fi360 Blog

SEC Advisory Committee provides views on the federal fiduciary duty

As industry observers eagerly await Senator Christopher Dodd's revised financial reform bill to be released later this week, industry and consumer advocates on the SEC Investor Advisory Committee met on Monday to further discuss and recommend ways the SEC can act on its own to provide greater investor protections absent legislative action. 

During the Committee's afternoon session, the Investor as Purchaser Subcommittee, led by Mercer Bullard, opened up discussion on fiduciary responsibility, using a memo it had prepared on the fiduciary duty to facilitate the discussion.  Based on the memo and discussions at the meeting, the subcommittee is expected to work on recommendations for how the SEC can strengthen the fiduciary duty and to present those recommendations at the next committee meeting in a few months. 

The subcommittee's memo is a worthy read as it takes the time to discuss the substance and scope of the "federal fiduciary duty," which the subcommittee defines as the fiduciary duty owed by an investment adviser to his clients under the Investment Advisers Act of 1940 (Advisers Act).  The memo notes that statutes, SEC rules, and common law principles comprise an important aspect of the SEC's role in developing and implementing the federal fiduciary duty. 

An interesting discussion in the memo also notes that while a broker who provides investment advice and charges only commission is not subject to the Advisers Act and the federal fiduciary duty, the broker may be subject to a fiduciary duty in other contexts, such as state common law, ERISA, and state securities laws.  Moreover, broker rules promulgated by the SEC and FINRA can impose fiduciary requirements, such as the pending rules that would require mutual fund point of sale disclosures.  The memo acknowledges that the SEC and FINRA "might object to the suggestion that they have shoehorned fiduciary standards into a non-fiduciary regulatory scheme," but points out that "some broker rules have a decidedly fiduciary flavor."

All of this discussion is to suggest that the while the federal fiduciary duty applies only under the Advisers Act, a (non-federal) fiduciary duty can apply nonetheless in other contexts outside of the Act.  Moreover, the memo highlights that the scope and substance of non-federal fiduciary duties can be greatly impacted by SEC action that may range from informally guiding parties in their application of the fiduciary duty to formally preempting a conflicting standard.  On the other hand, the memo notes that SEC inaction "may leave the fiduciary space open to be filled by a variety of actors in that space, include state and federal courts, state regulators, FINRA and arbitration panels."

In preparing the memo, the subcommittee chose not to address pending legislation due to its uncertain fate.  By doing so, the subcommittee has drawn attention to the areas where it believes the SEC already holds authority with regard to the federal fiduciary standard.  What remains to be seen is how the SEC will exercise that authority if legislation fails to extend the fiduciary standard to brokers who provide investment advice.  However, with concrete recommendations expected to be delivered by the Investor Advisory Committee, the SEC likely will be on the hot seat to take action to respond to those recommendations.  

Fiduciary Links: More on the Johnson amendment

The news of Sen. Tim Johnson's proposed amendment for a study on regulatory standards for investment advice, rather than actually enacting a standard, has predictably led to strong reactions. I don't typically like to lead off the Fiduciary Links with the same subject two weeks in a row, but with this being the dominant story from the past week, it seemed like it deserved its own category:

• Advisor, financial-planning and consumer groups quickly lined up in opposition [InvestmentNews]
• If the Johnson amendment stays, does it open the door to adviser regulation from FINRA? [RIABiz]
• Is the Johnson bill a negotiating tactic? [Registered Rep]
• Bob Clarke says that the bright side to the amendment is that it shows the brokerage and insurance industries are legitimately worried that a fiduciary standard is coming. [Investment Advisor]
• Looking at the Johnson amendment and the difficult fight over a fiduciary standard [New York Times]
• Kate McBride laments the fact that putting investors' best interests first needs to be studied [Wealth Manager Web]

And, if you missed Kristina's post from last week, you can see why we think the amendment is bad for investors. We would encourage you to let Johnson and the rest of the Senate Banking Committee know what you think as well.

Now on to the rest of the best links from the last week.

In the news/commentary:

• Despite the guarantee, annuities aren't always a bargain [Wall Street Journal]
• A new financial reform bill is due from Dodd this week [Wall Street Journal]
• Target date fund transparency on the SEC and DOL's to-do list [Financial Advisor]
• A look at how fees impact 401(k) plan results [Financial Advisor]

From the organizations/associations/government/academia:

• The SEC's Investor Advisory Committee is meeting today, and their agenda includes a discussion of the fiduciary standard [SEC]

From the blogs:

• The Curious Capitalist thinks proactive measures are needed on top of a fiduciary standard in regulatory reform. [Time]
• The Bucks Blog presents a fiduciary pledge investors should ask their advisors to sign [New York Times]
• The Committee for the Fiduciary Standard's Knut Rostad talks about how most brokers want a fiduciary standard and already conducts themselves as if there was one. [Wall Street Journal]
• The number one hope for upcoming DOL 401(k) advice regulations: conflict-free advice [The 401(k) Fiduciary Advice Blog]
• A look at a 401(k) plan that exemplifies the need for regulatory reform [Huffington Post]
• A blogger suggests tying compensation to performance to address concerns about broker motives. However, he seems to miss the point that a fiduciary duty is about process. [The Atlantic]

Have a link we missed? Leave them in the comments section or email us at blog@fi360.com. For more of the best links during the week, make sure you follow us on Twitter.

Practice 1.4: Choose your fiduciary partners carefully

When choosing service providers, fiduciaries have an obligation to choose wisely, to ensure that the arrangement fits the needs and rules for the plan, and to make sure that the engagement continues to make sense on an ongoing basis. The best way to manage to those obligations is to reduce any agreement of substance to writing. A written agreement provides both parties with a clear understanding of the roles and responsibilities being delegated, the cost of those services, and other information that could be relevant to the fiduciary appropriateness of the relationship.

Let's take a look at Practice 1.4 and its associated Criteria, which covers agreements with service providers:

Once it has been determined what needs for service providers exists, the fiduciary needs criteria to evaluate providers against. ERISA requires a fiduciary to evaluate fees paid for services for "reasonableness." However, not much more guidance has traditionally been available as to what constitutes reasonableness. New 408(b)(2) rules from the DOL are about to change that.

After long delay, new 408(b)(2) rules are reportedly due out in May of this year. The original rules that were never finalized would have required service provider agreements to be in writing and include all services being provided, all compensation arrangements (direct and indirect), acknowledgment of fiduciary status, disclosure of conflicts of interest, and how any changes to the agreement would be communicated. The new rules are expected to be similar. While the new rules don't lay out exactly what constitutes reasonable, they do provide standard points of comparison that must be provided to allow the fiduciary to make apples to apples judgments. Keep in mind there are other factors to consider that should be addressed in the RFP, such as how well the providers fit the needs and objectives of the portfolio and if anything about them would conflict with the rules of the portfolio.

While 408(b)(2) applies specifically to ERISA plans, the requirements to establish and evaluate service agreements also exist in other fiduciary legislation (see additional resources below for full legal substantiation) and we expect the impact of the new rules will eventually extend beyond the ERISA world. We consider requiring 408(b)(2)-like disclosures for all types of portfolios an industry best practice that would simplify the fiduciary's duty to prudently select service providers.

Even the best service agreements are not something that can just be set and forgotten. The investment industry is constantly evolving, as will the needs of the portfolio. What may have been a good contract intially, may not be so good a few years down the road. For this reason, we recommend reviewing vendor contracts every three years. This gives the fiduciary the opportunity to see if any of the factors that led to the selection of a service provider have changed, including:

• The portfolio has grown in size and new price breaks have become available
• Fees have gone down due to competitive pressure
• The scope of required services has changed
• The vendor's product offering may have expanded
• More appropriate vendor's have entered the market

If a vendor were ever to breach its fiduciary duty, the fiduciary who selected them could be liable for making a poor decision. What would protect them from liability is being able to demonstrate that the selection was based on a prudent process and the provider had given them every indication that they were the most appropriate option available.

For additional resources regarding service provider selection, consult the following resources:

• Complete text of Practice 1.4 from the Prudent Practices for Investment Stewards handbook
• Legal substantiation from Practice 1.4
• DOL updates on 408(b)(2) rules
• Reish article on 408(b)(2) status (see the first bullet)
• The CFA Institute's model RFP
• fi360's 408(b)(2) checklist (available only to AIF/AIFA designees in the designee portal)

Why Sen. Johnson's amendment is unnecessary and bad for investors

As has been widely reported this week, Senator Tim Johnson, has drafted an amendment that, if adopted, would put on hold the extension of fiduciary duty to brokers providing advice and instead require a study by the SEC of regulatory standards for brokers and advisers.  The amendment is the result of considerable lobbying done on the part of the insurance and brokerage industries.  However, consumer and advisory industry advocates for the fiduciary standard are concerned that Johnson's amendment is merely a stalling tactic. 

While it is true that harmonization of broker and adviser regulation and extending the existing fiduciary standard to brokers who provide advice will not be easy tasks, how a study would assist the process remains unclear.  A look at the amendment reveals that the SEC would be required to study "the effectiveness of existing legal or regulatory standards of care" and "whether there are legal or regulatory gaps or overlap" in those standards.  Such a request is puzzling, though, given that the SEC is the expert in legal and regulatory standards for brokers and advisers.  In fact, a recognition of existing gaps in regulation is what led the SEC to suggest to the Obama administration that harmonization and the fiduciary standard should be addressed in the plan the administration released last summer.

Johnson's amendment would require the SEC to consider several factors when conducting a study of broker and adviser standards of conduct.  In particular, the SEC would be required to consider how the protection under broker regulations compare to the protection under adviser regulations.  However, given that the RAND report, issued just two years ago, already addressed these different protections and investors perceptions of them, it's unclear what a new study would achieve.  Other factors the SEC would be required to consider are the impact and cost to entities and individuals of any changes in the standard of care for brokers and the impact on SEC resources.  However, as a result of significant administrative requirements, such impacts and costs would as a matter of necessity be quantified and considered in a rulemaking by the SEC.  Therefore, it's again unclear why a separate study is needed.

When considered as a whole, it is hard to understand how Johnson's proposal is anything but a delaying tactic given the SEC's significant amount of expertise in this area and the careful consideration the SEC would be required to undertake in any rulemaking it engages in to set conduct and other requirements for brokers and advisers.  In fact, it is puzzling why the information Congress would be asking for couldn't be provided through testimony or meetings with the SEC as well as in current legal and regulatory literature, rather than waiting for a report to be issued eighteen months after legislation is passed and delaying rulemaking for up to two years.   

The fiduciary debate is not new, and as recognized by the Committee for the Fiduciary Standard, the time for action is now. The Committee has asked its members to advocate against Johnson's amendment and has raised the following three key points for opposing the proposal:

1. All investors need protections afforded by the fiduciary standard, now.  As SEC Commissioner Walter has repeatedly pointed out, investors need to count on their adviser being held to the fiduciary standard and not worry about varying protections that different standards might provide.
2. The concerns expressed by lobby groups against the fiduciary standard are not generally held by brokers in the field.  According to a survey conducted by the Committee and SEI, a majority of brokers SUPPORT being held to the fiduciary standard.
3. Finally, most of the questions the proposal poses be addressed in the study are already answered or known in The Rand Report, other independent academic research, or through the SEC itself. The study is not needed.

Fi360 supports the advocacy efforts of the Committee and hopes that other supporters of the fiduciary standard will heed the Committee's call to action and contact Senator Johnson and his staff directly to voice their opposition to his amendment. 

Fiduciary Links: The lobbying efforts against the fiduciary standard are working

Bloomberg reported last week that a new proposal for regulatory reform from Sen. Tim Johnson (Dem.-S.D.) would include an SEC study on if a fiduciary standard is needed, rather than actually including the fiduciary standard itself. This comes just a week after a joint effort by various consumer groups warned that such a tactic was possible and urged Congress to resist.

Further study isn’t needed to determine whether the fiduciary standard is better for advice-seeking investors – it undeniably is. The only reason to study the issue is to determine whether investors’ interests should be compromised for the interest of financial service firms to maximize profits and minimize the cost of compliance. It is also worth noting that the SEC has in effect already studied the issue and reached their conclusion. When the Rand Report on investor perception of advisors came out, it led to SEC Commissioners concluding that advisors and brokers should be regulated according to what they do, not what they call themselves, including extending the fiduciary standard of the Investment Advisers Act to all who give advice, as originally intended by the legislation.

The news of Mr. Johnson's proposal is discouraging at best, as it is clear that powerful brokerage, insurance and banking lobbies are all too effective in pushing the issue back far enough that they hope everyone will forget about it. If you would like to let Mr. Johnson know what you think of his proposal, you can contact him via his web site: http://johnson.senate.gov/contact/

Now on to the rest of the best links from the last week.

In the news/commentary:

• Surprise SEC custody audits has advisers reconsidering whether they want custody.  [InvestmentNews]
• Robert Powell looks at DOL's request for information on annuities for 401(k) plans [MarketWatch]
• Editorial: "the markets themselves don't exist to serve the intermediaries, nor should they be so regulated." [InvestmentNews]
• Non-profit board members have fiduciary responsibility [Redding.com]
• Risk and regulation among the hot topics at TD Ameritrade Institutional Conference [Financial Advisor]

From the organizations/associations/government/academia:

• Fi360 recently participated in a podcast on what the fiduciary standard means for an advisor's practice [CFA Institute]
• The latest Reish bulletin looks at what's on the plate of regulators for 2010 [Reish & Reicher]

From the blogs:

• Congratulations to Carl Richards of Behavior Gap, who recently began bloggin on the Bucks Blog of the New York Times. [Behavior Gap]
• A look at one of 2009's biggest fiduciary stories, the DOL's decision to pull back 401(k) participant advice rules, and what we might expect from new rules expected out this month. [Fiduciary News] 
• A look at some of the potential issues in requiring annuities as a 401(k) option [Chicago Financial Planner]
• Investment risk means more than just volatility [The Investment Fiduciary]

Have a link we missed? Leave them in the comments section or email us at blog@fi360.com. For more of the best links during the week, make sure you follow us on Twitter.

A look at the legislative and regulatory agenda for 2010

This week, law firm Reish & Reicher issued a Washington D.C update, outlining the full agenda the feds have planned this year.  As discussed in greater detail in the bulletin, industry observers can expect action in Washington in the following areas:

• DOL plan-level disclosure rule: DOL is expected to release a new final rule under ERISA section 408(b)(2) in May.
  
• DOL participant investment advice proposal: DOL is expected to issue a new proposed regulation governing participant-level investment advice to replace the rule that was withdrawn in late 2009.
  
• SEC and DOL target date fund guidance: SEC is expected to provide guidance for target date funds on labeling marketing materials and communications about risks; DOL is expected to provide guidance that expands the communication requirements in the QDIA regulation and provides checklists to plan sponsors and participants.
  
• DOL participant disclosure regulation: DOL is expected to issue a new regulation under ERISA 404(a)(5) on participant disclosures by the end of 2010.
  
• DOL and Treasury request for information (RFI): DOL and Treasury have issued an RFI asking for information that will help them consider whether they should take steps to facilitate access to arrangements that would provided a stream of income to individuals after retirement. Comments are due May 3, 2010.

The Reish & Reicher bulletin also provides an update on the status of legislation meant to deal with disclosures to plan sponsors, disclosures to participants, fiduciary advice for participants, and target date funds.  For a more detailed discussion of all of these legislative and regulatory actions, check out the bulletin.  Fi360 designees can also expect to receive a customized version of the bulletin within the next couple of weeks providing additional insights on how these changes in Washington may affect your fiduciary responsibilities and practices.

The potential conflict of being sponsored to attend training

In our business of delivering fiduciary training to investment professionals, we often are asked whether it is a conflict for an adviser or broker representative to be sponsored by a fund company or other product provider to attend a training program.  When in doubt, a rep should always seek guidance from his firm's compliance department on conflicts of interest.  However, there are some basic regulatory requirements that we can point to as a starting point when it comes to receiving training and education.

For broker reps, FINRA rules 2310 and 2320, and NASD rule 2830 address when a product provider of securities may conduct and pay for a training and education meeting for representatives that sell the provider's products.  As explained in these rules and previous guidance issued by NASD (now FINRA), a provider may pay for training as long as the following conditions are met:

• The representative gains the approval of his firm prior to attending
• The location of the training is appropriate to its purpose
• Attendance at the training is not tied to a sales target or other incentive
• Payment is not applied to guests of the representative
• The representative's firm maintains a record of the training as non-cash compensation received by the representative.

When these rules were first adopted, NASD explained that they are not intended to prevent a firm from designating a representative to attend training based on past performance or to encourage future performance, but attendance cannot be based on a specific target or incentive.

Thanks to our friend and ERISA attorney Fred Reish, we found out that similar standards apply to an adviser that is a fiduciary to a qualified retirement plan (or plans).  Specifically, under ERISA section 406(b), the adviser cannot use its fiduciary status to obtain additional money or valuable benefits.  A logical extension of that rule is that, if an adviser has to qualify to receive a benefit such as training (e.g., the adviser has 15 plans with the provider or at least $50 million under management with the provider), then the adviser is using his fiduciary status to get the benefit and the receipt of training would be a prohibited transaction.  On the other hand, if the provider sponsors the adviser in an attempt to get new business from the adviser, the receipt of training would not be a prohibited transaction under ERISA because the adviser would not yet be acting in the capacity of a fiduciary. 

In sum, an adviser or broker rep generally should not accept training paid for by a sponsor if the training is offered based on a specific incentive or quota set by his employer or the product provider offering the sponsorship.  Moreover, the rep should get approval from his employer before attending the training, and in particular, should get guidance from the appropriate compliance official within his firm to avoid any unintended conflicts of interest.

Fiduciary Links: Thinking through a Roth IRA conversion

Beginning this year, most investors can now convert traditional IRAs to Roth IRAs. The conversion could make sense for affluent investors, who anticipate their tax rates will only go up from where they are now. But the factors aren't that simple for many investors, or for fiduciaries who are advising on the decision. In his Other Voices column for InvestmentNews, AIF designee Andy Rice takes a look at many of the factors that a fiduciary needs to consider before making a recommendation for their client.

Also related to Roth retirement plans, there has been recent lobbying for Roth conversions to be allowed for 401(k) plans and the Obama administration last week endorsed Roth IRAs as the default option for automatic enrollment plans.

With the decision of whether to tax now or tax later on retirement assets having such a big impact on what investors will be able to withdraw, fiduciaries should be familiarizing with the benefits and risk of Roth plans and a process for determining what works best for each of their clients.

Note: Andy's article is an entrant in the fi360 member article competition. You can leave feedback on entered articles from our website. And, if you are an AIF/AIFA designee who has written an article in the past year and would like more information on entering it into the competition, log in to the designee portal for more information or email resources@fi360.com.

Now on to the rest of the best links from the last week.

In the news/commentary:

• Survey shows that brokers think a fiduciary standard will not be implemented for advice [Registered Rep]
• Another look at the same study though, finds that advisors believe the fiduciary standard would be beneficial for their profession [Financial Planning]
• Expect the new 401(k) investment advice rules related to the Pension Protection Act to come out soon. [InvestmentNews]
• Scapiro says the SEC will examine 12b-1 fees this year [InvestmentNews]

From the organizations/associations/government/academia:

• A study shows that many plan sponsors are facing challenges in compliance with new 403(b) regulations [TIAA-CREF]
• Regulators are seeking comment on the use of annuities in retirement plans [DOL]
• Consumer group worries that the brokerage and insurance lobbies will be successful in weakening currently proposed fiduciary standard from regulatory reform. You can also listen to their news conference. [NASAA]

From the blogs:

• A look at the potential fiduciary issues associated with using ETFs in retirement plans [Fiduciary News]
• A look at how arms-length contracts can become fiduciary relationships via the Mark Cuban insider trading case [Business Law Prof Blog]

Have a link we missed? Leave them in the comments section or email us at blog@fi360.com. For more of the best links during the week, make sure you follow us on Twitter.

Who Wants to be a Fiduciary Adviser?

Assistant Labor Secretary Phyllis Borzi indicated earlier this week that the new proposed rules governing advice to 401(k) participants should be released by the Labor Department by the end of the month.  The comment period is expected to last approximately 60 days before the rules are finalized.  In the absence of an advice regulation to date, most advisors have been taking a "wait and see" approach before deciding whether to step into the "fiduciary adviser" role as defined by the Pension Protection Act (PPA).

But advisors are starting to get antsy.  At a retirement plan symposium in New York City earlier this week, several speakers, including me, were asked questions about providing advice to participants.  Many of these questions were ones we typically receive and related to whether an advisor is crossing the fiduciary line based on the level of service (advice?) being provided, or centered around computer-driven advice models and the concept of level compensation.  However, some questions were a little different, such as:

1. Should I step into the fiduciary adviser role now (I've waited long enough for the advice regulation), or wait until the regulation is finalized?
2. Is it a prohibited transaction if I manage a participants rollover IRA after they have cashed out of the 401(k) plan?

Whether one chooses to assume a fiduciary adviser role before the advice regulation is finalized is a business decision. There is minimal risk if one is making reasonable efforts to follow what guidance is available. The self-assessment questionnaire that we have prepared does not provide total clarity because the PPA does not get as specific as the associated regulation will.  But, our expectation is that the final regulation will be less stringent. 

If you intend to pursue fiduciary adviser arrangements with plan sponsors based on the premise that the relationships will be profitable because of access to rollover IRAs, we suggest you wait.  To our knowledge, there is no clear consensus on whether providing advice to participants on 401(k) assets, as well as their rollover IRAs, constitutes a prohibited transaction or not.  The final advice regulation may provide some guidance.  If not, then seek the advice of legal counsel.

What’s in an expense ratio?

Last month’s Fund Analysis blog post, Three fundamental questions every advisor should be prepared to answer, focused on the Prospectus Net Expense Ratio and its revenue sharing components, including the 12b-1 fee.  This month, we're taking a look at two other common ratios, the Prospectus Gross Expense Ratio and Audited Net Expense Ratio, and how they compare and contrast to the Prospectus Net Expense Ratio.

So, what’s the difference between the Prospectus Net and Audited Net?  And, what’s the difference between the Prospectus Gross and Prospectus Net? Sometimes the numbers can be exactly the same, and sometimes they could be radically different.

Prospectus Net Expense Ratio vs. Audited Net Expense Ratio
The difference between Prospectus Net and Audited Net can be explained by a difference in time periods. The Audited Net is the audited fee charged during the previous fiscal year for the fund.  It can be considered a “backward-looking” number. The Prospectus Net is a “forward-looking” number and is the anticipated expense the fund company plans to charge for the upcoming fiscal year.  If the numbers are different, a comparison of the two can be conducted to see if the fund company anticipates an increase or decrease in fees charged.  Both numbers include the 12b-1 fee and other management fee or administrative costs for the fund.  They do not include any sales or transaction charges.

For fund of funds, the Audited Net and Prospectus Net will be different because two different numbers are being reported. The Audited Net will only report the wrap fee at the fund of fund level.  The Prospectus Net will report the wrap fee and the weighted average of the underlying fund expense ratios. 

Both numbers are net of any conditional waivers or temporary deductions in the expense ratios and this leads us to the second comparison.

Prospectus Net Expense Ratio vs. Prospectus Gross Expense Ratio
The difference between the two Prospectus ratios, Net and Gross, can be explained through conditional or contractual waivers or reimbursements the fund company may impose. The Prospectus Net will include the waivers or reimbursements, while the Prospectus Gross will exclude the waivers or reimbursements. 

You will typically see a waiver or reimbursement for funds with small asset bases.  For these funds, the actual fee that they are contracted to charge could be a significant percentage of the fund assets.  Therefore, they waive a percentage of the funds expenses to bring it into alignment with a “reasonable” number.  As the asset base of the fund grows, or if the contracted waiver period expires, the fund’s expenses could change. It’s important to check the fund prospectus to see if any waivers or reimbursements are in effect, and to see if this could change the expense ratio of the fund in the future.

In conclusion, no expense ratio is right for every application.  Consider the situation and intended use.  The following table may help.  For a complete definition of each expense ratio, refer to the fi360 Toolkit Help Center Glossary and look under the letter E. Each of the ratios is featured in the new Fee & Expense Report feature in the fi360 Toolkits released last month.

	Prospectus Net ER	Audited Net ER	Prospectus Gross ER
Data Source	Fund Prospectus	Audited Annual Report	Fund Prospectus
Time period	Upcoming fiscal year	Previous fiscal year	Upcoming fiscal year
12b-1 fees	Yes	Yes	Yes
Mgmt. fees	Yes	Yes	Yes
Admin./Asset-based fees	Yes	Yes	Yes
Sales/Trans. charges	No	No	No
Waivers/Reimbursements	Yes	Yes	No