fi360 Blog

Delays working in favor of fiduciary in reform

The tides for the fiduciary standard appear to be turning, and for once the delay on Capitol Hill to adopt financial regulatory reform may have worked in its favor.  While Republicans blocked debate on the Senate's financial reform bill  most of this week in hopes of achieving consensus behind closed doors on issues such as "too big to fail", derivatives, and financial consumer protections, the fiduciary standard quickly gained greater attention thanks to the SEC's case against Goldman Sachs and a drawn out Senate hearing this week in which Goldman execs were grilled for over 10 hours. 

Now that Republicans appear ready to debate financial regulatory reform, it still remains to be seen whether the changing tide and increased public focus on the fiduciary standard will have any real impact on financial reform.  For example, questions put forth by Senator Susan Collins (R-ME) during Tuesday's hearing raised the issue of whether proposed reforms aimed at extending the fiduciary standard to broker-dealers should apply the standard equally to all investors, as is the case under the Investment Advisers Act of 1940.  To date, most consideration of the fiduciary standard by the Senate and House has focused on investment advice provided to retail clients.  However, despite Collins' deep scrutiny of Goldman representatives and apparent interest in the fiduciary standard, she does not yet appear to be willing to fully back the extension of the fiduciary standard, a reluctance that appears to be common among legislators who have likely been influenced by the large brokerage and insurance lobby against the fiduciary standard.

Although many legislators have been unwilling to fully embrace the fiduciary standard to date, it is clear that they are outraged by the lack of transparency and dubious ethical dealings on Wall Street and are seeking solutions to address those issues.  Indeed, a closer look at Senator Collins' line of questioning reveals that she was not so worried about legal standards, but rather whether Goldman on its own had embraced a fiduciary ethic, which should have provided a moral compass for the investment bank's activities. While it's true Washington can't completely legislate or regulate away unethical behavior, regulatory standards can and do provide a moral compass for market participants to judge their actions.  And what the fiduciary standard, in particular, does is provide a course whereby financial professionals are challenged to act in a transparent and ethical manner by properly addressing and disclosing conflicts to the benefit of investors.  As soon as legislators realize that the fiduciary standard provides a proven path to address much of the questionable behavior displayed on Wall Street, they will see they have at least part of the solution to ensuring, in Senator John Ensign's (R-NV) words, "we don't end up hurting the little guys out there on Main Street." 

Formalizing the investment strategy

Our Spotlight on Practices series has looked at all of the Practices in the Organize step of the fiduciary quality management system and will soon be moving into the Formalize step. In the Formalize step, the fiduciary will be expected to act as a prudent expert in establishing proper portfolio diversification and preparing an effective investment policy statement.

Beginning with the first Practice of this step, the fiduciary will be making the decisions that will eventually lead to actual investment selection. There is a hierarchy to those decisions that many investors and fiduciaries have a tendency to reverse. They tend to focus on the hot manager or fund before developing an asset allocation strategy when research has shown that the allocation of assets is the most important determinant of the variation of returns in portfolios. As a fiduciary, your priorities must be properly placed upon asset allocation issues.

The following hierarchy of investment decisions illustrates our prioritized approach to asset allocation, which leads to manager/fund selection: 

 

The most important decision is to determine the investment time horizon, which we define as that point in time when more money is flowing out of the portfolio than what is coming in from contributions and the anticipated growth.  All other decisions flow from this.

Second only to the time horizon in importance is the decision regarding what asset classes will be considered. If the time horizon is less than five years, the portfolio should be limited to fixed income and cash.  If the time horizon is long (meaning five years or more), equities and other asset classes can be considered.

The next decision is to determine the proper mix among broad asset classes.  For example, if our time horizon is long, we will include equities, bonds, and cash.  What will be the mix between these classes? That depends upon a number of factors that we will discuss later, but for the sake of illustration, a balanced portfolio may include 60% allocated to equities, 30% to fixed income, and 10% to cash.

Next, we consider what will be the allocation to sub-asset classes and/or peer groups within the broad classes. For example, what percentage will be in large-cap stocks, versus the proportion allocated to growth, value or blend?

Finally, and the least important decision in the hierarchy, is the selection of the manager or fund.

 * * * * *

The Spotlight on Practices series highlights one of the Prudent Practices for Investment Fiduciaries in order each month. To learn more about the Practices, click "Spotlight on Practices" link in the categories list or visit the Practices page on fi360.com.  If you have any questions or comments, leave them in the comments section below each post, or email us at blog@fi360.com.

Fiduciary Links: Another reform bill enters the picture

Last week saw the introduction of a new fiduciary reform bill from the Senate Agriculture Committee. The bill would regulate derivatives and a include a fiduciary standard for swap dealers. Provisions from the bill are expected to be included in the reform bill from the Senate Banking Committee. We also saw a number of commentators saying that whether Goldman eventually gets found guilty or not, the details of the case highlight why a fiduciary standard for advice is so important.

Find these and more of the best fiduciary links from the past week below.

In the news/commentary: 

• Bank of America's Sallie Krawcheck gives an endorsement for the fiduciary standard [InvestmentNews]
• The Goldman Sachs case highlights the difference between the fiduciary and suitability standards, and adds momentum to the fiduciary push for reform. [InvestmentNews]
• Guilty or not guilty, Goldman Sachs highlights why a fiduciary standard is important [Forbes]
• A nice, simple summary of what's in the financial regulatory reform Senate bill [WSJ]
• Brokerages worried that a fiduciary standard won't be good for brokerages [Dow Jones]
• John Bogle says fund managers should be held to fiduciary standard [Investment Advisor]

From the organizations/associations/government/academia:

• The Senate Agriculture Committee approves financial reform bill that includes a fiduciary standard for swap dealers [Senate Agriculture Committee]
• DOL is hosting a series of webchats this week to discuss the regulatory agenda of their respective agencies, including EBSA, which is scheduled from 2-3 p.m. EDT today. [Department of Labor]
• NAIFA alerts their members to oppose the forthcoming Menendez-Akaka amendment that would extend fiduciary standards to broker-dealers (see also the CFA/NASAA/AARP/NASS letter linked within)  [NAIFA]

From the blogs:

• The realities of the market will push the fiduciary standard forward, even if Congress doesn't. [WSJ's Financial Adviser]
• Comparing the financial planning process to movie directing, yes really [Behavior Gap]
• What might advisors have done differently if they saw the financial crisis coming sooner? [Chicago Financial Planner]
• Managed accounts should be treated as a method of advice, not an alternative to it. [The 401(k) Fiduciary Advice 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.

The Goldman Sachs defense: We aren’t fiduciaries and the fair dealing standard is a low bar

Yesterday’s “Fiduciary Links” post provided links to articles that highlighted possible fiduciary ramifications of the SEC’s suit against Goldman Sachs. These articles touched upon alleged conduct by Goldman that  exemplify clear breaches of fiduciary responsibility, such as conflicts of interest that disadvantaged clients and failure to provide full and fair disclosure of material information. However, the SEC complaint against Goldman is not directed at fiduciary issues; rather, the SEC is after Goldman for failing to disclose material information that would be required even under the much lower fair dealing standard.

Back in mid-January, in testimony before the Financial Crisis Inquiry Commission, Goldman CEO Lloyd Blankfein laid out the Goldman perspective on the firm’s role in CDO deals. Here is a relevant excerpt from that testimony.

“FCIC CHAIRMAN ANGELIDES:

…Based on the review of public documents, as you know, your firm sold a significant amount of subprime mortgage-related securities. And it appears, at least according to public documents and other reports, that you may have simultaneously betted against the securities you sold to clients. According to the reports, you sold about $40 billion in 2006, 2007. In December 2006, I think, you came to the conclusion the mortgage market was heading south and you began to reduce your own positions. And many of the securities that you sold to institutional investors, other folks went bad within months of issuance. Now, one expert in structured financing said, “The simultaneous selling of securities to customers and shorting them because they believe they are going to default is the most cynical use of credit information that I’ve seen.” Do you believe that was a proper legal, ethical practice? And would the firm continue to do that practice? Or do you believe that’s the kind of practice that undermines confidence in the marketplace?

BLANKFEIN:

Well, the way it’s—let me—the short answer is this is the practice of a market maker. And I would like to explain this. But the answer is I do think that the behavior is improper, and we regret the result—the consequence that people have lost money in it, but I just want to explain—and this is a very important—and I appreciate the opportunity to do this because there’s so much press swirling around this that I really want—I really need to explain.

In our market-making function, we are a principal. We represent the other side of what people want to do. We are not a fiduciary. We are not an agent. Of course, we have an obligation to fully disclose what an instrument is and to be honest in our dealings, but we are not managing somebody else’s money. [Emphasis added]

When we sell something as a principal—which is what we are as a market maker—the next minute, that item will have gone up—in which case we’ll wish we hadn’t sold it that minute—or it will go down—in which case, we’ll actually be glad we did for our own P&L and sorry for the person who bought it. But we are market makers in that. In most of these cases, the person who came to us came to us for the exposure that they wanted to have.”

It would appear from Mr. Blankfein’s  testimony and from what we have seen so far from Goldman’s response to the SEC suit, that those who do business with Goldman in deals such as this should be aware that Goldman doesn’t consider you a client, but a counterparty. Moreover, those counterparties should know that under the Goldman interpretation of the fair dealing standard, the “obligation to fully disclose what an instrument is and to be honest in our dealings” is one that is so far removed from the fiduciary obligation for full and fair disclosure as to be almost out of sight.

If Goldman’s low-bar interpretation of the fair dealing standard holds, it offers clear and compelling evidence of why the fiduciary standard must be extended to all who give advice to investors. Opponents of the fiduciary standard have argued that the gap between fiduciary and fair dealing obligations is not great. This case provides a concrete example that nothing could be further from the truth.

Fiduciary Links: SEC's Goldman Sachs charges have fiduciary implications

Last week's big story was the SEC charges against Goldman Sachs for alleged conflicts of interested and fraud from lack of transparency. The case could have significant implications on future SEC actions, investor lawsuits, and even the momentum of financial regulatory reform. Here's what some others are saying about the fiduciary implications of the charges:

• Jill Schlesinger thinks there are broad fiduciary implications to the SEC charges against Goldman Sachs. [CBS Moneywatch]
• Did Goldman Sachs breach its fiduciary duty to CDO investors? [Seeking Alpha]
• Why was Paulson involved at all in portfolio selection? [Business Week]

Now on to the best links from the last week.

In the news/commentary: 

• State securities regulators unimpressed with the way financial regulatory reform is shaping up so far. [Daily Finance]
• Two senators mulling a fiduciary amendment for financial reform [RIA Biz]
• Another week, another look at which way the pendulum is swinging in terms of the inclusion of a fiduciary standard in reform [InvestmentNews]

From the organizations/associations/government/academia:

• SEC Chairman Schapiro calls on Congress to allow for self-funding. [SEC]
• Fi360 Conference speaker Ron Surz is doing a webinar on Wednesday on Best Practices in Target Date Fund Investing [Target Date Solutions]
• The new Reish Report to Plan Sponsors offers some help on language addressing QDIAs in the investment policy statement [Reish & Reicher]

From the blogs:

• Ignore the "noise" and learn to live with uncertainty. [The Investment Fiduciary]
• Life insurance is not an investment [Behavior Gap]

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.

Help support the Akaka-Menendez amendment in Senate bill

After meeting with top Republicans and Democrats from Capitol Hill this week, President Barack Obama and Treasury Secretary Timothy Geithner expressed optimism about the prospects of a financial regulatory reform bill passing this year.  While Republicans have shown mixed support for proposed reforms, there still appears to be a willingness to work with Democrats to reach compromise on key provisions in the proposed Senate financial bill.   

Meanwhile, support for the fiduciary standard on Capitol Hill appears to be growing.  Senators Daniel Akaka (D - HI) and Robert Menendez (D - NJ) are considering offering an amendment to the Senate bill that would remove a provision that calls for a study of whether the fiduciary duty should be extended to broker-dealers.  The proposed study would be replaced with a provision that would authorize the SEC to adopt rules requiring broker-dealers who provide advice to comply with the fiduciary standard--an approach similar to that approved in the House financial bill.   The Senators, however, must first determine whether their colleagues will support their proposal because a vote against the amendment could jeopardize future efforts by the House to maintain their fiduciary provision in final legislation.

Another key issue also gained attention this week as Senator Charles Schumer (D - NY) teamed up with SEC Chairman Mary Schapiro and several former SEC Chairman to support self-funding for the Commission.  Self-funding would give the SEC greater control to budget and plan for the long-term.  In addition, self-funding would likely allow the SEC to retain its role as the sole regulator of investment advisers and improve its oversight and enforcement programs.

In order for these key provisions to be adopted along with comprehensive financial reform legislation, support and advocacy from professionals and investors alike will be critical.  To this end, industry groups, including the Committee for the Fiduciary Standard, have been encouraging professionals to support the fiduciary standard and SEC self-funding.  In particular, you can do your part by calling, e-mailing, or writing your Senators to voice your support for the proposed Akaka-Mendendez amendment and the existing provision that ensures SEC self-funding.   Here is an example of what you can write/say to your Senator: 

Dear Senator _______

I am an investment professional calling/writing from _____ (city) about the Senate's Restoring America's Financial Stability Act.  I urge you: (1) to support an amendment sponsored by Senators Akaka and Menendez that would require financial professionals who provide investment advice to comply with the well-established fiduciary standard; and (2) to keep the SEC self-funding provisions in the bill.

Fiduciary Standard.  The future well-being of the nation requires that all Americans increase their savings and make the best possible investment choices.  As investing has become more complicated, the role of financial professionals has become more vital.  Research by the Investment Company Institute found that 73% of investors consulted a professional financial advisor before investing in a mutual fund. Unfortunately, not all financial advisors are required to be fiduciaries, who, by law, must put the client’s best interests first. The key overriding mandates of the fiduciary standard are highlighted in the following five core principles:

• Put the client’s best interests first;  
• Act with prudence; that is, with the skill, care, diligence and good judgment of a professional;
• Do not mislead clients; provide conspicuous, full and fair disclosure of all important facts;  
• Avoid conflicts of interest; and
• Fully disclose and fairly manage, in the client’s favor, any unavoidable conflicts

The Akaka-Menendez amendment would ensure that all investor's receiving investment advice would be protected under these fiduciary principles.

SEC Self-funding. The bill currently includes a provision that allows for an SEC self-funding mechanism. This is critical to allow the SEC sufficient funding so that it can plan for long term internal investments and better fulfill its investor protection mission. I support the SEC as the exclusive regulator of federally registered investment advisers, including providing the agency with the resources it needs to fulfill this role.

I appreciate your consideration of my concerns.

Respectfully,
(Name)
(City, State)

With financial regualtory reform legislation expected to be debated on the Senate floor as early as next week, you should call or write your Senator as soon as possible.  Moreover, please encourage your colleagues and associates to do the same as an united front is critical to the success of the fiduciary standard and to ensuring continuity in SEC oversight. 

Fiduciary Links: Senate back and ready to focus on financial reform

Back from a two-week break, the Senate is back in session today and financial reform is at the top of their agenda. As health care reform had been the dominant topic to this point, most debate has been confined to the Senate Banking Committee. Now under the attention of the full Senate, we should learn a lot over the next couple of weeks about how this fight is going to play out. Posturing has already begun, though, as both Republicans and Democrats took to the Washington Post over the last week to defend their positions.

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

In the news/commentary: 

• Reish & Reicher's Jason Roberts (a 2010 fi360 Conference speaker) discusses 408(b)2 [MarketWatch]
• The NAIFA again is using scare tactics to fight against the fiduciary standard [Financial Advisor]
• Kristina talks financial reform with Investment Advisor, twice. [Investment Advisor] 
• Blaine's new Fiduciary Corner column says the new participant advice rules are a signal that the DOL is taking fiduciary duty very seriously. [InvestmentNews]
• Bob Clark says the Committee for the Fiduciary Standard is creating a general acceptance of fiduciary standards for investment advice [Investment Advisor]

From the organizations/associations/government/academia:

• In light of last week's Jones v. Harris decision, the Supreme Court sends another mutual fund fee case back to the Court of Appeals. [Supreme Court]
• MetLife study finds that many plan sponsors don't understand stable value funds, despite their widespread use in 401(k) plans. Also, most stable value fund providers do not consider themselves fiduciaries [Business Wire]

From the blogs:

• Fiduciary News looks at both the potential good and the potential bad of DOL's new participant advice rules [Fiduciary News]
• University of Cincinnati law professor Barbara Black posted a work-in-progress paper looking at professionalism standards vs. fiduciary standards for investment advice [Securities Law Prof Blog]
• Let contributions do a larger share of the work in retirement savings, don't just rely on performance [The 401(k) Fiduciary Advice Blog]
• A links post from an ERISA law blog has some interesting stuff on 403(b) and surety bonds [Boston ERISA and Insurance Litigation 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.

Former Treasury Secretary Paul O'Neill talks fiduciary

Former treasury secretary Paul O'Neill has been outspoken in taking to task major financial institutions and the U.S. government for their actions both leading up to and in the wake of the recent financial crisis. Among his chief criticisms has been the lack of government accountability to act as stewards on behalf of the taxpayers and the lack of transparency on Wall Street.

Mr. O'Neill will be the opening speaker at the 2010 fi360 Conference on May 6 in Orlando. His address, Government spending and personal accountability, will look at the ramifications of the conduct on Wall Street and in Washington and how it will affect the markets moving forward. In addition, he will be talking about how individual advisors can succeed by not following the recent examples set by Wall Street and Washington and abiding by fiduciary principles in servicing clients.

He was kind enough to lend us his thoughts on a few subjects as a precursor to his appearance at our conference.

On financial regulatory reform:

We should pass a two page financial reform law.  The first page should make it illegal for anyone to give or receive a home mortgage without a 20% equity down payment, and the equity component should be stapled to the instrument so that the absolute amount of the equity component is always a buffer. The second page of the legislation should provide parallel equity requirements for all financial transactions in the U.S. We wouldn't need a legion of new regulators to enforce these single requirements.

On restoring investor confidence:

Trust is a function of experience. It is going to take time to restore a sense of trust in the system.

Attributes of a successful advisor:

Most important attribute for an advisor is complete mastery of the subject matter and anticipating the needs of the advisee.

On transparency:

Openness and transparency take away the barriers to continuous learning and continuous improvement.  Hierarchy is the enemy of full participation and full accountability for every person in an organization.

Everything you ever wanted to know about 3(21) and 3(38) fiduciaries

A few weeks ago we did a webinar explaining the differences between ERISA 3(21) and 3(38) fiduciaries and other non-ERISA fiduciaries. Both during the webinar and in follow-up, we received a lot of questions asking for further clarification. 

In this post, you'll find answers to the majority of questions submitted during the session written by the three panelists from the original webinar. In addition, both of our guest panelists have written follow up articles on the subject. You can find Scott Pritchard's article here, and Scott Simon's here.

A recording of the webinar can be viewed on the webinars page of our website. If you still have any questions, let us know in the comments.

More clarification on the different roles
Q: What is the difference between a 3(21) and a broker or insurance agent? Can a broker serve as 3(21)?
A: An ERISA 3(21) is one who acknowledges a fiduciary role without taking discretion; they provide investment advice, but leave the ultimate decision to the plan sponsor.  They can be an advisor that is subject to the Investment Advisers Act of 1940 (1940 Act), a bank or an agent working for an insurance company.  A broker working for a B/D that is duly registered as an RIA, can assume this role provided their firm permits them to assume a fiduciary role.

Q: What is the difference between a limited scope 3(21) and 3(38)?
A: An ERISA 3(21) is one who acknowledges a fiduciary role without taking discretion; they provide investment advice, but leave the ultimate decision to the plan sponsor.  An ERISA 3(38) assumes discretion for selecting, monitoring, and replacing investment options with authority to buy and sell securities as appropriate. This role is effectively the outsourcing of the role of hiring and firing the managers or choosing and replacing other specific investment options.

Q: What is the difference between 3(21) limited scope and 3(21) full scope?
A: A limited scope ERISA 3(21) is one who acknowledges a fiduciary role without taking discretion; they provide investment advice, but leave the ultimate decision to the plan sponsor.  A full scope ERISA 3(21) or Named Fiduciary has complete discretion and effectively assumes responsibility for the management and operation of the plan. That would include all investment management decisions unless a 403(a) Trustee has been named in the plan documents or if a 3(38) has been appointed. It’s often the case that the 403(a) Trustee and the 3(21) Named Fiduciary are the same person. The Named Fiduciary is responsible for hiring, monitoring and replacing all other service providers.  If appointed by a plan sponsor, the only responsibility the plan sponsor retains is the proper selection and monitoring of the ERISA 3(21) Named Fiduciary.

Q: Is a limited scope 3(21) needed if there is a 3(38)?
A: An ERISA 3(38) is focused on the selection, monitoring and replacement (as necessary) of the underlying investments within a portfolio. Those fiduciary functions not addressed by the 3(38) are performed by the 403(a) Trustee or the 3(21) Named Fiduciary if the 403(a) Trustee is not identified specifically in the plan documents.  Of course, the 403(a) Trustee that wanted to keep discretion over non-3(38) fiduciary functions could engage a limited scope 3(21) for additional advice, but they retain most of the liability since they are the decision maker.

Fiduciary Links: Another fund fee case decision from the Supreme Court

The big fiduciary story from the last week was the Supreme Court's decision in the Jones v. Harris Associates L.P. case. In it, the court said that the mutual fund fee dispute in the case should be judged against the "Gartenberg" standard, which holds that a fee can not be so high that it could not reasonably have been the product of an arms-length negotiation. The ruling overturns an appeals court decision to dismiss the case on the basis that there was disclosure and no fraud had occurred.

The reaction to the case indicates that the fund industry likes the ruling, as the bar remains high for claiming excessive fees. However, some commentators noted that the court's acknowledgement that the difference in fees for different types of clients deserves examination and that disclosure of fees is not enough are possible signals that there is momentum to the investor side of the mutual fund fee issue.

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

In the news/commentary: 

• Jim Pavia says 12b-1 fees need brought into the light of day [InvestmentNews]
• Edward Jones memo may have been influential in having fiduciary standard removed from Senate reform bill [InvestmentNews]
• Fiduciary problems presented by the Hecker v. Deere Supreme Court decision [Employee Benefit News]
• Citi's makeover includes a fiduciary focus [RegisteredRep]
• Alan Roth asks if the SEC is really concerned about the fiduciary duty of fund companies to the fund shareholders [CBS Moneywatch]

From the blogs:

• Non-fiduciary thinking highlighted in the response to DOL's recent statements [The Float]
• Jason Roberts looks at what's brewing at the DOL and how it will affect financial services providers [PPA Fiduciary Adviser Legal and Compliance Report]
• What the Morningstar study on open vs. closed architecture target-date funds didn't tell us [Bright Scope 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.