fi360 Blog

Fiduciary consulting--embrace it

We received a call from an AIF designee earlier this week asking for help.  He was updating his personal information in the CFP database and having trouble finding a category in the database drop down list that fit the fiduciary service he was providing to clients.  My impression was that there must have been an "Other" category that he could select, but he needed to provide a short description of what "Other" was.  His voice mail indicated that he was thinking of using "Fiduciary Adviser," but when we talked, we agreed that "Fiduciary Adviser" was too narrow as it typically refers to providing specific investment advice to qualified plan participants per the Pension Protection Act.  After listening to what services he was providing, my suggested description was "fiduciary consulting."  He liked the description and intended to contact the CFP Board and suggest it be added to the drop down list in their database.

Our sense is that the demand for fiduciary consulting is increasing.  We just completed AIF and AIFA programs at the University of Pittsburgh that had to be added to the initial schedule released at the beginning of the year.  CEFEX has seen a steady increase in phone calls asking about fiduciary assessments and certification programs.  Large insurance providers are partnering with registered investment advisory firms that provide ERISA 3(21) and 3(38) services to qualified plans.

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. 

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.

Does Adherence to the Practices Really Make a Difference?

I was teaching an AIF classroom program in San Diego last month and one student asked during a break:  "how can I convince prospective clients that these Practices really make a difference; most of them just don't get it."  His underlying message was that the focus is always on performance and that any discussion beyond that is either misunderstood, disregarded, or ignored. 

I proceeded to give my standard answer as I get this question somewhat regularly.  This standard answer typically touches on the following basic points:

• The fiduciary standard is a process, not performance, standard, so if someone complains and you end up in litigation or arbitration, it is your process that will be scrutinized.  Admittedly, part of that process includes monitoring performance.
• Following the Practices, which we often refer to as a defined checklist, helps to ensure that something does not fall through the cracks.  Most fiduciary breaches result from errors of omission, rather than commission; most are trying to do the right thing.
• As your process improves, better performance will follow.  For example, using established, objective criteria to select the investments and service providers; formalizing an investment policy statement to guide all investment management decisions; and controlling and accounting for investment expenses, will all drive better performance.

The last point is usually where I hear (and this time was no different):  "do you have any data to support the notion that better process means better performance?"  In the past my answer has been no ("we firmly believe it is true, but can't prove it"), but a recent study does provide some ammunition; finally!

Practice 1.4 of our Prudent Practices for Investment Advisors handbook says "Fiduciaries and parties in interest are not involved in self-dealing."  That means you avoid conflicts of interests whenever possible, or you disclose and get informed consent to any conflict that remains.  In 2005, the SEC conducted a study of pension consultants and found that the majority of those consultants had conflicts that were not adequately disclosed.  A recent GAO follow-up study titled "Private Pensions - Conflicts of Interest Can Affect Defined Benefit and Defined Contribution Plans" and published on March 24, 2009, points to a statistically significant 1.2 to 1.3 percent performance differential between defined benefit (DB) plans where the pension consultants adequately disclosed their conflicts of interest and those that did not.  Those plans that were better informed regarding conflicts of interest had higher investment returns.  The study focused on DB plans, but argued that the results could be applied to defined contribution (DC) plans as well.  Although the GAO Report clearly points out that this study alone is not "necessarily evidence of a causal relationship," and the study only relates to one of the fiduciary practices, it is data that supports our firm belief that incorporating the Practices will result in a better process, which drives better performance.

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.

The Satyam scandal and the risk of emerging markets

Last week, we looked at the Madoff scandal and how following a fiduciary process would help you avoid getting caught in it or a similar scheme.  Also during last week, the Satyam scandal broke in India, where the chairman of the outsourcing company admitted he had been cooking the books to overstate their performance.  Much of the attention stemming from the scandal here has been focused, obviously, on confidence in India's corporate governance culture, or lack thereof, and lack of confidence in emerging markets in general. 

Now the question for you, as a fiduciary, is what to do regarding emerging markets?  Well, I think that what this latest scandal highlights is just why emerging markets are considered the higher risk proposition to begin with. 

Practices 2.1-2.3 of our Prudent Practices for Investment Advisors handbook outline how to identify risk, return and time horizon in establishing proper portfolio diversification. Practice 2.4 then states, "Selected asset classes are consistent with the risk, return and time horizon." The basic premise is that asset classes should be selected in the context of how they advance a client's investment goals.  If emerging markets are to be used, it should be understood just how risky they are and the potential for the "worst-case" scenario to unfold is weighted appropriately.

In terms of practically applying those Practices, the two questions as it relates to emerging markets are how good are your capital market inputs and when does it make sense to add them as an asset class.  As references from fi360, our Asset Allocation Optimizer uses New Frontier Advisors' capital market inputs (which are due to be updated by the end of January, so you may want to check back to this link at that time) and our AIF Training program includes a slide on suggested sequence for adding asset classes, both of which demonstrate the high level of risk we associate with implementing emerging markets into a portfolio. When markets are particularly volatile or industry-affecting events occur, your may want to reevaluate your inputs and asset classes selected. 

What all this means is that while the Satyam scandal has given investors a lot to think about in regards to India and emerging markets in general, a well-diversified portfolio built using sound fiduciary processes is not going to overly depend on the use of emerging markets, if they are even used at all.  Emerging markets are, by definition, coming from areas with high levels of volatility and political, governance, and other risks, risks that can come to fruitiion in regards to investment return in scenarios such as this one. So, before attempting to implement emerging markets into a fiduciary portfolio, you should have an understanding of their context within the Formalize Step of the Fiduciary Quality Management System.

Mapping Retirement Assets in Down Markets

The following post was written by AIFA designee Lyle Kearns. It is an interesting situation in which he seeks input from you, his peers, in how best to approach a specific retirement plan transition. If you have any thoughts, please leave them for all to see by clicking the "Comments" link below the post. This is the first post written by a designee on the fi360 Blog. It is a great example of how we would like to make this blog a valuable resource available to all AIF/AIFA designees. If you would like to write a post like this one, or of interesting insights you have to offer, let me know by emailing blog@fi360.com to request access.

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Retirement plan transitions can be tricky enough in the best of times but with the market down roughly 40% there are some additional issues that arise.  Now consider a plan in which half of the assets belong to retired participants and a significant number of them are holding 100% equity portfolios.

Facts & Circumstances

Our firm is working with a new client to help improve their $20 Million 401(k) plan.  Over the last year we have worked closely with management to educate them about the retirement plan industry and their fiduciary responsibility; we have also conducted multiple participant surveys and focus groups as well as informational meetings.  Most recently we have completed an RFP process and helped the client select a new bundled retirement plan provider (they previously worked with a regional record keeper that provided no education or advice).  The new vendor will take over the plan on March 31, 2009.

This plan was a trustee directed plan for years and the trustees had placed all the assets with one money manager who ran a US equity multi-cap value strategy.  For the last ten years the manager did a terrific job and posted some exceptional numbers.  Through the downturn in 2000-2003 they provided amazing returns and many participants thought their accounts were invincible.

Approximately three years ago the money manager sold his firm and retired.  It was at this time that the plan trustees decided to open the plan up to participant direction and, in addition to what was now the US large cap value oriented separate account, they added a US large cap growth mutual fund and a total return bond fund.  A simple line up of three choices seemed appropriate for participants that had never exercised self direction before.

As of today, 68% of the plan assets remain in the large value separate account.  Our conversations with participants indicate that their lack of diversification is a result of both the confidence they had in the strategy based on past experience and a lack of sophistication and education regarding investments.

The organization has now approved a fully diversified fund lineup to be used on the new vendor's platform.  18 institutional mutual funds representing various asset classes and styles of investing as well as a series of passive target date funds that have been approved for use as QDIAs.

Continue reading "Mapping Retirement Assets in Down Markets " »

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The requirement for a well-defined and consistently applied due diligence process for selecting and monitoring investment options is without question. It is a common thread throughout the four-step investment management process detailed in the Prudent Practices for Investment Advisors handbook

• Practice A-2.6 states “There is an Investment Policy Statement which contains the detail to define, implement, and monitor the client’s investment strategy.”
• Practice A- 3.1 states “Each client’s investment strategy is implemented in compliance with the required level of prudence.”
• Practice A-4.1 states “Periodic reports compare investment performance against an appropriate index, peer group, and IPS objectives.
• Practice A-4.2 states “The periodic reviews are made of qualitative and/or organizational changes of investment decision-makers.”

The “Custom Due Diligence Criteria” feature of the fi360 Platinum Toolkit facilitates the satisfaction of the aforementioned Practices. Subscribers now have the ability to define a unique due diligence criteria made up of as many as 15 sets of “factors” and “thresholds.” [An example of a factor and threshold set is 5-Year Performance (factor) and Top Quartile (threshold).] Numerous factors are available, including the fi360 Fiduciary Score™ which has become an industry standard, independent, rating of the minimum due diligence criteria any fiduciary should be using. In addition, each factor and threshold set can be assigned a level of importance: "Required" or "Optional".

Go to the "Managing your Watch List" heading and select "Creating your own Due Diligence" on our Tutorial page to learn more.

Investment Due Diligence--Search, Selection and Monitoring

The requirement for a well-defined and consistently applied due diligence process for selecting and monitoring investment options is without question. It is a common thread throughout the four-step investment management process detailed in the Prudent Practices for Investment Advisors handbook

• Practice A-2.6 states “There is an Investment Policy Statement which contains the detail to define, implement, and monitor the client’s investment strategy.”
• Practice A- 3.1 states “Each client’s investment strategy is implemented in compliance with the required level of prudence.”
• Practice A-4.1 states “Periodic reports compare investment performance against an appropriate index, peer group, and IPS objectives.
• Practice A-4.2 states “The periodic reviews are made of qualitative and/or organizational changes of investment decision-makers.”

The “Custom Due Diligence Criteria” feature of the fi360 Platinum Toolkit facilitates the satisfaction of the aforementioned Practices. Subscribers now have the ability to define a unique due diligence criteria made up of as many as 15 sets of “factors” and “thresholds.” [An example of a factor and threshold set is 5-Year Performance (factor) and Top Quartile (threshold).] Numerous factors are available, including the fi360 Fiduciary Score™ which has become an industry standard, independent, rating of the minimum due diligence criteria any fiduciary should be using. In addition, each factor and threshold set can be assigned a level of importance: "Required" or "Optional".

Go to the "Managing your Watch List" heading and select "Creating your own Due Diligence" on our Tutorial page to learn more.