fi360 Blog

What's the best way to provide or receive participant advice?

We continue to receive questions from financial service professionals who are considering providing investment advice to retirement plan participants.  We have previously stated in this blog that most are waiting for the participant advice rule to be finalized before making a decision in that regard.  Others have been providing advice to participants well before the Pension Protection Act of 2006 (PPA) was passed and continue to do so.  Many of them are relying on prior DOL guidance provided in the SunAmerica Opinion Letter (2001-09A).

One of the most recent questions we received essentially asked: when do advisors providing participant advice need to enter into an "eligible investment advice arrangement" (arrangement) with the plan sponsor, as defined in the PPA and the proposed participant advice rule? The short answer: they need to enter into an arrangement with the plan sponsor when a prohibited transaction would result from providing advice and an exemption from that prohibited transaction is required.

Those providing advice who are controlled by or affiliated with other financial service companies, such as mutual fund companies, broker dealers, and insurance companies must engage the plan sponsor through an arrangement because of the inherent conflicts of interest that exist.  The arrangement as specified in the proposed participant advice rule requires that the compensation received for advice is level, or that a computer model is used. The level fee limitation applies to both the person and entity rendering advice, including any person working for that entity as an employee, agent, or registered representative, and there is speculation that this limitation may be extended to all affiliations of the entity as well. If a computer model is used, it must be independently certified.  All arrangements must be audited annually.

On the other hand, independent investment advisors who have no affiliations with other financial service providers that would create inherent conflicts based on how those providers and the advisors are compensated, can continue to provide advice without entering into an arrangement with the plan sponsor. These advisors do not need an exemption because they do not benefit from the advice they provide to participants (other than the fee they charge for those services) and therefore are not committing a prohibited transaction. ERISA attorney Fred Reish refers to this as the "pure" level-fee model. 

We still recommend that advisors working under a pure level-fee model inform their plan sponsors of the new (fiduciary adviser) "safe harbor" that results from entering into an eligible investment advice arrangement so the plan sponsor can make an informed decision on whether it should not bring the advisor relationship into conformance with the new law and the associated regulation (e.g., required disclosures, annual audit requirement, etc.).  The last thing you want is for the plan sponsor to become aware of this "safe harbor" during the discovery process tied to potential litigation resulting from a participant's complaint of a fiduciary breach.  At that point, the plan sponsor won't be happy to learn that revising the structure of the relationship with their advisor may have afforded them additional protection from liability.

It should be noted that requirements related to entering an arrangement with a plan sponsor and complying with the proposed participant advice rule likely will increase the cost for providing participant advice.  Some believe the additional cost is or will be worth it because the arrangement will help ensure that plan participants are getting objective advice.  Others believe it makes more sense to engage an advisor that utilizes a "pure" level fee model.  We always recommend the avoidance of conflicts if at all possible, but ultimately, it's up to the plan sponsor.

Monitoring client and investment fees

The fifth Global Fiduciary Precept is to control and account for all investment expenses. It is a fundamental duty of a fiduciary to ensure that all forms of compensation are reasonable for the services being rendered. As such, it is important that fees are evaluated as part of selection, benchmarked against similar options, and regularly monitored to ensure they continue to be reasonable given the alternatives available and as circumstances change.

Yesterday, Mike and Rich presented a webinar that went over why fees and expenses need to be monitored closely; the scrutiny fee transparency is currently receiving from the various lawmakers, rulemakers, media and investors; and the three main fee areas to look at when evaluating investments: client-level fees, operational fees, and shareholder fees.

The recording of the session and slides can both be found on the webinars page of our website. In addition to what is available as part of the recording, we also wanted to highlight some additional reading and materials that were mentioned throughout the webinar as good resources for monitoring fees:

• Practice SA-4.4 from the Prudent Practices for Investment Stewards handbook
• Practice SA-4.5 from the Prudent Practices for Investment Stewards handbook
• The American Jobs and Closing Tax Loopholes Act, which is the House bill currently in the works that will include a fee transparency provision.
• An update on DOL activities from Reish & Reicher, including 408(b)(2) fee disclosure rules expected later this year.
• Information on important, recent fee-related lawsuits:
  • Hecker v. Deere
  • Braden v. Wal-Mart Stores, Inc.
  • Martin v. Caterpillar, Inc.
  • Jones v. Harris
• Reporting and benchmarking tools available from:
  • fi360 Toolkits (the Fee & Expense Report was specifically mentioned in the webinar)
  • Fiduciary Benchmarks
  • Investment Company Institute's Factbook (free resource)
  • Brightscope
  • Ann Schleck & Co.'s Fee Benchmarker

UPDATE: RegisteredRep was in attendance and wrote a nice story about our webinar. Read it here.
  

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.

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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.

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.

How fiduciaries can help confront investor overconfidence

In one of his recent blog posts for the New York Times' Bucks Blog, Behavior Gap's Carl Richards looked at the problem of investor overconfidence. An overconfident investor will often trade too frequently, trade at the wrong time and fail to diversify, a classic recipe for underperforming compared to the markets. Carl suggests two questions for investors to consider before making an investment decision: how would being right affect you and how would being wrong affect you? 

Unfortunately, most of the information being digested by investors from outside sources will focus on the potential for return. Therefore, it is not surprising that many investors focus on the first question and perhaps even individual managers they are feeling confident about when discussing the investment strategy. It is up to the fiduciary to force investors to consider the second question and refocus the conversation on the ultimate objectives for investing (i.e., retirement, education, charitable giving, etc.).

To do this, we suggest an exercise for testing the investor's risk tolerance. Show them models for optimistic, most likely and pessimistic return scenarios of an investment strategy over time. For each of these possible outcomes, ask the client, "if this happens, can your objectives still be met?" and fill out the following matrix:

	Optimistic	Most Likely	Pessimistic
1-year	Yes / No	Yes / No	Yes / No
3-year	Yes / No	Yes / No	Yes / No
5-year	Yes / No	Yes / No	Yes / No
Longer	Yes / No	Yes / No	Yes / No

If the answer to any of the scenarios is "no," then the investment strategy needs to be reexamined and possibly altered to fit a risk-return profile that the client is more comfortable with. Otherwise, the investor is likely to fall victim to the traits of an overconfident investor and alter the strategy at the wrong time and for the wrong reasons.

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.