fi360 Blog

12b-1 fees create conflict for fiduciaries

The House-passed financial regulatory reform bill (The Wall Street Reform and Consumer Protection Act) calls upon the SEC to “…examine and, where appropriate, promulgate rules prohibiting or restricting certain sales practices, conflicts of interest, and compensation schemes for brokers, dealers, and investment advisers that the Commission deems contrary to the public interest and the protection of investors.”  While the Senate is still deliberating its version of the bill and enactment of a new law is not yet imminent, it is worth noting that the SEC already has considerable rule-making authority in this regard.  For example, SEC Chairman Mary Schapiro recently announced that the Commission will be undertaking a review of 12b-1 fees to determine if they are appropriate.

In my Fiduciary Corner column that appeared in Investment News this week, I expressed the view that 12b-1 fee plans should be eliminated in favor of more straight forward disclosure of fees in a few key categories. These fees are confusing to investors, they create conflicts for advisors and fund company directors, and they complicate the comparison and control of costs across funds. In short, they are “contrary to the public interest and the protection of investors.”

The most compelling reason to keep 12b-1 fees is that they are pervasive and change isn’t easy. Roughly 70% of mutual funds have adopted 12b-1 fee plans and investors pay these funds about estimated $13 billion annually from 12b-1 fees.

Elimination of 12b-1 fee plans won’t automatically save investors billions in costs and wipe-out a comparable amount of annual fund company revenue. The point is, funds should show their costs in a few cost categories (such as investment management, administration, and sales compensation) so investors, and fiduciaries serving investors, can more clearly understand what they are paying for and include meaningful cost analysis in their due diligence. This transparency would almost certainly lead to lower costs over time as a result of competitive pressure.

Not all of the money currently collected through 12b-1 fees stays with the fund companies. In fact, the primary use of the fees is to pay trail commissions to brokers and advisors who distribute the funds. Here again, I am not arguing that compensation for distributors should end; I am arguing that, to be consistent with fiduciary duties and serve the interests of investors, this compensation must become more transparent. Moreover, if compensation is pulled out of the internal expenses of the fund, advisors can avoid having to go through a compensation-leveling exercise to manage the conflict of using funds that pay different trail commissions.

To me, elimination of 12b-1 fees is obviously a good thing in principle (especially in fiduciary principle) but I also recognize that implementing this change will be disruptive to current fund company practices. Post your thoughts on the merits and methods of eliminating 12b-1 fee plans.

Target date funds: What about risk?

In my most recent Fiduciary Corner column, I looked at how fiduciaries can make the difference in reforming target date funds. A question arose however as to where risk is accounted for. An email I received made the case that the products were being made on the cheap, saying "What is missing is the most important factor of all: RISK. These life-cycle funds are fatally flawed as they assume the same risk tolerance for all investors retiring in a certain year. Risk drives behavior. Individuals usually fail because of behavior." The emailer suggested that by not providing subsets based on risk tolerance for each target date year, managers are feeding the same bad investor behavior that causes investor performance to consistently lag behind fund performance.

Risk is obviously an important factor in the construction of a portfolio--second only to time horizon. If an investor has a very short time horizon, i.e. they have an immediate liquidity need, their opportunity to diversify is limited. That is why the question of whether the target date fund is targeting "to" or "through" retirement is so critical.  If the intent of the investor is to invest "to" retirement, a target date fund may be entirely appropriate (ignoring for the moment other correctable flaws in many of the funds I mentioned in my article).

By definition, diversification is intended to manage risk, which is why I assumed it.  Pre-diversified portfolios have risk management as their reason for being. If investors were capable of building and maintaining a customized portfolio themselves or had access to professional advice to help them, target date funds might not be necessary. But keep in mind that these funds are primarily designed for investors who are either unable or unwilling to structure an appropriately designed portfolio for themselves.

To say that a pre-diversified option is "fatally flawed" seems to me to be an overstatement in the same sense that it would be an overstatement to say that no one can ever benefit from buying preassembled furniture. Custom built furniture will generally be superior, but pre-built isn't inherently worthless. Of course, if someone needs a desk and goes shopping for something pre-built but comes home with a dresser, their needs aren't going to be met. There is a certain level of understanding that the buyer needs to have of what they need and what they are buying.

As I indicated in my article, there are currently some inherent problems with target date funds. For example, the "to" versus "through" issue is the equivalent of getting a pre-built piece of furniture without knowing what’s in the box. In addition, the exemption that treats underlying funds in the target date product as not being plan assets allows the provider to have conflicts of interest. But these and other flaws are correctable, not fatal.

To be clear, I am not a big fan of target date funds. However, in the limited circumstance of trying to address the needs of people who are otherwise likely to chase the returns of whatever happens to be the hottest performing fund of the moment, or those who will only park their money in a money market or stable value fund that won't get them to their retirement income goals, new and improved target date funds can play a role (e.g. as a QDIA).

A true fiduciary standard can't compromise basic principles

In my most recent Fiduciary Corner column in Investment News, I wrote about The Committee for the Fiduciary Standard and the five fiduciary principles the Committee focuses upon. The five principles capture the essence of the fiduciary standard that is well established in law and regulation. They are paraphrased here:

1. Place investors best interests first (singular duty of loyalty to the investor)
2. Provide advice with the skill, care, diligence and judgment of a professional (duty of due care or the prudent expert standard)
3. Provide full and fair disclosure of all material facts (duty of utmost good faith)
4. Avoid conflicts of interest (because conflicts are situations that make fulfillment of the duty of loyalty less reliable)
5. Manage unavoidable conflicts in the best interest of the client (which is meant to assure that the objectivity of the advisor is not impaired)

Some financial service industry trade groups and a handful of transaction-oriented firms are advocating, either overtly or by lobbying legislators behind the scenes, to establish a “new fiduciary standard” that purportedly would draw from both the principles-based fiduciary standard and the lower rules-based fair dealing standard associated with traditional brokerage activities.

While these efforts are couched in terms of finding a workable compromise solution, they amount to a call to abandon the true fiduciary standard and christen the fair dealing standard as the “new fiduciary standard.”

Simply put, you can’t compromise principles and claim to adhere to them.  Consider what it would mean to compromise on the five fiduciary principles.

1. Compromising the singular duty of loyalty results in divided loyalties, which is at odds with the very definition of a fiduciary.
2. Compromising due care results in acceptance of less than a professional level of competence.
3. Compromising on full and fair disclosures results in the suppression of material information and a failure to provide the transparency crucial to relationships of trust.
4. Accepting conflicts of interest that can reasonably be avoided undermines the integrity of the duty of loyalty.
5. Permitting unavoidable conflicts to be merely disclosed rather than managed in the best interests of clients creates a “buyer beware” overtone to client interactions that is inconsistent with the entire concept of professional advice

In short, regulatory reform that compromises fiduciary principles is not reform at all; it is regulatory regression that would weaken investor protections and push the business of investment advice further from becoming a true profession. Moreover, the fiduciary standard stripped of its core principles bears no resemblance to the true standard whatsoever. Please speak out on behalf of investors and the professionalization of investment advice by contacting legislators and regulators, commenting on financial blogs like this one, and joining The Committee for the Fiduciary Standard (www.thefiduciarystandard.org).

Why Brokerage-based Advisors (Should) Want The Fiduciary Standard

In my Fiduciary Corner column in Investment News this month, I make the case that advisors who work in wire-house firms should be, and often are, among the strongest proponents of the Obama Administration's proposal to extend fiduciary status to anyone who gives advice. If enacted, the proposal is likely to require brokerage firms to retool their management, sales and compliance structures for all but the purely transactional (generally online and/or discount) segment of their businesses.

There are many brokerage-based advisors who recognize that investment advice is a fiduciary function and are well prepared to embrace the change in regulatory approach and the resulting operational and cultural changes that are likely to occur. Here are five reasons why:

1. These advisors have already been operating under a fiduciary ethic (i.e., placing clients' best interests first and adhering to fiduciary duties) but have been constrained by suitability-oriented sales and compliance infrastructure and culture. They are often unable to use professional designations that may imply fiduciary status (e.g., AIF, AIFA, CFP, etc.) and to accept fiduciary status in writing.

2. As more clients and prospective clients become aware of the importance of working with a fiduciary when they seek investment advice, those who can and will acknowledge fiduciary status have a clear competitive advantage.

3. In a predominately suitability-oriented organization, training, resources and support for fiduciary activities are often inadequate. This will have to change if all forms of investment advice are subject to fiduciary laws and regulations. Already, a number of large wire-houses are beginning to plan or establish separate units within their organizations where the business model will be designed to foster a culture of fiduciary responsibility.

4. Products built for a suitability distribution network generally don't work well for distribution through fiduciaries. Sales incentives create conflicts and elevate internal expense levels. Imposition of the fiduciary standard should spark development of more products that are designed to compete on their investment merits alone. In a sales/suitability environment, YTB (yield to broker) is a necessary factor to consider because compensation is typically built into the product by the investment company rather than assessed at the overall account-level where compensation is set by the advisor.

5. Under the law, investment advice is recognized as a fiduciary service and advice givers may be held personally accountable for compliance with applicable fiduciary requirements. If a company-imposed suitability defense to a claim of fiduciary breach fails, the advisor's best defense is to be able to demonstrate that they adhered to fiduciary practices. It is much easier for an advisor to adhere to the fiduciary standard if the organization is geared to promote and sustain fiduciary conduct in all aspects of their business model.

I have received many calls and emails from brokerage-based advisors. Most have been supportive of the Administration's plan to extend fiduciary status to all advice givers, primarily for the reasons given above. I welcome you to post your thoughts about this aspect of the Administration's financial regulatory reform plan as well.

The process of picking a co-fiduciary

In his August Fiduciary Corner column, Blaine writes about a fiduciary's duty to delegate responsibility to "prudent experts" when their level of training, experience and expertise is not adequate. Fiduciary duty requires that all aspects of managing investments for others are done so to a professional standard of care. When a fiduciary cannot do that his or herself, he or she must delegate that responsibility to a professional who can. And, the fiduciary must also demonstrate a prudent delegation process that resulted in the best professional for the job being selected. Blaine's article explains these duties and the key components for a proper search for investment professionals.

Practices 1.3, 3.1 and 3.4 in our Prudent Practices for Investment Advisors handbook also are about delegation, with 1.3 describing the "prudent expert" rule, 3.1 addressing the selection of investment managers (the handbook also includes suggested due diligence fields) and 3.4 addressing the selection of the custodian and other service providers. The three Practices together give a pretty full picture of the delegation duty. Reading the Legal Memoranda on those Practices gives the full substantiation to those Practices from ERISA, UPIA, UPMIFA, MPERS and other legal sources.

Make sure you read Blaine's full article at InvestmentNews.com and click the "Recommend" button at the top of the page if you like it.  We've already received some feedback via email from those who disagree with and support this idea, and we'd like to hear more and respond to it in hope of advancing the conversation on how to provide an environment more conducive to success for retirement.  Please leave those thoughts in the comments section below. 

Choices, not direction, best way to address 401k deficiencies?

Earlier this month, I looked at whether participant-direction of retirement plans is really in the best interests of the participants. While much of the feedback we have received has been supportive, even enthusiastic of the idea, some felt that participant-direction wasn't going anywhere so a better solution was best sought elsewhere.  Scott Pritchard, AIFA® of Capital Directions, LLC in Atlanta, GA had this to say:

Investment committees and trustees are simply made up of participants who have agreed to serve on the committee or as a trustee.  Rarely do those individuals have any more expertise or experience than the typical participant. 

And worse yet, those committees and trustees are typically “advised” by a provider who makes recommendations from among the investment offerings that pay the provider (certainly the term “adviser” is not appropriate) a share of the revenue generated by those offerings being in the plan.  No one in that typical plan relationship is serving the fiduciary standard of acting “solely in the best interests of plan participants”.

So, giving those committees or trustees the responsibility for managing participant assets will do no better than the current model.

Self-direction is here to stay.  And the solution to the current problem is in improving the nature of the choices that are offered to participants.  Advisor-managed portfolios constructed with low-cost, institutional tools according to Modern Portfolio Theory will give participants the ability to determine their own tolerance for risk and their own appropriate time horizon.  That is a decision that should be left to the individual.  Managing a pool of assets for the benefit of a large group, even when done by an objective investment professional,  will invariably lead to unsuitable investments for the majority.

Scott is right that most investment committee members and trustees are not investment professionals and should not be doing the job of investment management on their own. The vast majority need to use investment advisors and managers and those key professionals should absolutely be true fiduciaries.It also is true that participant direction is going to be with us for a long time. However, I do believe that centralized professional management of a large portfolio has some distinct advantages over decentralized non-professional management by individuals.

Either way, as participant-direction has continued to fail to achieve results that best prepare individuals for retirement, it is obvious that changes need to be made, and disclosure and education don't seem to be doing the trick.  What do you think? Is trustee direction the way to go? Or is Scott correct that a change in how offerings are constructed have the better long-term potential?  Let us know how you would fix the 401k in the comments below. 

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Editor's note: Scott is the author of the article The Tyranny of Choice, which further explains his contention that better choices is the better solution to addressing the problem of participant-direction in 401k plans. The article was also a finalist in our first annual article competition.

Is participant-direction really in participants' best interests?

In his July Fiduciary Corner column in InvestmentNews, Blaine looks at the evolution of 401(k) plans and how no amount of tinkering with the formula has reliably equipped participants to make good investment choices.  Dalbar's annual Quantitative Analysis of Investment Behavior study famously demonstrates that almost without fail, investors fail to keep up with market growth.  Legal and regulatory changes to allow for improved investment choices and education have not resulted in improved results. In addition, the cost of participant direction and the lack of incentive for plan sponsor's to control costs has caused plan fees to become the target of lawsuits.

Rather than continue to try to make work what has continued to prove to be an exercise in futility, Blaine suggests that it may be time to reconsider the notion of participant-direction altogether.  Centrally administered portfolios, as you'll find in foundations, endowments and defined benefit plans, tend to be less complicated and more successful.  It places a dedicated fiduciary in a position of accountability from design to execution who is in a better position to draw on the support of professional advisors and managers to be more responsive to the changing circumstances that will be faced on the road to retirement. Perhaps it would be in participants' best interests to move to committee or trustee-directed portfolios and try to mimic that success?

Make sure you read Blaine's full article at InvestmentNews.com and click the "Recommend" button at the top of the page if you like it.  We've already received some feedback via email from those who disagree with and support this idea, and we'd like to hear more and respond to it in hope of advancing the conversation on how to provide an environment more conducive to success for retirement.  Please leave those thoughts in the comments section below. 

Commissioner Aguilar's regulatory reform proposal the best option for investors

We've been focusing on this topic a lot lately, so I'll be brief.  Blaine's latest Fiduciary Corner column throws our support behind the ideas of SEC Commissioner Luis Aguilar.  Chief points among Aguilar's comments during a recent speech at the Investment Advisor Assocation's annual conference were:

• “There is only one fiduciary standard and it means that a fiduciary has an affirmative obligation to put a client's interests above his or her own.”
• "[None of the alternative proposals] measures up to the fiduciary standard that currently exists, and there is great concern that these proposed standards may have the effect of diluting the existing high fiduciary standard that serves as an important investor protection.”
• The SEC was orginally given oversight of investment advice, brokers were exempt because, at the time, they weren't giving advice.  Now that they are giving advice, they should fall under the same oversight as the investment advisors who have always been regulated by the SEC.
• All the SEC needs to successfully take on this role for what would be a much greater pool of advisors is increased resources.   

The logic of this proposal makes the most sense to us. It is the brokers who have transitioned their models to include the provision of investment advice, so why should regulation and oversight cater to them with a watered down fiduciary standard? We also prefer the idea of a more adequately resourced SEC for oversight than a conflicted SRO like Finra.

There is clearly a lot at stake for the impeding reform. And, with a lot to lose, there are well-organized, well-funded groups who will vigorously defend their interests.  Aguilar's proposal prefers the interests of investors over those of those who are supposed to serve them.  If you agree, we urge you to contact the SEC and your elected representatives to voice your support.  Here are additional resources for you get involved:

• Our letter to the SEC in support of Aguilar
• Our recent Webinar on regulatory reform
• Contact information for the SEC, the House and the Senate for you to submit your own letter

Make sure you read Blaine's full article at InvestmentNews.com and click the "Recommend" button at the top of the page if you like it.  And, make sure to leave your thoughts in the comments section below.

What would be different under a "universal" fiduciary standard?

Now that we've called for a fiduciary standard for all investment advice (and we mean a real fiduciary standard), the next question is, "ok, why?" or, "how would it change things?" 

In his May Fiduciary Corner column, Blaine takes a look at this question and arrives at six significant changes for the benefit of the investor.

1. Greater accountability for adherence to professional principles and reduced reliance on prescriptive rules.
2. Consistent emphasis on competent management of portfolios.
3. Reduction or elimination of sales-based compensation systems.
4. Increased emphasis on investment expertise.
5. Investment products will become more competitive on the basis of their merits as investments.
6. Currently low public perceptions of financial intermediaries and advisors will climb as a new era of fiduciary responsibility and accountability takes hold and the positive outcomes above become widely recognized.

Of course, these benefits can only be recognized if a true, ERISA-level fiduciary standard is applied for all investment advice.  If we see a watered-down version that seeks to meet the suitability standard in the middle, consumers will still be the ones who suffer as conflicts of interest continue to result in substandard products, services and standard of care for investors. 

Make sure you read Blaine's full article at InvestmentNews.com and click the "Recommend" button at the top of the page if you like it.  And, make sure to leave your thoughts in the comments section below.

The high cost of conflicts

In his newest Fiduciary Corner column for InvestmentNews, our CEO, Blaine Aikin, looks at the high cost of conflicts of interest and four suggestions for how a fiduciary should address them. 

Just the idea of trying to reconcile a conflict of interest with a fiduciary duty is difficult.  How can a fiduciary be trusted to put the best interests of their client first when they have a financial stake in their decision-making?  And, as Blaine mentions, it is more than a trust issue, it is a results issue. 

In the column, he cites two scholarly studies, one from the Financial Analysts Journal (requires membership to view entire article) that shows how disclosed conflicts of interest increase the operational risks for hedge funds and another from the Government Accountability Office showing that undisclosed conflicts results in underperformance in both DC and DB plans.

Given that conflicts both add to public distrust of the industry and are more likely to result in poor performance, Blaine offers his four conclusions on conflicts of interest:

• Avoiding, rather than disclosing and managing, conflicts is by far the more preferable option
• If a conflict must exist, full disclosure is an absolute must
• Conflict disclosures should be verified by regulators or independent auditors
• A self-regulatory authority for advisers is itself a conflict, and therefore the wrong solution for oversight

Make sure you read Blaine's full article at InvestmentNews.com and click the "Recommend" button at the top of the page if you like it.  And, make sure to leave your thoughts in the comments section below.