fi360 Blog

Your questions on monitoring client and investment fees

For our last webinar in June, we addressed the topic "monitoring client and investment fees." 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 panelists from the original webinar. 

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 below.

Our next webinar will be on Thursday, September 9 from 4:00-5:00 p.m. EDT on the topic of how regulatory reform will change the way advisors and brokers do business. To register, click here.

Now on to those questions:

Q: For the mutual fund companies, the management fee is normally included in the expense ratio, correct?
A: Yes, the management fee is included in the expense ratio.  We typically use the Prospectus Net Expense Ratio in our analysis and it includes the management fee, 12b-1 fee, administrative fee, and all other asset-based costs incurred by the fund.

Q: Where do you get the information for the sub t/a fees? We have found that different custodians negotiate different sub t/a fees from fund families.
A: The sub t/a fees used in the presentation were examples.  You are correct in stating that the sub t/a fees can change from custodian to custodian and from plan to plan.

Q: For an individual with a 403b annuity plan, it sounds like all annuity fees are included in the published "expense ratio," correct?
A: When evaluating an annuity expense ratio we look at the expense ratio for the underlying investment and the M&E risk charge for the annuity component.  There are other fees and expenses that are not part of this "expense ratio" that should be considered such as contract charges, annuity administration fees and surrender fees.  These components are not part of the expense ratio.

Q: What resources do you recommend (books, websites, etc.) to determine what are reasonable plan fee's, industry avg's  etc.
A: Fiduciary Benchmarks, Brightscope, icifactbook.com, and 401k Averages Book

Q: Please clarify how the ERISA bucket works, why created, etc.

Is it prudent to cap retirement plan investment options?

Today's fiduciary Q&A comes from an advisor concerned about the perception and advisability of capping the amount that can be invested in a particularly volatile investment option.

Q: We have been introducing more specialty type funds to our plan sponsors.  In a few cases the plan sponsors have asked if we would limit a participant’s exposure to certain funds.  For example, by only allowing participants to direct a maximum of 6% of their current allocation into a commodities fund.  Yesterday at a client meeting the plan sponsor asked what if any liability the fiduciaries would have if a participant complained at some point in the future that by restricting their purchase of this fund they were held back from meeting their retirement goals?  What is fi360's opinion about limiting access to certain funds within a plan? 

A:  There is always the potential that a participant may complain about how the plan has been managed.  A participant could complain about limitations placed on an investment option to which they wanted to allocate a greater percentage of their portfolio.  Conversely, if the commodities fund performs poorly, they could complain that you should not have made it available to begin with because of its inherent volatility.  It’s a judgment call that must be made with the overriding objective of doing what is in the best interest of the participants.  If volatility is the issue, the safest approach is not to offer the commodities fund in the plan.  But if the decision is made to include it, capping the amount participants can invest is probably prudent. 

If the decision is made to cap the investment, the plan sponsor should clearly communicate the risk/return profile and other characteristics of each investment option to the participants.  This is one of the requirements of 404(c).  In conjunction with that disclosure, information about the cap should be provided as well.  If the participants have issues with the cap, they can always opt not to invest.

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If you have a fiduciary question you would like to have answered, submit it to blog@fi360.com. 

The opinions expressed in this post are those of fi360 and should not be regarded as advice.  Fiduciaries should always make decisions within the context of achieving the goals of the investors they serve.  When in doubt, it always best to consult legal counsel regarding the liability associated with investment decisions.

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.

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.

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.