fi360 Blog

Practice 1.4: Choose your fiduciary partners carefully

When choosing service providers, fiduciaries have an obligation to choose wisely, to ensure that the arrangement fits the needs and rules for the plan, and to make sure that the engagement continues to make sense on an ongoing basis. The best way to manage to those obligations is to reduce any agreement of substance to writing. A written agreement provides both parties with a clear understanding of the roles and responsibilities being delegated, the cost of those services, and other information that could be relevant to the fiduciary appropriateness of the relationship.

Let's take a look at Practice 1.4 and its associated Criteria, which covers agreements with service providers:

Once it has been determined what needs for service providers exists, the fiduciary needs criteria to evaluate providers against. ERISA requires a fiduciary to evaluate fees paid for services for "reasonableness." However, not much more guidance has traditionally been available as to what constitutes reasonableness. New 408(b)(2) rules from the DOL are about to change that.

After long delay, new 408(b)(2) rules are reportedly due out in May of this year. The original rules that were never finalized would have required service provider agreements to be in writing and include all services being provided, all compensation arrangements (direct and indirect), acknowledgment of fiduciary status, disclosure of conflicts of interest, and how any changes to the agreement would be communicated. The new rules are expected to be similar. While the new rules don't lay out exactly what constitutes reasonable, they do provide standard points of comparison that must be provided to allow the fiduciary to make apples to apples judgments. Keep in mind there are other factors to consider that should be addressed in the RFP, such as how well the providers fit the needs and objectives of the portfolio and if anything about them would conflict with the rules of the portfolio.

While 408(b)(2) applies specifically to ERISA plans, the requirements to establish and evaluate service agreements also exist in other fiduciary legislation (see additional resources below for full legal substantiation) and we expect the impact of the new rules will eventually extend beyond the ERISA world. We consider requiring 408(b)(2)-like disclosures for all types of portfolios an industry best practice that would simplify the fiduciary's duty to prudently select service providers.

Even the best service agreements are not something that can just be set and forgotten. The investment industry is constantly evolving, as will the needs of the portfolio. What may have been a good contract intially, may not be so good a few years down the road. For this reason, we recommend reviewing vendor contracts every three years. This gives the fiduciary the opportunity to see if any of the factors that led to the selection of a service provider have changed, including:

• The portfolio has grown in size and new price breaks have become available
• Fees have gone down due to competitive pressure
• The scope of required services has changed
• The vendor's product offering may have expanded
• More appropriate vendor's have entered the market

If a vendor were ever to breach its fiduciary duty, the fiduciary who selected them could be liable for making a poor decision. What would protect them from liability is being able to demonstrate that the selection was based on a prudent process and the provider had given them every indication that they were the most appropriate option available.

For additional resources regarding service provider selection, consult the following resources:

• Complete text of Practice 1.4 from the Prudent Practices for Investment Stewards handbook
• Legal substantiation from Practice 1.4
• DOL updates on 408(b)(2) rules
• Reish article on 408(b)(2) status (see the first bullet)
• The CFA Institute's model RFP
• fi360's 408(b)(2) checklist (available only to AIF/AIFA designees in the designee portal)

Practice 1.3: No self-dealing

The fundamental duty of an investment fiduciary is to manage investment decisions for the exclusive benefit of another party. In the second Practice for stewards and advisors, the objective is to identify and document all of the fiduciaries associated with a portfolio. The third Practice is making sure that those fiduciaries are clear of conflicts of interest.

In a December '09 Report to Plan Sponsors, Fred Reish and Joe Faucher wrote that conflicts fall into two broad categories, those where the plan sponsor has a conflict and those involving service providers. An example of the former would be where the fiduciary gains a personal advantage via their position to direct assets, such as by self-dealing. An example of the latter would be if the advisor is in a position to receive greater compensation by choosing one investment over another. While some conflicts are strictly prohibited, many others are not. Nonetheless, conflicts have the potential to negatively impact a portfolio and its investors/beneficiaries. For that reason and to help limit fiduciary liability, every fiduciary should have a stated conflicts policy that focuses on the disclosure and management of all material conflicts.

Let's take a look at Practice 1.3 and the associated criteria:

In forming a policy, you will want to identify the various types of conflicts that may exist and should be disclosed. An FDIC examination manual identifies the following areas of potential conflict: receipt of fees beyond the trustee's fees, securities related activities, own-bank deposits, administration of discretionary purchase, sale or retention, investment in securities underwritten by own-bank or affiliates, relationships with outside service providers, inter-account or multi-account transactions, contravention of the governing agreement, and privacy. These are obviously bank-specific, but it serves as a starting point for the type of conflicts that can be specified in your own policy.

The next part of the policy would be to specify what to do about them. Again, you would first want be aware of what the legal requirements are for the type of portfolio you are working with. If certain transactions are strictly forbidden, that needs to be noted. If other conflicts are allowable if properly managed, that needs specified as well. A memorandum written for the Council on Foundations advises that, in the case of a Foundation Board, some ways to manage a conflict are to require disclosure in plan documents of all conflicts and make that disclosure available to other decision makers and beneficiaries and to forbid the conflicted party from participating in discussions or votes that relate to the conflict.

Finally, to ensure that all parties are aware of this and other policies, you should include it in yearly reviews and require every fiduciary to acknowledge the policy; their acknowledgement should require them to disclose any conflicts.

Of course, the best thing you can do regarding conflicts is to avoid them altogether. If a fiduciary even thinks he or she may have a conflict of interest, then they probably do.  An excellent question to ask before deciding or voting on an investment issue is:  “Who receives the greatest benefit from this decision?”  If the answer is any party other than the client, participant, and/or beneficiary, the likelihood is the fiduciary is about to breach his or her duties.

One of the surest ways to avoid conflicts is to separate the four major roles--money manager, broker, custodian and advisor--to provide for a system of checks and balances. In examining cases involving breach of fiduciary responsibility, you most often find that one party was responsible for multiple functions. In the case of Madoff, he was essentially wearing all hats.

For additional resources on policies and procedures regarding conflicts of interest and self-dealing, consult the following resources:

• Complete text of Practice 1.3 from the Prudent Practices for Investment Stewards handbook
• Legal substantiation of Practice 1.3
• Reish article: The Plan Sponsor’s Ability to Evaluate Conflicts of Interest
• Reish whitepaper: The Fiduciary Duty to Avoid Conflicts of Interest in Selecting Plan Service Providers
• SEC/DOL joint Tips for Fiduciaries: Selecting and Monitoring Pension Consultants
• Office of the Comptroller of the Currency: Conflicts of Interest

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The Spotlight on Practices series highlights one of the Prudent Practices for Investment Fiduciaries in order each month. To learn more about the Practices, click "Spotlight on Practices" link in the categories list or visit the Practices page on fi360.com.  If you have any questions or comments, leave them in the comments section below each post, or email us at blog@fi360.com.

Concerns about fiduciary responsibility are not U.S. specific

It was not long after we published the Practices in our first fiduciary handbook in 2003 that we were approached by a New Zealand financial services firm.  They had been referred by a common business associate and wanted to learn more about these defined fiduciary practices; it was something they felt was missing in New Zealand.  It was not our intention to expand beyond the U.S. so soon, but since that initial inquiry we have published fiduciary handbooks in New Zealand, Canada, and Australia and there is interest in doing so in Singapore, South Africa and the United Kingdom.  We have found that the Practices are substantially the same in these developed countries: managing money is managing money.

We have written numerous posts over the past several months highlighting what has been happening with financial services reform in general, both legislative and regulatory, and efforts to extend the fiduciary standard in particular.  In light of what is happening here, we decided to take a closer look at what is happening elsewhere and see if it might provide some useful insights.

New Zealand and Australia are grappling with the same issues and coming to the same conclusions; more must be done to protect those whom the fiduciaries serve: plan participants, beneficiaries, and investors.  In November 2009 the Parliamentary Joint Committee on Corporations and Financial Services in Australia completed what is commonly referred to as the Ripoll Report (www.aph.gov.au/senate/committee/corporations_ctte/fps/report/index.htm), which looked at issues associated with the collapse of Australian financial services firms including Storm Financial and Opes Prime.  The report made eleven recommendations; Recommendation 1 stated;

"The committee recommends that the Corporations Act be amended to explicitly include a fiduciary duty for financial advisers operating under an AFSL (Australian Financial Services License), requiring them to place their clients' interests ahead of their own."

Our adjunct faculty member in New Zealand recently heard from a colleague to whom he has preached the fiduciary message for several years now who said:

"I have noted that the Ripoll Report into financial advice in Australia is talking about enshrining advisers fiduciary responsibilities in legislation and that the code committee here (New Zealand) is looking at advisers fiduciary responsibilities.  It seems the time may well be coming where accredited fiduciaries would be well regarded."

New Zealand often looks to the U.S. to get a sense of where the financial services industry is headed.  With respect to fiduciary responsibility, we're please to see it appears Australia, New Zealand and the U.S. are heading in the same direction.

Practice 1.2: Roles must be documented and acknowledged

It is not uncommon for some investment fiduciaries to be unaware of their status and liability when working with investment portfolios, or for gaps to exist where certain essential functions are not being performed for the portfolio. This is particularly true among investment stewards, who will ultimately be held responsible for ensuring all duties are being fulfilled. Ignorance, however, is not a viable excuse when it results in a fiduciary breach. For this reason, the second Practice in a prudent investment process is to identify every party involved, fiduciary and non-fiduciary alike, document their respective roles and have those who are acting in a fiduciary capacity acknowledge so in writing.

Let's take a look at the Practice and associated Criteria:

As we touched on in Practice 1.1, the investment policy statement (IPS) is the de facto business plan for an investment portfolio and must contain the details for the management of the investment plan. As such, it is here that you should define the roles and responsibilities of everyone involved in the investment process. Some of the specific roles that should be spelled out in the IPS are those of the investment committee, the investment advisor, the custodian, and money managers. Those are the primary involved parties, but may not be exhaustive of all the roles involved in a particular portfolio. Also, roles may be identified by title in the IPS, rather than name, for the sake of continuity when turnover occurs. Names can be attached to titles in service provider agreements and fiduciary acknowledgment letters.

Practice SA-1.1: Know and follow the rules

The first of the Prudent Practices is all about knowing and following the rules. This goes for all rules impacting the portfolio, including legal requirements and those set in documents related to the establishment and management of investments. The starting point for the fiduciary process is similar to the starting point in any management task or starting a new business: know your goals and objectives, know the rules, and know what limitations you face. Let's take a look at the Practice and criteria themselves:

Applicable law and oversight depends on the type of portfolio being managed. One of the first things you will want to do as a fiduciary is to verify with legal counsel the appropriate body of law governing the plan or portfolio. In general, corporate qualified plans like 401(k)s and pensions fall under ERISA with Department of Labor oversight; Taft-Hartley multiple-employer plans, which have a special sub-set of rules under ERISA, do as well. Most other fiduciary portfolios fall under state oversight. In these cases, there are uniform codes drafted by a national commission that states may choose to adopt (MPERS for public retirement plans, UPMIFA for foundations and endowments, and UPIA for private trusts) or they may have adopted their own legislation or tweaked the uniform acts for their state. You will need to confirm the exact statutes governing these types of plans for your state.

The next place to look for special rules are in trust or plan documents set at the establishment of the portfolio. Here you may find restrictions on certain asset classes, socially-responsible investment mandates, relief of certain fiduciary duties, participant and beneficiary requirements, etc. This criterion serves two purposes: to familiarize yourself with the special rules and to ensure special plan rules are not in conflict with legal requirements.

The remaining essential document to review at the outset is the investment policy statement. The IPS is perhaps the most important document in the management of an investment portfolio. It is the equivalent of the business plan and needs to contain detail such that a competent third party can step in and administer the portfolio if necessary. We won't get into the development of an IPS until Practice 2.6, but if your review of plan documents for an existing portfolio reveals that no IPS exists or it is poorly written, you will want to take steps to address the deficiency immediately.

Finally, you'll want to compile the various documents pertaining to fiduciary processes into a "Fiduciary File."  This ensures that there is a single place to refer to when questions about plan or portfolio management arise and for the successful continuation of that management in the case of steward or advisor turnover. At a minimum, the fiduciary file should include trust documents, the IPS, meeting minutes from investment committee meetings, custodial and brokerage agreements, service agreements with investment service providers, ADVs for each mutual fund manager, and performance reports from service providers. If you look back to our post on the fiduciary role of investment stewards, the fiduciary file would contain any documents you would want with you when you visited "the chair" to defend your investment management decision-making process.

Different types of fiduciaries will have different levels of expertise, and each will have to dedicate varying amounts of time and energy on the first Practice.  Each portfolio is different, which is why it is so important for every individual or firm stepping into a fiduciary role to familiarize themselves with the unique needs and requirements of the investors they are serving.

For more information on fiduciary rules, check out the following resources:

• Full text of Practice 1.1 from Prudent Practices for Investment Stewards
• Legal substantiation by Reish and Reicher
• fi360's IPS Generator
• The National Conference of Commissioners on Uniform State Laws website for more information on MPERS, UPIA and UPMIFA
• All about UPMIFA
• Cross reference of ERISA in U.S. Code with links to complete text 
• Department of Labor ERISA compliance assistance
• Morningstar Investing Classroom's Creating your IPS

Special note to Practice 1.1: For this post, we are referring to the first practice on the Practice Periodic Table, all of which apply to both investment stewards and advisors. However, in the Prudent Practices for Investment Advisors handbook there is a unique practice that precedes SA-1.1 . This additional Practice was added to cover those rare circumstances when the advisor may not be deemed to be a fiduciary. In such situations the advisor must still demonstrate an awareness of fiduciary roles and responsibilities in order to assist the client who does have fiduciary status.

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The Spotlight on Practices series highlights one of the Prudent Practices for Investment Fiduciaries in order each month. To learn more about the Practices, click "Spotlight on Practices" link in the categories list or visit the Practices page on fi360.com.  If you have any questions or comments, leave them in the comments section below each post, or email us at blog@fi360.com.

Intro to the Prudent Investment Practices

Not only do investment fiduciaries have a major role in the fiscal health of individual investors and of our country, they also carry major personal liability. And yet many fiduciaries either are unaware of the full extent of their responsibility or do not follow a defined process. Their success or failure is ultimately judged by the process they follow, rather than the specific decisions they make. For this reason, the Prudent Practices for Investment Fiduciaries were introduced as a guide for an investment process that covers all of the major responsibilities of an investment fiduciary. 

This is the first post in a new series we're introducing to the fi360 Blog, in which we'll highlight the individual Practices in order, beginning with today's post on the formation of the Practices. In the meantime, you can always visit the Practices page from our website to learn more and download PDF copies of the handbooks that detail the Practices, as well as other supporting documents and information.

The Practices were formed first by looking at the the major pieces of U.S. law governing investment fiduciaries: ERISA, UPIA, MPERS and UPMIFA. From these four laws, seven common principles, or, as we call them, Precepts, can be derived that address the basic tenets of fiduciary responsibility: the duty of loyalty, exclusive purpose and utmost good faith.

Another important influence on the structure of the Practices is the idea of a standard. Using the International Organization for Standardization (ISO) as a model, standards are a body of knowledge that are substantiated and authoritative. Standards are comprised of Practices that detail the application of the Precepts, with each Practice further detailed by Criteria for the implementation of the Practice. Specifically, we have adapted the ISO 9000 standard as an organizational model for the Practices, which is a quality management system that stresses continual improvement (see graphic below).

Using the Precepts as the guiding principles; legislation, regulation and case law for the specific requirements; and organized around the four-step investment management process, we developed the Practices and supporting Criteria, forming a complete Standard. The objectives of the Practices are to define a prudent process that is comprehensive, but not cumbersome, provide a checklist approach to guide any investment fiduciary in the pursuit of fiduciary excellence, and enable any organization to assess its fiduciary process.

The Practices are detailed in the handbooks Prudent Practices for Investment Stewards and Prudent Practices for Investment Advisors, each book containing the same Practices, but with specific information for the implementation of the Practices for the different types of investment fiduciaries. There is also a Prudent Practices for Investment Managers handbook with a different set of Practices for money managers based on best practices. All of the Practices can viewed in the Periodic Table below (click on the image for a larger view), which shows both sets organized within the quality management system.

The Practices are available to the public and intended for all investment fiduciaries who want to strengthen their fiduciary processes. Legal citations in the handbook were provided by the law firm of Reish & Reicher, with full legal substantiation provided in a separate Legal Memoranda handbook. The handbooks also have been reviewed by the Personal Financial Planning Division of the AICPA.  Implementing and demonstrating adherence to the Practices limits liability as a fiduciary, as they help establish evidence that a prudent investment process is being followed and ensure that all fiduciary duties and responsibilities are being addressed by the various parties in the investment process, among other benefits.

This is only a brief introduction to the Practices and we encourage you to download copies of the handbooks for a more thorough introduction and to review the Practices themselves. If you have any questions, let us know either in the comments below, or by emailing us at blog@fi360.com. 

Next month, we'll look in detail at Practice SA-1.1, "Investments are managed in accordance with applicable laws, trust documents, and written investment policy statements."