interests” standard.

The financial services industry continues to put up disingenuous arguments, most notably the “increased costs” and the “lack of access to advisers” arguments. Yet, according to the SEC, the industry did not produce much evidence when the SEC requested information to support the “costs” claim.

They did not produce such evidence because the claim is a ruse. Since the NASD release Notice to Member 94-44 and the emergence of the RIA sector, most broker-dealers have created their own proprietary RIA. Consequently, they should already be reviewing such trades under the fiduciary “best interests” standard, especially since FINRA has stated unequivocally that all brokers and  are required to always act in a customer’s best interests. So, the industry’s “increased cost” is either a complete ruse, or the industry’s “cost” claim is an admission against interest, an admission that they are not, and have not been, acting in compliance with FINRA’s compliance rules.

The financial service industry claims that a universal fiduciary standard will result in fewer advisers willing to work with investors, including pension plan participants. In a court of law, this argument would be tossed as purely speculative. The industry has introduced no evidence to support their contentions.

Advisers who are not willing to put a customer’s best interests first may well reduce their activity. However, that would simply provide more opportunities for the majority of brokers and investment advisers who do operate honest and ethical practices and would be glad to provide investors with valuable and objective advice. To be honest, the public would be better served by the loss of the ne’er-do-well, dishonest advisers.

In my opinion, it is highly unlikely that the SEC will adopt a universal fiduciary standard soon, if ever. This present a unique  marketing opportunity for independent RIA firms. Proprietary broker-dealer RIA firms and RIA firms with dually registered members are  not going to be allowed to seize this opportunity, for obvious reasons. This simply increases the opportunity for independent RIA firms.

I liken the current opportunity to the well-known quote attributed (falsely) to Nathan Bedford Forrest, a lieutenant general in the Confederate Army, “get there firstest with the mostest.” (According to the New York Times, he actually said “Ma’am, I got there first with the most men.”) The current situation presents an obvious opportunity for RIAs to create a personal “WOW” value factor by educating the public about the fiduciary/non-fiduciary situation and the implications for their personal financial well-being.

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