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Practice 2.3: Model a level of return that is optimal and realistic

In last month's post on Practice 2.2, we talked primarily about the risk side of the balancing act a fiduciary must perform in meeting the investment time horizon objectives set in Practice 2.1. Practice 2.3 then focuses on the return side of the equation. It focuses on modeling a portfolio that is tied to cash requirements and is based on reasonable assumptions.

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

We say that the modeled level of return needs to be both optimal and realistic. "Optimal" means that the selected profile can be found on the efficient frontier at a point that is expected to allow the investor to meet his or her objectives without taking on unacceptable risk. "Realistic" means that there is a fiduciary obligation to use reasonable assumptions and reliable tools to estimate the return. Projecting returns that are unlikely to be achievable or unfairly skew to favor types of investments that an advisor or manager would benefit from at the expense of the investor would be considered fiduciary breeches.

That said, there is no fiduciary requirement or expectation that the advisor be capable of forecasting future returns. Rather, fiduciaries are required to demonstrate that a prudent process was followed in developing the assumptions used to model the probable outcomes of a range of investment strategies. Equipped with a modeled return, a fiduciary can conduct discounted cash flow models to determine if the return will be sufficient to meet the portfolio goals and objectives.

To learn more, consult the following resources:

• Complete text of Practice 2.3 from the Prudent Practices for Investment Stewards handbook
• Legal substantiation to Practice 2.3 from ERISA, UPIA, UPMIFA and MPERS
• fi360's Asset Allocation Optimizer, which can calculate the risk, return, and large loss scenarios of a client’s portfolio utilizing the Resampled Efficiency™ portfolio optimization technique
• Research from New Frontier Advisors, the developers of Resampled Efficiency™
• Harry Markowtiz's landmark work on modern portfolio theory: Portfolio Selection: Efficient Diversification of Investments

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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.

Practice 2.2: Find a level of risk that is necessary and tolerable

Proper diversification and effective portfolio management techniques can help control the amount of investment risk a portfolio is exposed to. However, in most cases, some level of risk is necessary in order to meet future cash flow requirements. The second practice of the Formalize step of the Fiduciary Quality Management System is to identify a level of risk for a portfolio that is just enough to meet investment objectives, yet not so much that fiduciaries would be compelled to abandon the investment strategy at exactly the wrong time.

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

  

The balancing act that the fiduciary must perform is to both be comfortable that they have put the portfolio in a position to succeed in meeting it's stated objectives as well as not exposing it to so much risk that it couldn't weather a "large loss" scenario if things didn't play out as anticipated. Simply stated, a fiduciary has the potential to "fail" by being too conservative or too aggressive. A fiduciary could adopt a "safe" strategy by keeping a portfolio in cash, but then see the portfolio's purchasing power whither under inflation. Or, a fiduciary could adopt a sound, long-term aggressive growth strategy that is abandoned at the first sight of a downturn in the market.

One suggested approach is to "stress test" an investment strategy by analyzing possible investment outcomes (large loss, most likely, and best case) over the next one, three, and five years. The fiduciary should then consider the possible consequences of each outcome:

1. Will the investment results enable the fiduciary to cover short- and long-term liabilities and/or objectives?
2. Can the fiduciary stomach the "large loss" scenario?

If the answer to either of these questions is "no," then the fiduciary has some decisions to make. They must either adjust the investment strategy until they find one that passes this stress test, or recalibrate objectives to allow a lower risk and return strategy.

To learn more, consult the following resources:

• Complete text of Practice 2.2 from the Prudent Practices for Investment Stewards handbook
• Legal substantiation to Practice 2.2 from ERISA, UPIA, UPMIFA and MPERS
• fi360's Asset Allocation Optimizer, which can calculate the risk, return, and large loss scenarios of a client’s portfolio
• A primer from FINRA on managing investment risk
• FinaMetrica's risk profiling system, an article that profiles their strides in making risk tolerance profiling a more meaningful pursuit, a study using FinaMetrica that measures peoples' behaviors when confronted with investment risk and their own primer on risk profiling (Note: Finametrica is an fi360 partner)
• The Ibbotson® SBBI® Valuation Yearbook for "estimating the cost of capital"
• The online book An Introduction to Investment Theory on calculating risk and return

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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.

Practice 2.1: Project cash requirements to determine the time horizon

To introduce the Formalize Step of Practices, the last post in our Spotlight on Practicesseries featured the hierarchy of decisions. At the top of that hierarchy, and the focus of Practice 2.1, is the identification of the investment time horizon. 

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

Regardless of the type of portfolio being managed, the most fundamental concern is to appropriately align the cash that can be generated from the portfolio to the cash outflows that will be required to be withdrawn from the portfolio. Think of cash outflows as liabilities. Ideally, we are seeking to align the asset composition to the liabilities. If the expected near term liability stream is high, the time horizon is short. Conversely, if most liabilities are not expected to occur until many years in the future, the time horizon is considered long.

For all types of portfolios cash flow projections are critical. It is strongly recommended that cash flow projections be documented and included as an attachment to the investment policy statement. The second through fifth criteria above indicate special considerations necessary for the different portfolio types.

The final criteria calls upon the fiduciary to maintain sufficient liquidity to meet contingency plans. For portfolios where significant cash outflows are expected, a specific allocation to cash is recommended to minimize disruptive trading. If the portfolio is quite large and the timing and amount of cash flows is highly uncertain, the fiduciary should focus on protecting the value of invested positions rather than to hold a large amount of cash.

To learn more, consult the following resources:

• Complete text of Practice 2.1 from the Prudent Practices for Investment Stewards handbook
• Legal substantiation to Practice 2.1from ERISA, UPIA, UPMIFA and MPERS
• An SEC beginner's guide to asset allocation, diversification and rebalancing

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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.

Formalizing the investment strategy

Our Spotlight on Practices series has looked at all of the Practices in the Organize step of the fiduciary quality management system and will soon be moving into the Formalize step. In the Formalize step, the fiduciary will be expected to act as a prudent expert in establishing proper portfolio diversification and preparing an effective investment policy statement.

Beginning with the first Practice of this step, the fiduciary will be making the decisions that will eventually lead to actual investment selection. There is a hierarchy to those decisions that many investors and fiduciaries have a tendency to reverse. They tend to focus on the hot manager or fund before developing an asset allocation strategy when research has shown that the allocation of assets is the most important determinant of the variation of returns in portfolios. As a fiduciary, your priorities must be properly placed upon asset allocation issues.

The following hierarchy of investment decisions illustrates our prioritized approach to asset allocation, which leads to manager/fund selection: 

 

The most important decision is to determine the investment time horizon, which we define as that point in time when more money is flowing out of the portfolio than what is coming in from contributions and the anticipated growth.  All other decisions flow from this.

Second only to the time horizon in importance is the decision regarding what asset classes will be considered. If the time horizon is less than five years, the portfolio should be limited to fixed income and cash.  If the time horizon is long (meaning five years or more), equities and other asset classes can be considered.

The next decision is to determine the proper mix among broad asset classes.  For example, if our time horizon is long, we will include equities, bonds, and cash.  What will be the mix between these classes? That depends upon a number of factors that we will discuss later, but for the sake of illustration, a balanced portfolio may include 60% allocated to equities, 30% to fixed income, and 10% to cash.

Next, we consider what will be the allocation to sub-asset classes and/or peer groups within the broad classes. For example, what percentage will be in large-cap stocks, versus the proportion allocated to growth, value or blend?

Finally, and the least important decision in the hierarchy, is the selection of the manager or fund.

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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.

Practice 1.5: Have recourse if the money disappears

Practice 1.5 is the final Practice in the Organize step of the fiduciary quality management system. The purpose of this Practice is to ensure that legal recourse exists in the event that it is determined fiduciary assets are not being prudently managed.

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

When the Department of Labor stepped in and appointed outside trustees to replace Enron's pension committe, it was a perfect example of how important the first criteria can be. It may not have prevented abuse, but it at least gave the victims recourse when it did happen. If assets are held out of country or outside the purview of any regulator, then little can be done when mismanagement or fraud occurs.

A permissible exception would be when advisors are managing the personal assets of an individual client or private trust. They are not precluded from considering the establishment of foreign accounts. However, the fiduciary should be able to demonstrate that this is in the client's best interest, does not conflict with any trust documents, and explain what protections do or do not exist in the event of mismanagement.

In the case of an ERISA-qualified retirement plan, fiduciaries are required to ensure a surety bond is in place to ensure that the assets of the plan are protected from loss due to theft or embezzlement.

While specific requirements for this Practice are not always defined in the major legislation, the law firm of Reish & Reicher notes in the Legal Memoranda handbook that each does imply a fiduciary duty to "preserve and protect assets from risk." A duty that would best be fulfilled by measures such as maintaining assets in the United States, insuring against losses from fiduciary violations, and bonding those who have acces to assets. Failure to do so could be considered a breach itself.

To learn more, consult the following resources:

• Complete text of Practice 1.5 from the Prudent Practices for Investment Stewards handbook
• Legal substantiation to Practice 1.5
• Visit the DOL's ERISA enforcement page for examples of the types of actions they may take to protect and preserve at-risk plan assets

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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.

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)

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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.

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.