Category Archives: prudent

Best Practices for Plan Sponsors #6

Best Practices: Why Wait Until After You are Sued?

I am writing two series of articles that together are called “The Bests.” One is about Best Practices for plan sponsors, while the other is about the Best Interest Standard of Care for advisors. Each series is numbered separately to make it easier to identify the subject that is most relevant to you.

This is the sixth of the series about Best Practices for Plan Sponsors.

I am surprised that, after all of the fiduciary litigation against 401(k) plan sponsors, many plan sponsors and their committees have not taken the basic steps to minimize the risk of being sued, or if sued, of being liable. In most of the settled cases, the plaintiffs’ class action attorneys require that certain conditions—or “best practices”—be adopted by the plan fiduciaries. And, in settlement after settlement, those conditions are, by and large, the same. That raises the obvious question, why haven’t plan committees reviewed these cases and instituted the practices required by the settlement agreements?

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Best Interest Standard of Care for Advisors #7

What Does Best Interest Mean . . . In the Real World? (Part 4)

I am writing two series of articles that together are called “The Bests.” One is about Best Practices for plan sponsors, while the other is about the Best Interest Standard of Care for advisors. Each series is numbered separately to make it easier to identify the subject that is most relevant to you.

This is the seventh of the series about the Best Interest Standard of Care.

In my last three posts (Best Interest Standard of Care for Advisors #4 and #5 and #6), I discuss the Best Interest standard of care and its practical application. This article discusses a novel approach for compliance with the fiduciary standard for the selection of investments for 401(k) plans. All the more interesting, the approach was part of an opinion of the U.S. First Circuit Court of Appeals.

In October 2018, the First Circuit considered an appeal of a 401(k) case where Putnam Investments, and its fiduciaries, were the defendants. At one point, the defendants argued that, if the court found fiduciary liability under the facts of the case, it would discourage employers from adopting 401(k) plans. The Court of Appeals responded by saying:

“While Putnam warns of putative ERISA plans foregone for fear of litigation risk, it points to no evidence that employers in, for example, the Fourth, Fifth, and Eighth Circuits [which found that similar facts could result in liability], are less likely to adopt ERISA plans.”

The opinion went on to describe a “safe harbor” from fiduciary liability:

“Moreover, any fiduciary of a plan such as the Plan in this case can easily insulate itself by selecting well-established, low-fee and diversified market index funds. And any fiduciary that decides it can find funds that beat the market will be immune to liability unless a district court finds it imprudent in its method of selecting such funds, and finds that a loss occurred as a result. In short, these acts are not matters concerning which ERISA fiduciaries should cry ‘wolf.’”

I think it goes without saying that the court’s language was gratuitous . . . and it is a bit disturbing for judges to give investment advice.

Nonetheless, there is a point to be made. That is, at least from this Court’s perspective, the starting point is to consider index funds. Then, plan fiduciaries should seek to identify other funds, including actively managed funds, that can reasonably be expected to match or outperform the index funds. (Note that I say index funds, rather than indexes. That’s because an index fund, subject to its expense ratio, is the investable version of an index.)

In some ways, this is not different from what is commonly done. Based on my participation as a lawyer in plan committee meetings, the investment reports that advisors give to plan committees typically compare the plans’ mutual funds to appropriate indices. And, if there is sustained underperformance vis-a-vis the index, the advisors usually recommend that a fund be removed.

However, it is more complicated than that. For example, other factors can be considered, such as volatility. A less volatile investment may be more appropriate for a retirement plan and particularly for a plan covering employees who aren’t experienced investors. Also, a particular index may not be an appropriate benchmark for certain mutual funds.

In the final analysis, the issue is whether a plan committee engaged in a prudent process to select the investments; it is not whether the process predicted the best future outcome. Nonetheless, the process must have an intended outcome, and it is not unreasonable to conclude that one objective of the process is to select investments that are anticipated to outperform a comparable index fund.

Advisors and plan sponsors shouldn’t be fearful of selecting actively managed funds where there is a reasonable basis to believe that the performance of those funds will, over time, equal or exceed that of comparable index funds. So long as the process is prudent, the fiduciaries will have satisfied their legal responsibilities.

To automatically receive these articles in your in box, you can sign up on my blog at http://fredreish.com/insight/. Just enter your name and email address under the “sign up for our e-newsletter” option, and click on the button to subscribe.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

 

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Best Interest Standard of Care for Advisors #6

What Does Best Interest Mean . . . In the Real World? (Part 3)

I am writing two series of articles that together are called “The Bests.” One is about Best Practices for plan sponsors, while the other is about the Best Interest Standard of Care for advisors. Each series is numbered separately to make it easier to identify the subject that is most relevant to you.

This is the sixth of the series about the Best Interest Standard of Care.

In my last two posts (Best Interest Standard of Care for Advisors #4 and #5), I discussed the definition of the Best Interest standard of care, with a particular focus on the duty to exercise care, skill, prudence and diligence in developing recommendations for investors. Those articles commented on the consistency in the Best Interest and fiduciary standards being developed by the SEC and several states (including New York), as well ERISA’s duty of care and duty of loyalty.

Bests #9 discussed the similarities of the standards of care and Bests #10 talked about the consideration of costs. This article focuses on considerations of the quality of the products and services and on portfolio investing.

Under ERISA’s fiduciary rules, advisors are required to use generally accepted investment theories and prevailing investment industry practices, based on factors such as the needs and circumstances of the investor and the purpose for the investment recommendation. While there is not an explicit definition of “generally accepted investment theories,” the most accepted investment theory is Modern Portfolio Theory. Generally stated, Modern Portfolio Theory contemplates a diversified portfolio of investments that are not highly correlated with each other. Thus, while there may be cases where non-diversified recommendations could be made, the starting point—and the general rule—is that a Best Interest advisor should recommend a balanced portfolio that is appropriate for the investor. It is fair to say that Best Interest advice mandates the use of a balanced portfolio, absent circumstances that would reasonably justify an exception.

The second subject of this article is greater emphasis on the quality of investments, products and services imposed by the Best Interest standard. For example, an advisor (and his or her supervisory entity) would need to consider the financial stability of an insurance company when recommending an annuity. Similarly, an advisor would need to consider the quality of the investment manager in recommending a mutual fund or collective trust.

Think about it. While many similar investments may be suitable for a particular investor, a critical distinguishing factor—in addition to cost—between different investments is the quality of the investment management. Where an advisor is required by a Best Interest standard to (1) act with care, skill, prudence and diligence in determining which investments to recommend, and (2) to act in the best interest of the investor, it seems fairly obvious that the result of that process would be a high-quality, reasonably-priced investment. For example, with mutual funds or collective trusts, it would mean that the investment managers had superior skills and research and that their track record supported that conclusion. In other words, it involves both a qualitative and a quantitative analysis. The qualitative analysis would look both backwards and forwards. By backwards, I mean that the investment managers would have demonstrated that they are able to produce superior results. By forward looking, I mean that the investment advisory organization would be likely to continue to produce those results into the future. That involves consideration of the investment managers, the support staff–including analysts, the stability of the organization, the experience in managing in that style, and so on. On the other hand, the quantitative analysis is primarily backward looking. It would be historical performance measured against appropriate benchmarks, diversification, volatility, and so on. In effect, it would be historical numbers that measure important attributes of past performance.

The considerations for annuities are similar, in the sense that the quality and strength of the organization—that is, the insurance company—are critical factors. Is the insurance company financially stable and likely to continue to be so in the future? For example, where an annuity is recommended, the payments may extend 20 or 30 years, or more, into the future. Based on today’s financial data and the quality of the management of the insurance company, is it likely that the company will be there to make the annuity payments when due?

It is critical that advisors and their firms understand and evaluate these issues. Compliance requires nothing less.

While much of the burden of compliance falls on individual advisors, the responsibility can be shared with their firms. For example, a broker-dealer can vet the financial stability of the insurance companies that can be recommended by its advisors. In turn, if the advisors understand that process, and reasonably conclude that it is adequate they can adopt it as their own and use it as a basis for recommending those products where they satisfy the Best Interest standard for the customer. In other words, the responsibilities discussed in this article can be satisfied collaboratively by the combined efforts of the firm and the individual.

To automatically receive these articles in your in box, you can sign up on my blog at http://fredreish.com/insight/. Just enter your name and email address under the “sign up for our e-newsletter” option, and click on the button to subscribe.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

 

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Best Interest Standard of Care for Advisors #4

What Does “Best Interest” Mean? (Part 1)

I am writing two series of articles that together are called “The Bests.” One is about Best Practices for plan sponsors, while the other is about the Best Interest Standard of Care for advisors. Each series is numbered separately to make it easier to identify the subject that is most relevant to you.

This is the fourth of the series about the Best Interest Standard of Care.

“Best Interest” has become part of the American lexicon . . . as an aspirational goal or a demanding standard—depending on the point of view. But, what does best interest mean? It may mean different things to different people . . . and perhaps even to different regulators. However, I believe that most people would agree on the definition in this article.

As I read the guidance issued by the Department of Labor (DOL), the Securities and Exchange Commission (SEC), and New York State, there are actually two different best interests. The first is a standard of care and the second is a duty of loyalty. Of the two, the duty of loyalty is the easiest to define because, in all of the guidance it boils down to a requirement that an advisor cannot put his interest ahead of the investor’s.

The best interest duty of care is more complicated. The only agency that has offered a full definition is the DOL in its vacated Best Interest Contract Exemption. That definition was:

Investment advice is in the ‘‘Best Interest’’ of the Retirement Investor when the Adviser and Financial Institution providing the advice act with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor, without regard to the financial or other interests of the Adviser, Financial Institution or any Affiliate, Related Entity, or other party. [Emphasis added.]

 The SEC provided a partial definition in its proposed Regulation Best Interest, but the definition is, to a degree, circular:

 The best interest obligation . . . shall be satisfied if: The broker, dealer, or natural person who is an associated person of a broker or dealer, in making the recommendation exercises reasonable diligence, care, skill, and prudence to:… Have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks and rewards associated with the recommendation; . . . [Emphasis added.]

 New York State has adopted a best interest regulation for insurance and annuity products:

 The producer, or insurer where no producer is involved, acts in the best interest of the consumer when . . . the producer’s or insurer’s recommendation to the consumer reflects the care, skill, prudence, and diligence that a prudent person acting in a like capacity and familiar with such matters would use under the circumstances then prevailing.

If you look closely at the DOL’s best interest standard, you can see that it has three parts. The first is the requirement for a prudent process, that is, that the advisor act carefully, skillfully, diligently and prudently as a knowledgeable professional to develop the recommendation. The second is that the recommendation be based on the needs and circumstances of the investor, which in the case of ERISA, is the plan or participant. The third is a requirement that the advisor be loyal to the investor and not place his interest ahead of the investor’s.

The duty of care in the SEC’s proposed Reg BI and the New York standard also requires that an advisor exercise care, skill, diligence and prudence in developing a recommendation for an investor or, in the case of New York, an insured.

Because of the identical language in all three rules—the requirement to act with care, skill, diligence and prudence, it is likely that the three standards of care will be interpreted similarly. Since ERISA has a developed history through litigation and regulatory guidance, it would likely be the primary source for interpreting and applying that standard. Looking at the ERISA history, a careful, skillful, diligent and prudent advisor would engage in a thoughtful process to gather the information relevant to making a decision (that is, information that would be material to a knowledgeable person) and would then evaluate that information in light of the needs and circumstances of the investor. That process would be measured by the objective standard of a knowledgeable professional.

Stated differently, it appears that these best interest standards require that advisors engage in a thoughtful, professional process to obtain and evaluate the information needed to make a recommendation that is in the best interest of the investor. ERISA calls that a prudent process.

In a nutshell, the best interest standards are more demanding than the current suitability standards. That is particularly true of the weight to be given to costs and compensation. The SEC made that point in its discussion in Regulation Best Interest. However, I believe that it also increases the responsibility of advisors to consider the quality of the products and services being recommended, for example, the quality of the mutual fund managers and the financial stability of insurance companies.

To automatically receive these articles in your in box, you can sign up on my blog at http://fredreish.com/insight/. Just enter your name and email address under the “sign up for our e-newsletter” option, and click on the button to subscribe.

 The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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Best Practices for Plan Sponsors #4

What is the Baseline for A Committee to Act in the Best Interest of its Participants? (Part 3)

I am writing two series of articles that together are called “The Bests.” One is about Best Practices for plan sponsors, while the other is about the Best Interest Standard of Care for advisors. Each series is numbered separately to make it easier to identify the subject that is most relevant to you.

This is the fourth of the series about Best Practices for Plan Sponsors.

 In my last two posts (Best Practices for Plan Sponsors #2 and Best Practices for Plan Sponsors #3), I discuss the NYU case and the “bad” and “good” behavior of committee members. I concluded my last post with the point that process matters. Of course, it was unspoken that I was referring to a good process. This article discusses the fundamentals of a good process and the lessons learned from the NYU decision.

  • The NYU committee met quarterly.

There isn’t a prescribed timing for fiduciary meetings; the requirement is that plan fiduciaries, usually committee members, meet with the frequency necessary to properly do their job. Some aspects of the job, such as review of investments, may require more frequent meetings . . . at least annually, although quarterly would, under ordinary circumstances, clearly satisfy the requirement. An exception would be if a significant change occurred between meetings, for example, the sale of the mutual fund manager, the resignation of the mutual fund manager (where the fund was managed by a single manager), or other changes that could immediately impact an investment.

On the other hand, the monitoring of service providers may not require the same frequency. Absent extraordinary circumstances, annual reviews should ordinarily satisfy the fiduciary requirement (and, even there, it may not need to be that often). Of course, there are some exceptions for unusual events. One of those would be where an employer is receiving complaints from participants that, if valid, would raise concerns about the quality of the service provider, or the timely delivery of the services.

In any event, quarterly meetings are a reasonably good practice for risk management purposes.

  • The committee used an adviser with expertise with similar plans.

There is not a requirement that plan committees use advisers. Instead, it is a best practice. However, if committee members lack the expertise needed to prudently select and monitor a plan’s investments and to evaluate their expense ratios (including share classes), the committee members need to obtain that expertise from another source. Needless to say, good risk management dictates that the source be independent of the investments, in the sense that the source of information not be related to the mutual fund management company or to an organization that receives money from the mutual funds.

If an adviser has conflicts of interest, the committee has the added burden of identifying the conflicts and determining whether the participants will be adversely affected by those conflicts. It’s beyond the scope of this article to fully discuss the selection of advisers, but a starting point is that, when an adviser is paid directly by the plan or the employer, the potential of conflicts is reduced (and perhaps eliminated). On the other hand, where the adviser is paid from the investments, there is an obvious conflict, in the sense that the adviser is incentivized to recommend mutual funds or other investments that provide higher compensation. That’s not to say that all commissioned advisers (or other advisers who receive third party payments) will succumb to the conflicts. However, committee members need to know that they have a legal duty to understand and evaluate conflicts of interest.

  • The committee adopted and followed an investment policy statement.

There is not a legal requirement to have an investment policy statement (IPS). However, it is a best practice. A well-prepared IPS will describe the steps to be followed by a committee in evaluating the quality and costs of the investments. In effect, it will walk committee members through the process of investment selection and monitoring. As a part of that, the IPS should have specific criteria for different types of investments. However, at least in my view, an IPS should specifically state that the provisions are “guidelines” for the committee and that the expectation is that the committee will use its judgment and discretion, as opposed to strict adherence to the guidelines. That reflects my view that a qualitative analysis cannot always be defined by numbers and percentages. In fact, the court in the NYU case said the same, when it discussed the difficulty of benchmarking one of the investments.

These are important steps in a prudent process. However, the committee in the NYU case also made some mistakes. Based on the judge’s description, some of the committee members were not engaged and did not see themselves as being responsible for making fiduciary decisions. Instead, they viewed themselves as providing information and administrative services to the committee. Those people should not have been on the plan committee. Committee members should understand that they are fiduciaries and owe duties of prudence and loyalty to the participants. There is nothing wrong with having administrative personnel attend the meetings, but there is something wrong with a fiduciary that has a ministerial mindset.

The NYU case covered a number of issues, some of which are not discussed here. However, the discussions in this article, and the preceding two articles, are a primer for plan committee members. Advisers should help them understand the good and the bad of the NYU case.

To automatically receive these articles in your in box, you can sign up on my blog at http://fredreish.com/insight/. Just enter your name and email address under the “sign up for our e-newsletter” option, and click on the button to subscribe.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

 

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Best Practices for Plan Sponsors #3

What is the Baseline for A Committee to Act in the Best Interest of Its Participants? (Part 2)

I am writing two series of articles that together are called “The Bests.” One is about Best Practices for plan sponsors, while the other is about the Best Interest Standard of Care for advisors. Each series is numbered separately to make it easier to identify the subject that is most relevant to you.

This is the third of the series about Best Practices for Plan Sponsors.

This is my second article about the case of Sacerdote v. New York University. As I discussed in my last post, the Court’s opinion pointed out the deficiencies in the understandings and conduct of some committee members. However, the Court ultimately ruled in favor of the plan fiduciaries and against the plaintiffs. Why was that?

Despite the deficiencies (or “bad practices”) of some committee members, others on the committee were engaged and knowledgeable. Obviously, that was an important factor. However, there was more than that. The Court noted that “Between [the adviser’s] advice and the guidance of the more well-equipped Committee members . . . , the Court is persuaded that the Committee performed its role adequately.

In other words, while the involvement of the more informed and better engaged committee members was critical, the committee’s use of a knowledgeable adviser was also important. I can tell you that it was a well-regarded advisory firm with considerable expertise with retirement plans. It’s not clear that, absent the work of the adviser, NYU would have won the case.

One of the claims in the lawsuit was that NYU did not use RFPs as often as it should have. As explained by the Court, “Plaintiffs assert that more frequent RFP processes for both Plans would have exerted competitive pressure on recordkeeping vendors, resulting in either a reduction in fees by an existing vendor or a better deal altogether.” While there were a number of factors reviewed by the Court, one of the important ones was that the committee had successfully negotiated for reductions in recordkeeping fees. As explained by the Court, “In addition, plaintiffs ignore that over the course of several years, NYU’s recordkeeping fees consistently decreased as NYU obtained repeated rate reductions.

Plan committees should benchmark their service providers or issue RFPs on their service providers at appropriate intervals. But that begs the meaning of “appropriate intervals.” A common benchmark is for the costs of service providers to be reviewed every three years. However, the legal requirement is that the plan expenses for service providers be monitored at appropriate intervals. More precisely, that means that they should be monitored when a change in circumstances suggests that monitoring could result in lower costs for comparable services. That could occur as a plan grows or as the competitive marketplace reduces the expenses of service providers.

While the law does not require that committees select the lowest cost providers, committees should use RFPs, benchmarking, and negotiations to ensure that their plans are reasonably priced as compared to comparable plans (for example, plans of a similar size and with similar average account balances).

Another claim was that the committee failed, in its monitoring process, to remove two underperforming funds that allegedly had high fees and poor performance. The Court disagreed, noting that the plan’s adviser provided regular reports on the funds, that the committee discussed the funds at multiple meetings, and that the process was consistent with the plan’s investment policy statement. With regard to one fund – a real estate fund, the Court found that the structure of the fund was designed to be more conservative than a common REIT benchmark. In a sense, the Court concluded that a committee could prudently select a more conservative investment alternative, which might have a lower overall return, if the committee felt that it was appropriate for the plan and the participants.

The second fund was a widely-diversified equity fund including both domestic and international securities. The Court noted that it was “challenging to find an appropriate benchmark.” The Court then went on to say “The Committee focused on the difficulties with benchmarking that the [investment] presented due to its composition. It determined that, as a result of these benchmarking difficulties, the [investment] was one that warranted ‘specialized discussions.’ Such discussions occurred.

While the Court looked at a number of benchmarks, and considered other factors, it appears that the committee’s attention to the unique nature of the fund, the on-going discussions in that regard, and the assistance of the adviser were critical factors. The moral to this part of the story is that a given benchmark may not tell the whole story, and that committee discussions, with help from an investment adviser, can provide better insights than the use of a benchmark (and particularly of a benchmark that does not directly apply to the investment under consideration).

In reflecting on this decision, I have several thoughts. My next post will discuss those. For the moment, though, an important point is that committee processes really matter. Prudence is about the process. This decision confirms that. Committees should have robust discussions about plan investments, service providers, and expenses. The discussion should be documented in committee minutes.

All in all, this decision is a “laboratory” about fiduciary responsibility. There was good and bad, and both provide important information to advisers and committee members.

To automatically receive these articles in your in box, you can sign up on my blog at http://fredreish.com/insight/. Just enter your name and email address under the “sign up for our e-newsletter” option, and click on the button to subscribe.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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Best Interest Standard of Care for Advisors #2

I am writing two series of articles that together are called “The Bests.” One is about Best Practices for plan sponsors, while the other is about the Best Interest Standard of Care for advisors. Each series is numbered separately to make it easier to identify the subject that is most relevant to you.

This is the second of the series about the Best Interest Standard of Care.

In my last post, I discuss the remarkable similarities among the SEC’s proposed Regulation Best Interest, the SEC’s proposed Interpretation for investment advisors, the DOL’s Best Interest standard of care (which is a combination of ERISA’s prudent man rule and duty of loyalty), and the New York State Best Interest standard for sales of annuities and insurance products. All of those rules require that advisors act with care, skill, prudence and diligence, and that they place the interests of the investor ahead of their own.

In the first post, I conclude that the Best Interest standard requires the following:

  • A careful and skillful professional process measured by the objective standard of a knowledgeable and experienced advisor; and
  • A duty of loyalty to the investor.

This post discusses the type of process that would satisfy the Best Interest standard for all of those rules. However, since the process is not well defined (other than in guidance under ERISA), some of the suggestions in the post may, in fact, be Best Practices. Let me define that term. “Best Practices” means that the advisor is doing more than is required by the law. While Best Interest may be required, Best Practices is not; it is voluntary. As a result, Best Practices are for advisors who desire to excel, while Best Interest is for advisors who want to be compliant.

In my view, a combination of Best Interests and Best Practices suggests that advisors should use the following process:

  • Gather the information that is relevant to providing Best Interest advice. (“Relevant” means the information that is necessary to develop a recommendation that is appropriate for the investor. A synonym in this circumstance would be “material” information. If information about the needs and circumstances of the investor could affect the recommendation, then it is material and relevant).
  • Consider the types of investments (and insurance products) and strategies that are appropriate for the investor based on the analysis of the investor’s profile (that is, based on analysis of the relevant information). In effect, this step is the formulation of a strategy for the investor based on the products and services available to the advisor. While there may be some flexibility if the advisor only has access to limited types of products, that flexibility is limited, in the sense that any recommendation will still be measured by the Best Interest standard of care.
  • Select the particular investments, insurance products and services that will be recommended to the investor, that is, that will populate and implement the investment strategy. As the SEC said in its proposed guidance, while cost and compensation are not the only factors to be considered, their significance is enhanced under the SEC proposals. In other words, they are major considerations. Another obvious important consideration is the quality of the product. That includes the “management” of the product, for example, the investment advisor for a mutual fund, the investment manager for an investment service, and the insurance company issuing an annuity contract or life insurance policy.

I suspect that, if an advisor gets into trouble because of his or her recommendations, it will be the result of an inappropriate (and perhaps unsuitable) strategy, excessive costs and compensation, or inferior quality of the “manager” of the product.

That begs the question of, how does an advisor demonstrate a Best Interest process? Other than for the DOL and ERISA plans, there is not a requirement to maintain documentation of the process. However, it probably goes without saying that a well-documented process is good risk management (and, for that matter, that a well-documented process is likely to be a prudent process).

In the next year or two, the SEC may enhance its guidance to further define the processes that are needed to satisfy its Best Interest standard. More certainly, though, the SEC, FINRA, DOL and New York State regulators will, in due course—perhaps over the next three years or so—begin their enforcement activities. Unfortunately, it’s possible that we may see “regulation by enforcement,” meaning that the holes in the guidance are filled in by the enforcers, rather than the regulators.

To automatically receive these articles in your in box, you can sign up on my blog at http://fredreish.com/insight/. Just enter your name and email address under the “sign up for our e-newsletter” option, and click on the button to subscribe.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

 

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Best Interest Standard of Care for Advisors #1

What is the Best Interest Standard of Care?

I am writing two series of articles that together are called “The Bests.” One is about Best Practices for plan sponsors, while the other is about the Best Interest Standard of Care for advisors. Each series is numbered separately to make it easier to identify the subject that is most relevant to you.

This is the first of the series about the Best Interest Standard of Care.

For this inaugural article, let’s talk about the meaning of “Best Interest.”

There are at least four Best Interest standards. (While “best interest” can also refer to management of conflicts of interest, this article is about the best interest standard of care.)

  • ERISA’s best interest standard of care for plan sponsors and fiduciary advisors for private sector retirement plans. (While ERISA doesn’t literally have a best interest standard—because the Best Interest Contract Exemption was vacated by the 5th Circuit Court of Appeals, that best interest standard was a combination of ERISA’s prudent man rule and duty of loyalty which, of course, are still in the law. As a result, I will use the term to refer to the combination of ERISA’s prudent man rule and duty of loyalty.)
  • The SEC’s proposed best interest standard for broker-dealers in its Regulation Best Interest.
  • The best interest standard in the SEC’s proposed “Interpretation” for investment advisers.
  • The New York State Best Interest standard for recommendations of life insurance policies and annuity contracts.

Let’s look at how each of those are defined.

  • The ERISA Best Interest Standard for Retirement Plans (copied from the Best Interest Contract Exemption):

Investment advice is in the ‘‘Best Interest’’ of the Retirement Investor when the Adviser and Financial Institution providing the advice act with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims, based on the investment objectives, risk tolerance, financial circumstances, and needs of the Retirement Investor, without regard to the financial or other interests of the Adviser, Financial Institution or any Affiliate, Related Entity, or other party.

  • The SEC’s Proposed Best Interest Standard for Broker-Dealers:

The best interest obligation . . . shall be satisfied if: The broker, dealer, or natural person who is an associated person of a broker or dealer, in making the recommendation exercises reasonable diligence, care, skill, and prudence to:… Have a reasonable basis to believe that the recommendation is in the best interest of a particular retail customer based on that retail customer’s investment profile and the potential risks and rewards associated with the recommendation; . . .

A broker, dealer, or a natural person who is an associated person of a broker or dealer, when making a recommendation of any securities transaction or investment strategy involving securities to a retail customer, shall act in the best interest of the retail customer at the time the recommendation is made, without placing the financial or other interest of the broker, dealer, or natural person who is an associated person of a broker or dealer making the recommendation ahead of the interest of the retail customer.

  • The SEC’s Proposed Best Interest Standard for Investment Advisers:

The SEC proposal did not include a definition of best interest. However, the SEC proposal reaffirms that investment advisers are fiduciaries for their clients and includes the best interest standard as a part of the RIA fiduciary duty. It seems inconceivable that the best interest standard for investment advisers would be lower than that same standard for broker-dealers. And, since the SEC uses the same label—“best interest”—for both investment advisers and broker-dealers, the likelihood is that the standard is the same. (In some ways, though, those best interest rules are different, for example, the RIA best interest standard applies to a much wider range of advice and includes monitoring.)

  • The New York State Best Interest Standard:

The producer, or insurer where no producer is involved, acts in the best interest of the consumer when . . .

the producer’s or insurer’s recommendation to the consumer reflects the care, skill, prudence, and diligence that a prudent person acting in a like capacity and familiar with such matters would use under the circumstances then prevailing. Only the interests of the consumer shall be considered in making the recommendation. The producer’s receipt of compensation or other incentives permitted by the Insurance Law and the Insurance Regulations is permitted by this requirement provided that the amount of the compensation or the receipt of an incentive does not influence the recommendation; and . . .

I have highlighted language in each of the definitions. My purpose is to emphasize how similar the standards are. All of the Best Interest standards seem to require a process. That is, how can an advisor be careful, skillful, prudent and diligent without engaging in a process? In my view, there are several steps to that process. The first is determining the needs and circumstances of the investor; the second is evaluating the investment or insurance strategies in light of those needs; and the third is a consideration of the costs and quality of the investment and insurance products that are being considered. The gathering and analysis of that relevant information must be done carefully and skillfully based on a hypothetical knowledgeable and experienced advisor. In other words, the standard is not the ability of a particular advisor, but instead the industry expectations of professional advisors. The evaluation and performance of the advisor is based on that objective standard.

In addition, each of the definitions requires that an advisor place the interests of the investor ahead of the interests of the advisor. The Best Interest standard imposes a duty of loyalty on the advisor.

“Best Interest” does not mean that an advisor must pick the best investment or insurance product. However, it does impose a higher duty than suitability in the development of recommendations, and it may prove to be more demanding than many people expect. It does mean that quality and costs are more significant considerations than they are under the suitability standard.

To automatically receive these articles in your in box, you can sign up on my blog at http://fredreish.com/insight/. Just enter your name and email address under the “sign up for our e-newsletter” option, and click on the button to subscribe.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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Moving from Angles to Bests

Now that I have completed 100 articles about interesting Angles on birth –and death–of the DOL’s Fiduciary Rule, and the birth of an SEC best interest standard for broker-dealers and RIAs, I am going to start on a new series. The new series, rather than being titled “Angles,” will be called “The Bests.”

So, from now on, my articles—maybe the next 100—will focus on two “bests”—the SEC’s best interest standard and best practices for advisors and plan sponsors.

I figure that the SEC’s best interest rules will be developed and implemented over the next year or two, giving me a wealth of materials for new articles. But, I don’t want to be limited to that. I think that it’s important to talk about best practices for retirement plans and retiree investing and withdrawing, with a focus on helping participants to and through retirement—accumulation and decumulation.

With this introduction of the new series, the articles will begin after the Labor Day break.

Enjoy the dog days of summer . . . family vacations, baseball games and barbeques!

Fred Reish

To automatically receive these articles in your in box, you can sign up on my blog at http://fredreish.com/insight/. Just enter your name and email address under the “sign up for our e-newsletter” option, and click on the button to subscribe.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

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Interesting Angles on the DOL’s Fiduciary Rule #98

Regulation Best Interest: Consideration of Cost and Compensation

This is my 98th article about interesting observations concerning the Department of Labor’s fiduciary rule and the SEC’s “best interest” proposals.

The SEC’s Regulation Best Interest (Reg BI) proposes a number of major changes to the governance of broker-dealers. For example, it imposes a best interest standard of care on recommendations of securities transactions and it requires that material conflicts of interest involving financial incentives be eliminated or, alternatively, disclosed and mitigated. Based on the SEC’s examples of mitigation, it appears “real” mitigation is expected and not just existing practices with more disclosure.

There are other significant changes. For example, there is an increased focus on the costs and compensation related to recommended securities transactions and investment strategies. The SEC’s discussion explains that:

“[O]ur proposed interpretation of the Care Obligation would make the cost of the security or strategy, and any associated financial incentives, more important factors (of the many factors that should be considered) in understanding and analyzing whether to recommend a security or an investment strategy.” [Emphasis added.]

The SEC’s position is that both the costs of recommended securities or strategies and the associated compensation (that is, the financial incentives) will be more important factors than they have been in the past.

The SEC goes on to explain its position on costs:

“We preliminarily believe that, in order to meet its Care Obligation, when a broker-dealer recommends a more expensive security or investment strategy over another reasonably available alternative offered by the broker-dealer, the broker-dealer would need to have a reasonable basis to believe that the higher cost of the security or strategy is justified (and thus nevertheless in the retail customer’s best interest) based on other factors (e.g., the product’s or strategy’s investment objectives, characteristics (including any special or unusual features), liquidity, risks and potential benefits, volatility and likely performance in a variety of market and economic conditions), in light of the retail customer’s investment profile.” [Emphasis added.]

In addition, the SEC explained its position on compensation:

“When a broker-dealer recommends a more remunerative security or investment strategy over another reasonably available alternative offered by the broker-dealer, the broker-dealer would need to have a reasonable basis to believe that—putting aside the broker- dealer’s financial incentives—the recommendation was in the best interest of the retail customer based on the factors noted above, in light of the retail customer’s investment profile.”

The two quotes (which are together in a single paragraph in Reg BI) may appear to conflict with each other. However, they are consistent and coherent if they are interpreted as follows: a broker-dealer will need to justify recommending a higher-cost investment (over another reasonably available, but lower-cost alternative). However, if there are two similar investments (including costs), but one pays the broker-dealer (and the financial advisor), more than the other, and it is better for the investor, then it could be recommended under the best interest standard. The inverse of that, though, is that the higher cost (and higher compensating) alternative cannot be recommended unless there are different characteristics and features that justify the cost.

The SEC’s best interest will require that a broker-dealer be diligent, careful, skillful, and prudent—which suggests a process—and that the process result in an investment that is in the best interest of the investor, with a greater emphasis on cost and compensation.

For those of you who work with retirement plans, you will recognize that the process, and the factors to be considered, are similar to ERISA’s prudent process requirement.

The proposals under Reg BI are significant and will, if finalized, require changes in the operations, including supervision, of broker-dealers.

The views expressed in this article are the views of Fred Reish, and do not necessarily reflect the views of Drinker Biddle & Reath.

 

 

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