fi360 Blog

Different fiduciary roles bring different amounts of liability

While advisors share common standards for how they manage investment decisions, there are nuances to the amount of liability being assumed based on the type of fiduciary you are.

Starting at the broadest level, investment advisers who advise others in the buying and selling of securities are deemed to be fiduciaries under the Investment Advisers Act of 1940 (1940 Act) and are regulated by the SEC or individual states.  The 1940 Act and its associated rules provide guidance for advisors that can be exercised with or without assuming discretion.

For retirement plans, the scope of the advisor’s fiduciary duty is defined under ERISA based on the specific functions performed and the amount of discretion it exercises:

1. Limited-scope ERISA 3(21) fiduciary: Those who acknowledge a fiduciary role without taking discretion; they provide investment advice, but leave the ultimate decision to the plan sponsor.
2. ERISA 3(38) fiduciary: Those who select, monitor, and replace investment managers as appropriate; who have authority to buy and sell securities. This role is effectively the outsourcing of the role of hiring and firing the managers.
3. Full-scope 3(21) fiduciary: Those who take discretion for all fiduciary decisions including the selection, monitoring, and replacement of all other service providers, including the 3(38) fiduciary. Although this is rare, in this case the plan sponsor is only responsible for the prudent selection of the 3(21) fiduciary, who then takes over all other investment fiduciary duties of the plan sponsor.

Most retirement plan advisors are typically filling the limited-scope 3(21) fiduciary role, although many might not even realize that the differences exist. Probably the biggest question on most advisors’ minds is under what circumstances they should serve as the various types of fiduciary, how their processes should be structured accordingly, and how to differentiate their services in the marketplace.  Legal counsel should be consulted as you sort this out because your liability is commensurate with the scope of services provided.  More responsibility ensures more liability and should equate to more compensation.

Tomorrow, March 11th, we will be presenting a webinar on this subject in which we will go into greater depth in explaining how these types of fiduciary differ and what advisors can do to take greater advantage of their status.

UPDATE: The recording and slides from the webinar are now available at www.fi360.com/webinars. Look for follow up blog posts answering questions submitted during the presentation in the coming weeks, as well.

For further reading on the subject see:

• Scott Simon's Morningstar article "The Different Flavors of ERISA Fiduciary"
• Fred Reish's outline regarding fiduciary roles and the associated liability

Top issues to include in your year-end review

The annual performance review is an essential part of the monitoring phase of the investment process. In order to ensure that the investor's objectives are being met, each year the advisor must gather and analyze relevant facts regarding that state of the portfolio, create an action plan based on the analysis, report this all to the investor and then document what decisions were made. 

The following web presentation, Top issues to include in your year-end review, goes through a top-down approach to the process that first looks at how the investment landscape and investor objectives may have changed, then an asset class and portfolio composition review, and finally recommendations on manager retention and/or replacement. You may view the webinar by pressing the "play" button on the player below. 

Below are the links referred to in the presentation to the signup pages for daily email alerts from various sites that we find most helpful for monitoring the latest developments of note for investment professionals:

• InvestmentNews Daily
• Mondaq
• Seeking Alphan (daily email signup appears at bottom of page)
• Financial-Planning
• CFA Institute Financial NewsBrief
• Advisors4Advisors (site requires paid subscription)

In addition, the following links provide more detailed information on some of the specific topics mentioned during the webinar:

• Information on UPMIFA
• Latest on estate tax legislation
• PIMCO (global market commentary, search for Bill Gross's The New Normal)
• fi360's online SAFE
• Free trial to the fi360 Toolkit that was used to generate the reports used in the presentation

If you have any thoughts or questions related to the webinar that you want to share, let us know in the comments below. We'll attempt to answer as many questions as possible in the comments section or in future blog posts.

Check back again to the webinars page of fi360.com for other recordings, slide downloads and announcements of future webinars. You can also send us questions or suggestions for future webinars by emailing us at blog@fi360.com.

Is it Time to Get an Outside Opinion?

It's not unusual for those who are in a fiduciary role to be concerned about whether or not they are carrying out their responsibilities adequately.  In light of the recent dramatic downturn in the market, these concerns have increased and many are asking the question, "how often should we get an outside opinion to make sure we are managing the investment assets properly?"  Others wonder, "are we truly meeting our fiduciary obligations?"

There are two fiduciary practices that relate to this question.  The first is Practice 1.4 in the Steward's Handbook. Under that Practice, Criterion 1.4.4 states; "Consideration is given to putting vendor contracts back out for bid every three years."  This does not necessarily mean that a formal RFP (request for proposals) needs to be conducted (although that would be ideal), but there should at least be an informal RFI (request for information) to ensure that what was a good deal three years ago continues to be a good deal. The market is dynamic and fees may have gone down (or up), services offered may have expanded, and legal requirements may have changed. 

Investment advisors or brokers that come through our training often times push back when discussing this criterion, asking why they should advise a client to periodically check to see if they are still the best candidate for the job.  For the investment steward, an ongoing and critical part of their job is to ensure that the fees they pay for services provided are fair and reasonable.  This regular review demonstrates clearly that they are addressing this criterion.  For the investment advisor or broker, they set themselves apart and greatly enhance their creditability with the steward by helping to ensure the stewards meet this fiduciary requirement; even at the risk of losing their client.  Most stewards are reluctant to replace an advisor or broker that clearly demonstrates they have the steward's best interest at heart; although they may need to reduce their fees or expand their services to meet competitive pressures.  It also helps them to keep a close eye on the competition.

Practice 4.6 states that "There is a process to periodically review the organization's effectiveness in meeting its fiduciary responsibilities."  This practice most directly addresses the initial question.  The expectation here is that internal reviews are conducted more frequently, but at times it is necessary to have an outside party evaluate your process to ensure objectivity and impartiality.  The annual review of the IPS (investment policy statement) to determine if it is still consistent with the actual process in place is a large part of the ongoing internal review.  Those organizations that have their fiduciary house in order, however, eventually see the need and benefit of having an outside professional conduct an external review.  The idea would be for the consultant to compare the steward's investment process to the fiduciary practices and determine what is working and what is not.  A worklist is generated to address weaknesses, and, once the process is fully aligned (possibly over several years), consideration can be given to obtaining the fiducary equivalent of the "Good Housekeeping Seal of Approval," a CEFEX Certification. 

Seven Qualitative Due Diligence Factors

A sound due diligence process is the first step in investment selection. A good due diligence process begins by measuring investments using quantitative factors against set benchmarks and in relation to peers.  The fi360 Fiduciary Score, for example, is calculated using eleven quantitative factors that we consider to be the minimum due diligence criteria that you should use when evaluating an investment.  But in addition to quantitative analysis, fiduciaries should consider applying qualitative factors, which can help detect organizational instability. Organizational instability, over time, usually leads to underperformance.

Here are seven qualitative factors that a fiduciary should consider implementing into their due diligence process:

1. Manager Quality – Does the portfolio manager have the necessary experience to manage the type and size of portfolio you are investigating?  In addition to credentials, take a look at prior experience. This is especially important if the manager is new to the firm.

2. Staff Turnover – Along with the portfolio manager, you should also look at the professional staff of the investment company. Has there been significant turnover?  If significant turnover is found, you should dig deeper to find out why.

3. Organizational Structure – You should also investigate any structural changes to the investment company.  It’s important to examine the firm’s mergers or acquisitions to see if the organization is more focused on “castle building” than managing money. If they are building the firm, how will it benefit your client?

4. Level of service provided - Does the investment company provide a better level of service than other firms in the marketplace for a comparable fee? Does the money manager provide other share classes for a fund or Separately Managed Accounts? Depending on your client’s situation, you may be able to invest with the same portfolio manager, but at a lower cost.

5. The quality and timeliness of the money manager’s reports – Registered investment companies are required to report information to the SEC, but do they do so in a timely manner? In addition, does the manager provide an adequate amount of information to make an informed decision? If they do not, what is the cause of delay or omission?

6. Response to requests for information– Like every other service company, the investment company has customers, primarily advisors and investors.  Do they treat their customers with care? If you request information from the investment company, do they provide it in a timely manner with a relevant response?

7. Investment Education - Does the portfolio manager provide an adequate explanation of the investment decisions she makes and the factors she considers in making decisions?  Is the portfolio manager able to easily articulate the portfolio mandate, the plan to follow the mandate, and any problems they see in achieving the mandate?

This is by no means a comprehensive list. Instead, it’s a demonstration of the type of probing analysis an advisor can use in their selection and monitoring process.

What qualitative items do you look at when you are performing due diligence?  Let us know in the comments below.

Fiduciary Q&A: Use of alternative investments in defined contribution plans

Q: What is fi360's position on the usage of “alternative asset classes” in Defined Contribution plans?

A: The first thing we always say when asked about the appropriateness of an investment is that no investment is imprudent on its face. Prudence is dictated by facts and circumstances.

Moving past the idea that any investment can be considered, we believe alternative investments do not make sense for most defined contribution plans and should only be considered by sophisticated fiduciaries capable of extraordinary due diligence, as described below.

The first step in considering alternative investments would be to make sure the investment is specifically permitted in the investment policy statement. If alternative investments are specifically prohibited, then you can stop right there, the decision has already been made. Otherwise, because alternative investments can be difficult to categorize into an asset class and because reasonable risk, return, and correlations statistics for them can be elusive, the IPS should specifically authorize their use and specify their role within the overall investment strategy.

The next step is to assess the proposed investment itself. Generally, alternative investments are not regulated, transparent, easily valued nor liquid. In place of those safeguards, a fiduciary needs to have well-reasoned explanations to each of the following questions in regards to the management of the investments:

• Why are alternatives being considered?
• What alternatives will be used?
• Who will implement and who will monitor them?
• Where (which asset classes) will the investments be made?
• When will the investments be made and reviewed?
• How will the investments be governed?
• How much will be devoted to these investments?

Another important consideration for alternative investments is fees. Alternative investments typically involve performance fees, which have the effect of both being a drain on performance and rewarding managers for taking greater risks. They also require a higher level of monitoring than typical investments to ensure consistency to the agreed upon fees. An alternative investment should only be considered when it is determined that fees are reasonable when compared to similar options and will not impede the potential benefits of the considered investment.

If the fiduciary is comfortable with the fees, the management of the investment, the permissibility of the investment according to the IPS, and with the investment's benefit within the goals of the portfolio, then perhaps an alternative investment could make sense.

However, because of the extensive due diligence required and the increased risk that is inherent in the nature of alternative investments, they are better suited for pooled portfolios with long time horizons, such as defined benefit plans, that allow for more asset classes to be implemented and for greater dispersion of risk.

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Do you have experience you using alternative investments in defined contribution plans? If so, what due diligence did you perform before implementing the investment? Let us know what you think in the comments section below.

If you have a question you would like to see us answer in a future Fiduciary Q&A, send it to blog@fi360.com.  All questions will remain anonymous.