fi360 Blog

To provide or not to provide an IPS?

Ideally, a well-crafted investment policy statement (IPS) will be in place and be a guiding force before the selection of service providers. However, as many advisors out there can attest to, this is not always the case. Often portfolios have no IPS in place or have one provided by vendors that have already been selected. These scenarios present advisors with an interesting decision to make as to whether they should provide their own IPS. 

I spoke with an advisor recently who was looking for insights based on his encounters where the IPS either did not exist or was not created by the fiduciary that owns or has primary control of the assets, i.e., the steward. While he understood the importance of the IPS and had one that his company provided him with, it also came with a disclosure that basically said, "use an IPS, but don't blame us when things go wrong," which, to him, didn't seem like much of a recommendation at all.

This led him to ask the following questions: 

1. Why do some providers want nothing to do with an IPS for the end client?
2. Are fiduciaries better off not having an IPS governing their portfolio management activities, as they don't have a template to be accountable to?  He paraphrased this question by noting he didn't believe it, but it was still the story he was up against, the argument being if you have one, you have to stick to it, if you don't have one, nothing to worry about.
3. Is there a conflict in offering his company-approved IPS when one already exists through the vendor? If you have two separate IPSs, which one is the dominant one/overriding one?

While the first question involves speculation about the motives of providers and the other two depend on the facts and circumstances of each case, I believe my answers are fairly reliable based upon my experience on these issues.

Some providers steer clear of the IPS because they are trying to steer clear of any fiduciary role. They recognize that the IPS ultimately is “owned” by the steward. They may be concerned that by providing the IPS they are setting themselves up for the argument that they have assumed the duties to craft and maintain an IPS that is appropriate for, and in the best interest of, the beneficiaries. I believe this could be managed in other ways but that’s my best guess as to what it going on.

The argument that the portfolio would be better off without an IPS is particularly dangerous and pathetic, but all too common. It is pathetic and dangerous because, in the event of a DOL audit or a complaint from a beneficiary, it is difficult to demonstrate that prudent processes are being used in fulfillment of the steward’s fiduciary obligations. Moreover, a specific requirement under ERISA is to have an investment policy. The steward is immediately on the defensive if they have to argue that the portfolio is being operated according to an investment policy that has not been committed to paper. The steward will be called upon to demonstrate that the claim is true – no small task. It is pathetic because it suggests that (a) the fiduciaries to the plan are so incompetent as to be presumptively negligent in their willingness or ability to follow a written plan and (b) the beneficiaries are not deserving of having their assets managed according to a well developed and documented business plan (which is effectively what the IPS is). A steward without a written IPS may be called upon to concoct some story of how they really have a mental IPS that they have been following. This doesn’t square very well with the premise that the best reason for not having an IPS is based on acknowledged incompetence or propensity for negligence. To summarize, the “don’t have an IPS” school of thought doesn’t paint a very flattering portrait of the fiduciaries serving the plan, is likely to increase regulatory and litigation risks, and is inconsistent with the obligation to serve investors’ best interests.

As for the situation when a vendor-provided IPS already exists, I mentioned previously that the IPS is “owned” by the steward and it's ultimately up to them to either create or select and adopt a single IPS from the available options. Your role in assisting them should be based upon your engagement. If you are an advisor to the portfolio, you may include advice on the IPS as part of your service set. If you exclude anything having to do with the IPS from your engagement, you should still be able to recommend that they decide upon the IPS that will guide management of assets. A disclosure, such as the one the advisor’s company has included, is a good idea as it should help focus the plan sponsor on the importance of them giving serious thought to the IPS and taking ownership of it.

In short, it is our belief that the IPS is the single most important document in the management of investment decisions. Without one, the steward would be hard pressed to argue that they even have an investment policy. As an advisor, if you encounter a portfolio without one at all or with one that you believe may be inferior, you absolutely should inform them of the importance of taking ownership of the investment policy and provide them an IPS to get them started.

Who Wants to be a Fiduciary Adviser?

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

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

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

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

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

When is accepting a gift a problem?

With the holidays upon us, we've reached the time of year when most gift giving takes place. Fiduciaries are often the recipients of gifts and we were recently asked whether they are permitted to accept them?  If so, what kind and how large?  Although not an attorney, as fi360's CCO I have some suggestions.

When considering whether or not to accept a gift, a fiduciary should always ask his or herself whether they believe it will impair their ability to carry out their duties objectively.  DOL's Employee Benefits Security Administration (EBSA) provides guidance to investigators or auditors (See No. 12) evaluating if a fiduciary violation has occurred, stating that the investigator should determine if "the receipt of gifts, gratuities, or other consideration were for the fiduciary's personal account and received in connection with a transaction or transactions involving the assets of the plan."  They go on to say that the "Investigator/Auditor should also determine whether the fiduciary of the plan maintained a reasonable written policy or plan provision governing the receipt of items or services from parties dealing with the plan and whether the fiduciary adhered to that policy." 

EBSA's guidance is instructive for all fiduciaries, not just plan sponsors.  The first step is to have a gift policy that provides guidance regarding their acceptance.  A typical policy would set parameters under which gifts can be accepted and may include:

• the maximum monetary value allowed ($200-$300 seems reasonable)
• prohibition from certain types of gifts, such as high profile sports events (Super Bowl, World Series, etc.)
• a requirement to keep a record of all gifts received (this would not normally include things like an occasional lunch)

Of course, the policy could be that no gifts of any type or amount can be accepted at all, but this would most likely be excessive. Most policies would allow gifts of a nature that could not reasonably be interpreted as influencing decisions as a result. So, in general, think fruit baskets, rather than Final Four tickets.  

A comprehensive overview of accepting gifts and setting policies can also be found from the Vedder Price law firm. Always consult legal counsel when drafting policies on gifts to ensure they are in compliance with ERISA and all relevant laws.

So enjoy the holidays, graciously accept gifts that conform to your gift policy, and continue doing what all fiduciaries are called to do, look out for the best interests of your clients, participants and beneficiaries.

How does the Investment Steward become concerned about and engaged in the fiduciary process?

Many financial services professionals, particularly investment advisors and managers, have realized the importance of fiduciary processes and the beneficial impact they can have for themselves and the investors they serve. Many more are coming around as a financial crisis and regulatory reform has changed the landscape. But can the same be said for investment stewards? Have the benefits of implementing fiduciary processes resonated enough to motivate them to make changes? An email we received last week from an advisor who was trying to convince a prospective client to engage him to conduct a fiduciary review highlighted suggests not. 

The prospective client, an investment steward for a retirement plan, had told them, "You've spent a lot of time over the what, how, when, where and who of fiduciary processes - particularly in the investment arena.  The one thing I'm not catching is the why."  This statement gets to the heart of what many advisors struggle with; how can I convince prospective clients (plan sponsors and participants, foundation or endowment investment committee members, trustees, and retail investors) that incorporating a prudent investment process is important?  Several thoughts were either articulated by the email originator or come to mind from previous conversations we have had related to this topic.  

Through this and other discussions, we focused on the following arguments for stewards implementing a prudent process:

• Helps to avoid complaints for breach of fiduciary responsibility that may lead to litigation or, in the case of brokers, arbitration 
• Reduces liability by helping to uncover investment or procedural risks
• Helps ensure compliance
• Should lead to better investment performance

The first three points indicate that the process can prevent bad things from happening and the fourth focuses on the potential and significant positive result.  We mentioned in a previous blog post that adherence to the fiduciary practices can lead to better performance.  With limited data to support this claim, we suggest discussing particular practices (S-1.4, 3.1, 4.1, 4.2, 4.4, and 4.5 immediately come to mind) with the skeptical steward to logically explain why one would expect that implementing a prudent process by adhering to the fiduciary practices will generate improved performance.  However, we expect there are other things we have not thought of.

For that reason we would love to hear from you.  If you are a financial service professional, have you been able to motivate the investment stewards with whom you interact to embrace the notion of improving their investment management process?  If so, how did you do so?  Investment stewards that are reading this blog post have probably already decided that carrying out your fiduciary responsibility is a high priority.  What was it that got your attention and drove you to establish and maintain a prudent investment process?

Can an Investment Advisor be a Manager as well?

Q: Are there any fiduciary issues in assuming the role of both the investment advisor and manager?

A: We are not aware of anything that prevents an investment professional from assuming an investment advisor and investment manager role simultaneously; even to the extent of a registered investment advisor (RIA) including a mutual fund it manages as an option or QDIA in retirement plans to which it is acting as the investment advisor (Pending legislation regarding investment advice may change that).  However, is it a good idea?  By assuming both the investment advisor and manager role you create a conflict of interest, which makes fulfillment of a fiduciary's duty of loyalty less reliable.

A fiduciary’s primary duties to participants, according to ERISA 404(a), include loyalty, exclusive purpose and prudence. ERISA also speaks to the relationships formed when carrying out these duties by specifying certain prohibited transactions in ERISA 406(a) and 406(b).  The essential thrust of these duties and specified prohibited transactions is that fiduciaries must act solely in the interest of plan participants. 

As an example, let's assume that one's intentions are honorable and the advisor has determined it is in the participant's best interest for the advisor's mutual fund to be an option in the plan.  The mutual fund has cleared all screens specified in the objective due diligence process documented in the investment policy statement, the performance is competitive when compared to the fund's peers and an appropriate benchmark, it is aligned with the plan's stated goals and objectives, and even the related fees and expenses are below the industry average. One could still argue that the conflict makes it impossible to ensure that the participants are well served going forward because of the significant issue that the advisor is now in a position to monitor itself.  Will the advisor replace, or recommend replacement of, its mutual fund if it is called for?  Can the advisor remain objective or is even the appearance of impropriety problematic?

We believe the appearance of impropriety creates issues that will be difficult to manage. Any conflict of interest puts the fiduciary in a position where difficult choices may have to be made, which is why we always recommend that they be avoided if at all possible.  In this example, choose to be the investment advisor or the investment manager, but not both.

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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.

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.

The SRO Debate: Alive and Well?

During our most recent webinar exploring regulatory reform, we received a question regarding whether investment advisors will still be supervised by the SEC or their respective state.  In recent months, the Administration, Congress and regulators have been much more focused on other capital market issues as they consider financial regulatory reform, and the issue of oversight of investment advisors has gone largely unrecognized in Congressional hearings and proposed legislation. 

However, recent media reports make it appear as though regulation and oversight of advisors is still a burning topic.  Earlier this month, Texas securities regulator and NASAA President Denise Voigt Crawford stated she would like to see a greater role for the states in regulatory oversight of investment advisors and argued that the dividing line between SEC and state regulation should be raised from assets under management of $25 million (or less) to $100 million.  This week, however, the SEC's head of Investment Management, Andrew Donohue stated that the issue of whether advisors should be supervised by a SRO must be resolved before states are given more authority over advisors. 

But while oversight issues may be a hot topic among the industry and regulators, it is a lot less clear that it is an issue legislators are ready to address through legislation.  In fact, it was reported earlier this week that while the House Financial Services Committee plans to discuss investment advisor issues at a hearing on October 6, Congress may end up punting the fiduciary issue that has been a part of the public discussion to this point. 

While there continues to be much speculation about whether Congress will address fiduciary issues as well as oversight issues this fall through legislation, it is clear that the SEC is waiting for a signal from Congress on how to proceed.  Moreover, the SEC's ability to act is limited without legislation, particularly in the area of investment adviser oversight. 

It has been widely reported that the SEC lacks the resources to effectively oversee and examine the more than 11,000 investment advisors currently subject to its jurisdiction.  SEC Chairman Schapiro and Commissioner Aguilar have both publicly supported self funding for the agency as a means for increasing its budget, and Senator Charles Schumer has backed the idea with proposed legislation.  

Absent a legislative initiative to increase SEC resources, greater state involvement and/or SRO oversight of advisors could become the solution of choice to ensure more effective oversight of advisors.  But again, both solutions require legislation either to change the dividing line that separates state and federal regulation, or to set laws requiring any SRO responsible for supervising advisors to register with and be subject to the oversight of the SEC.  

Advisory trade groups and NASAA have argued against SRO oversight because they fear that FINRA will become the SRO of choice.  However, whether FINRA becomes the SRO responsible for advisors, it still stands to play a major role in regulating fiduciaries depending on how the fiduciary standard is extended to brokers that provide investment advice to investors.  All of these complicated issues likley will not be resolved anytime soon given the long list of issues Congress and the SEC are currently tackling.  Thus, the status quo of advisor oversight will stay in place for now.  However, given the growing list of frauds uncovered at the state and federal level this past year, advisors should not rule out a change in how they are regulated and the regulator to whom they answer, especially once Congress is finished tackling the larger reform issues early next year.  

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UPDATE 10/5/09:  On October 1, Congressman Paul Kanjorski released a discussion draft of the Investor Protection Act, which will be the subject of a House Financial Services Committee hearing on October 6.  Included among the various provisions of the legislative draft is a proposal for an independent study of the operations and structure of the SEC and SROs.  With regard to SROs, the draft bill specifically calls for the study of "the present self-regulatory organizational structure and a determination of whether the present reliance on self-regulatory organizations promotes efficient and effective governance for securities markets."  In addition, the draft legislation proposes to give the SEC the authority to collect fees from registered investment advisors to cover the cost of inspections and examinations of those advisors.  Given these proposals for a study and SEC funding, it is clear that Congress envisions the SEC and states maintaining their current roles overseeing advisors if this legislation is enacted and that an SRO for advisors would not become an option unless the independent study provided evidence that it could be an effective model.

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This question was asked during our most recent webinar exploring regulatory reform, "The converging worlds of brokers and advisors as fiduciaries under regulatory reform." To view a recording of this and previous webinars, as well as view the schedule of upcoming webinars, visit the webinars page of fi360.com.

 

 

When Does Limiting Investment Choices Become a Problem?

It was no surprise to many that the Department of Labor just recently pulled the investment advice regulations that were issued under Section 408(g) of ERISA earlier this year.  The new administration was concerned that the regulation went beyond what the Pension Protection Act of 2006 envisioned with respect to advice provided to participants under the statutory exemption.  The DOL will probably wait for legislative action before revisiting the participant advice question next year.  Among the issues contested in this ongoing debate are whether conflicted participant advice of any variety should be allowed and is there a problem if the investment choices available to plan sponsors are limited.

I received a related question last week from an investment advisor who took issue with the wirehouse firms that only offer certain products to their clients.  He inferred that these were either proprietary products or products from firms having special arrangements with the broker dealer.  His argument was that when a limited menu is offered, you are not acting in the client's best interests.

A student in one of our classes a while back posed the question; "If you limit the universe of investment choices available to your clients, haven't you already committed a fiduciary breech?"

Ideally, the entire universe of investment products should be open to investors and one could argue that any fiduciary that limits or accepts a limited universe has committed a breech.  However, there are other fiduciary practices that argue for reducing the number of investment choices for various reasons such as; not overwhelming the unsophisticated participants (Practice 2.4), simplifying the investment process (Practice 2.5), and/or minimizing costs (Practices 4.4 & 4.5).  As long as there are sufficient choices that afford the participant, beneficiary, or client the ability to meet their investment objectives, then limiting the investment choices should not be a problem.  The tricky part is determining what is a sufficient number and that question is dependent on the specific facts and circumstances of each situation.  Of course, this assumes that limiting the number of choices is done through an objective due diligence process (Practice 3.1).  It is this due diligence process that should ferret out problematic conflicts, excessive fees, and other fiduciary issues and help to ensure that the participant, beneficiary, or client are best served.

How many investment options are too many?

Last week we received a call from an AIF designee who was working with a plan that had over 75 investment options available for participants to choose from. He knew it was too many, but asked for our help in putting together a compelling case as to why too many options is not a good thing and what a reasonable number might be.

In the Prudent Practices handbooks, most of Step 2 instructs on designing an optimal asset allocation strategy based on the portfolio's goals and objectives. And in our classroom program, we include considerations of the “1/n” phenomenon, where investors divide equally among investment options available, as well as participants who will go to the opposite extreme and select a single investment option. These common behaviors illustrate why careful management of the number and type of investments offered in a participant-directed plan are critical plan design considerations.  A particularly helpful slide suggests an order for adding asset classes to a portfolio based on factors such as the size of the portfolio, the investment expertise of the fiduciary, the ability of the fiduciary to properly monitor the number and variety of options considered, and the sensitivity of the fiduciary to investment expenses.

Other than this guidance that the number of investment options should be based on facts and circumstances, we don’t offer any kind of formula or benchmark as to the specific number of options. To try to find more specific information, I turned to research to find how the number of investment options available can affect either investment behavior or portfolio performance.

First, a study from the Journal of Finance found investors tended to choose a small number of funds to invest in, no matter how many were offered, and that they tend to invest roughly equal amounts in each of the funds they select. So, at least in this one study, a large number of options does not correspond in participants taking advantage of them.

So what's the harm in making a large number of options available? The negative effects are most felt in investor behavior. A study from Columbia University found that when the number of investment options went up, enrollment went down, all the way to just 60% participation when the number of investment options approached 60.  (This study and others are cited in an Executive Summary from Vanguard on the subject).

Not only does the number of options affect participation rates, it can also affect how investors make their choice. One study from AllianceBernstein shows that as the number of investment options go up, so does the conservative nature of the funds chosen. The only factor that should be influencing selection should be which options help the beneficiary achieve their end goal.

Another important factor to consider is the number of options within a certain asset class.  In a review of its own state employee retirement system plan, the state of Missouri found that offering too many similar options was contributing to overlap and therefore improper diversification. It also found that by decreasing the number of options available and introducing target-date funds, it would be able to save on management fees and, potentially, administrative costs to the plan.

But perhaps the best case study I found demonstrating an effective and thorough process for selecting asset classes and investment options came from an investment option review by the Federal Thrift Savings Plan. The review found the plan to be comparable to peer plans with 10 available options.  The TSP review also includes great insight into their evaluation of investment options and why the individual asset classes either were or were not included among available options, and why some asset classes had only one option versus multiple options. You may find the 80+ page report excessive to reproduce for your own needs, but it demonstrates the type of thought process and documentation that a plan should be considering when building a prudently built portfolio of fund options that suits the goals and objectives of the end beneficiaries.

Other Resources:

• Plan design is just one of the metrics measured by Fiduciary Benchmarks, Inc., see this sample report.
• TIAA-CREF put together a research summary on plan investment options and investor behavior.
• Fi360 Tools offers an asset allocation optimizer for building diversified portfolios.

Have you had similar experiences where a plan has excessive investment options, seemingly just for the sake of having a lot of options? How did this affect the plan? Were you able to get the plan to revise their offerings to a more reasonable number? Let us know in the comments section below.

If you have a fiduciary question you need answered or would like to see addressed in a future blog post, let us know in the comments section or send an email to blog@fi360.com. 

Fiduciary Q&A: Invesment options not within the scope of the IPS?

The following question was sent to us from an investment committee member for a local medical research institute:

Q: We as a committee have done most if not all of the things suggested in your Prudent Practices handbooks. We have a situation where one of the senior members of the board has recommended an investment that lands outside our current investment policy statement (IPS). 

It is a synthetic insurance product.  We have current benefactor who is 82 years old, in good health and has excess insurance capacity.  His insurance agent has proposed we take $1MM from our endowment and buy a $1,060,000 insurance policy and a single premium annuity.  The income for the annuity will not only cover the insurance premiums but will allow for a current cash flow on the investment.  When the client dies, the annuity will disappear but will be replaced by the insurance policy. (Almost like a synthetic bond with a yield to maturity of 8.0%. But the maturity of the investment depends on the date of death of the participant)

I’m not terribly comfortable with this.  I was wondering if fi360 has any opinion on this vehicle when it comes to Endowments.  Thank you for your help in advance.

A: We always say that no investment is imprudent on its face and that certainly applies in this example.  Having said that, however, the concerns you have are legitimate and need to be addressed.  If the IPS does not address the investment in question, then the IPS should be changed to allow for it before making a decision to invest.  This necessarily will lead to a thorough discussion about this investment’s pros and cons, which is exactly what should happen.  It forces a discipline that helps to keep ad hoc investment decisions, that may not be prudent, at a minimum.  Think of this investment in terms of the other six Fiduciary Precepts as well.  For example:

• What standard or law governs this investment vehicle?
• Does it fit in with the overall asset allocation?
• Who is your prudent expert for this insurance vehicle?  How were they selected?  Was it an objective process?
• Have you considered fees and expenses?  Are they fair and reasonable?
• Who has the expertise to monitor the prudent expert?
• Are there any conflicts of interest that will result from making this investment?

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If you have any fiduciary-related questions you would like to see answered in the Fiduciary Q&A, let us know by emailing blog@fi360.com or leave your thoughts in the comments below.