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.

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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 #5

What Does Best Interest Mean . . . In the Real World? (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 fifth of the series about the Best Interest Standard of Care.

My last article, Best Interest Standard of Care for Advisors #4, discussed different definitions of a “best interest” standard of care. The point of that article is that, while there may be slight differences in the wording, the rules converge to require that an advisor (and the advisor’s supervisory entity) act with care, skill, diligence and prudence to make recommendations that are in the best interest of the investor. This article discusses how the standard applies to specific circumstances.

As background, there are three parts to any best interest standard. The first is that the advisor engage in a process–carefully, skillfully, diligently and prudently–to develop the recommendation. That process is measured by an objective standard . . . what are the relevant factors that a knowledgeable professional advisor would consider and how would that hypothetical advisor evaluate those factors. The second is that the advisor act with loyalty to the investor. The advisor cannot put his interests ahead of the investor’s. The third is that the recommendation appropriately consider the investor’s profile (e.g., the needs and circumstances of the investor).

Let’s focus on the first part–the process and the relevant factors.

In its proposed Regulation Best Interest (Reg BI), the SEC said that its best interest standard for broker-dealers elevates (as compared to the suitability standard) the importance of costs. That is consistent with the fiduciary standard in ERISA’s prudent man rule. And, in my opinion, it is consistent with the fiduciary standard for registered investment advisers (RIAs). In other words, the new best interest “world” is placing greater emphasis on costs as a “relevant” factor for determining whether a recommendation satisfies that standard. Obviously, the requirement is that costs (and the impact of those costs on an investor’s returns), among other things, must be objectively and prudently considered (and given appropriate weight).

Using mutual funds as an example, that means that advisors need to make sure that the expense ratios of recommended mutual funds are reasonable. For example, the best interest standard would generally require that an advisor recommend the lowest cost share class of a mutual fund that is available to the advisor and the investor. Depending on the circumstances, that could mean a particular share class for one investor, but a different share class of the same mutual fund for another investor (for example, if a share class requires a threshold investment amount).

Here’s another example of the consideration of costs in a best interest process for different investors.

If a retail (e.g., IRA) investor’s time horizon is for the long term, e.g., for retirement investing, and therefore it is contemplated that the mutual fund could be held for decades, it is likely to be cheaper to use A shares with a front end load (as opposed to C shares). However, if an investor’s time horizon for holding a fund is short term, it will likely be less expensive to hold a C share. A “best interest” analysis requires that an advisor consider the investor’s needs and circumstances in determining which recommendation would result in a lower cost to the investor based on, among other things, the holding period. This point is not limited to considerations of A shares versus C shares. The issue is bigger than that—and involves careful consideration of costs, considering the alternatives, based on an investor’s needs, circumstances, investment horizon and other relevant factors.

Similarly, where an advisor is managing an account for an investor, it may or may not be in their investor’s best interest to choose NTF (No Transaction Fee) mutual funds. In that case, if the investor’s anticipated holding period is short term, the NTF funds will likely produce a lower cost and, therefore, may be in the best interest of the investor. However, if the investor anticipates holding the mutual funds for the long term, it would ordinarily be more cost-effective to pay a transaction fee, in exchange for a lower expense ratio.

Those are examples of how a “best interest” advisor would consider the “relevant” factors in developing a recommendation.

That’s it for this article . . . but my next post will discuss other best interest considerations.

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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 #5

Fiduciary Training: The Need for Basics

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 fifth of the series about Best Practices for Plan Sponsors.

In three earlier posts—Best Practices for Plan Sponsors #2, #3, and #4—about the Sacerdote v. New York University decision, I discussed the good and the bad of the NYU plan committee and made several suggestions about best practices for improving committee performance. This article focuses on one of those suggestions—fiduciary education for committee members.

As a starting point, there is not a legal requirement that committee members receive fiduciary training. Instead, it’s a best practice and good risk management.

But, what should the fiduciary education cover? Based on my analysis of court decisions on fiduciary responsibility, I am worried that fiduciaries may not be adequately educated about their basic responsibilities and particularly their administrative oversight duties. If you look at decisions, such as the NYU case, the issues are basic. For example, one of the defendants did not know if he was still a member of the committee. Another committee member didn’t believe that she was a fiduciary or that she had legal responsibility for the decisions made by the committee. Instead, she thought her role was ministerial, in terms of setting up the meetings and distributing information.

With that in mind, here are my thoughts about fiduciary education:

  • Review the summary plan description.

One of the techniques used by plaintiffs’ attorneys is to ask committee members about the provisions in the plan. What does the plan say about the responsibilities of the plan committee? Who appoints the plan committee? Who monitors the plan committee? What are the areas of responsibility for the committee members for oversight of the investments, the service providers, and the plan expenses?

Those questions and answers are basic to understanding the duties of a committee member. For example, committees are typically responsible for making sure that eligible employees are properly included in the plan, that compensation is calculated properly for determining contributions and benefits, that participant loans and hardship withdrawals are properly approved, and so on. While committee members are not responsible for doing the ministerial work related to those activities, they are responsible for overseeing that the work is done competently.

One approach—an easy one—is to review the summary plan description. I suggest that be done each year.

Also, it is helpful if the employees who are responsible for those activities, as well as representatives of the service providers, attend the meeting. They could explain how the responsibilities for plan administration are being fulfilled.

  • Investment Policy Statement.

Plaintiff’s attorneys will allege that the failure to follow the terms of an investment policy statement is a fiduciary breach. As a result, a plan’s adviser should review the investment policy statement with the committee members at least once a year. The committee members should ask questions about the concepts and terminology, so that they fully understand their responsibilities.

Here, again, plaintiff’s attorneys like to ask committee members about the investment line-up and about the type and purpose of the investments in the plan. Their goal is to show that the committee members didn’t understand what they were doing.

  • Hot topics for DOL investigations.

Obviously, committee members should know the areas of greatest concern for the Department of Labor. For many years now, the #1 issue for DOL investigations has been the late deposit of deferrals. Committee members should understand those rules, so that they can ensure that the company is properly forwarding deferrals.

A new DOL “hot topic” is whether plan fiduciaries are keeping track of missing participants. In some cases, DOL investigators are asserting fiduciary breaches due to the failure to make earnest and ongoing efforts to locate missing participants. That problem becomes particularly acute when missing participants reach age 70½ and must be paid their required minimum distributions. (Note that relief from disqualification and penalties is provided where committee members, as fiduciaries, have made diligent and good faith efforts to fund missing participants and to pay the required minimum distributions. That will be the subject of a future post.)

  • Plan expenses.

It shouldn’t come as any surprise that most fiduciary litigation is based on overly expensive investments and on excessive compensation to recordkeepers.

In other words, almost all ERISA fiduciary breach litigation—once you take out company stock and proprietary investments—is quantitative, rather than qualitative. By “quantitative,” I am referring to the amount of money that is paid as expense ratios for mutual funds, and the amount of money that is paid, directly or indirectly, to plan recordkeepers.

Regarding expense ratios of plan investments, one type of claim is that the plan should have chosen a less expense share class. Essentially, that was the issue in Tibble v. Edison. In that case, even though the prospectuses had minimums for certain share classes, the expert witnesses testified that, if requested, retirement plans would be allowed to invest in a less expensive, institutional share class. In effect, the court created a “duty to ask.”

In some cases, though, the issue is more simple . . . the allegation is that the committee selected investments that were too expensive, even if the right share class was picked.

In both cases, the solution is to work with an adviser that is knowledgeable about share classes available to plans of different sizes and that has information about what expense ratios are too high. It’s possible that committee members could investigate on their own, but that’s a risky proposition, since most committee members lack the fundamental knowledge to properly apply general information to their specific circumstances.

With regard to excessive costs and compensation for recordkeepers, plan committees should consider using benchmarking services. Recordkeeping expenses can vary dramatically depending on the assets in a plan and the number of participants. Benchmarking services provide a cost-efficient way to obtain the necessary data. On the other hand, requests for proposals and requests for information are also good ways to get information about costs, particularly if the requests are sent to recordkeepers who focus on plans that are similar to the plan sponsors. However, RFPs and RFIs are expensive and time consuming. As a result, most plan committees and advisers opt to use benchmarking services.

How often should a plan be benchmarked? A general rule of thumb is every three years, unless there’s been a significant change in the interim, for example, a plan merger. However, it is a good practice to do it every year or two to keep the issue in front of the plan committee and to make sure that there is an ongoing discussion about the importance of monitoring fees and expenses.

Those are some of the key issues that should be covered in fiduciary education. I suspect that some of my suggestions are different than what is commonly done. However, based on my review of ERISA litigation and DOL investigations, the topics in this article should be at or near the top of the list.

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 #3

SEC Best Interests . . . When? And What About the DOL

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 the Best Interest Standard of Care.

The Regulatory Agendas for the SEC and DOL were recently issued. Both have plans for guidance by September of 2019, but the anticipated timing of the guidance has, by and large, been misinterpreted. To understand what I mean, read on.

The SEC’s Agenda said that Final Action on the Regulation Best Interest proposal for broker-dealers and the Interpretation of Standard of Conduct for investment advisers would be “09/00/2019.”

Similarly, the Department of Labor Agenda said that there would be a final rule on the “Fiduciary Rule and Prohibited Transaction Exemptions” with the date of “09/00/2019.”

Let’s start with the dates. For those inclined towards conspiracy theories, it was interpreted to mean that the DOL and SEC were conspiring to issue combined and comprehensive new fiduciary/best interest rules. But, that doesn’t make any sense. While the two regulators are certainly communicating with each other, that doesn’t mean that there is behind-the-scenes plotting and planning.

Another interpretation was that the SEC and DOL were both going to issue guidance in September 2019. But that’s not right either. This is the short term agenda for the government fiscal year that ends in September, 2019. The September dates just mean that both regulators are planning on getting out their guidance during the upcoming government fiscal year.

Here’s my bet on what the dates will really be. Based on meetings with the SEC, it appears that Reg BI and the RIA Interpretation are moving along towards completion. That probably means that the final rules will be completed near the end of the first quarter or early in the second quarter of 2019. There will then be a delayed implementation date. That could be January 1, 2020, or even later, e.g., one year after the final rule is published.

As a word of warning, though, the SEC takes the position that most of the guidance in the RIA Interpretation reflects the Commission’s view of the current requirements for RIAs. There are only three true proposals in the Interpretation and none of those deal with the standard of care.

What about the DOL? I believe that the DOL’s guidance will be sequential rather than concurrent. By that I mean that the DOL’s guidance will probably be, to a large degree, based on the SEC’s final rules. As a result, their guidance will follow the SEC’s, rather than being released at the same time.

I think the DOL guidance will, at the least, include a new class exemption to cover prohibited transactions resulting from nondiscretionary fiduciary investment advice. It would replace the joint DOL/IRS non-enforcement policy (Field Assistance Bulletin 2018-02). My best guess is that it would include, as some of its conditions, compliance with parts of Reg BI and perhaps even the RIA Interpretation. But, I think that it will also include the Impartial Conduct Standards, that is, adhering to the DOL’s best interest standard, receiving no more than reasonable compensation, and making no materially misleading statements.

It’s less clear what the DOL plans to do about the fiduciary rule. There may be nothing. On the other hand, there may be some tinkering, for example, saying that a fiduciary under the securities law is also a fiduciary under ERISA. That would obviously cover RIAs. However, I don’t see any possibility that the Department would re-propose the vacated Fiduciary Rule or anything close to it.

Caveat: The future in unknowable. The educated guesses in this article are just that . . . “guesses.” But they are educated by experience and information. Don’t take them to the bank, but don’t toss them out either.

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 Practices for Plan Sponsors #2

What is the Baseline for A Committee to Act in the Best Interest of Its Participants? (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 second of the series about Best Practices for Plan Sponsors.

The recent decision in the case of Sacerdote v. New York University is a classic story of the good and bad of plan committees. Let’s start with the bad.

Five current and former committee members testified at the trial. But not all of the testimony was helpful.

In the opinion, the Court said that the testimony of one of the co-chairs “was concerning.” The court went on to say:

She made it clear that she viewed her role as primarily concerned with scheduling, paper movement, and logistics; she displayed a surprising lack of in-depth knowledge concerning the financial aspects of managing a multi-billion-dollar pension portfolio and a lack of true appreciation for the significance of her role as a fiduciary. In a number of instances, she appeared to believe it was sufficient for her to have relied rather blindly on [the investment advisor’s] expertise. As a matter of law, blind reliance is inappropriate.

The court further noted that:

She bluntly testified that “[i]t’s not my job to determine whether the fees are appropriate” for the Plans.

With regard to another committee member, the court said that she “was similarly unfamiliar with the basic concepts relating to the Plan, such as who fulfilled the role of administrator for the Faculty Plan. When asked about her inability to remember Plan details, [the committee member] responded that she has a ‘big job’ (referring to her human resources role, not her Committee membership) and her role on the Committee is one of many responsibilities she has. This suggested that [the committee member] does not view herself as having adequate time to serve effectively on the Committee.”

The court also said, about another committee member, “that he did not even know whether he was, at the time of the trial (in April 2018), still a member of the Committee—and thus whether he bore a fiduciary responsibility to thousands of NYU participants.”

And, finally, the court said “Several Committee members stated that they did not independently seek to verify the quality of ‘investment advisors’ advice; rather, they simply relied on it.”

If this were the end of the story, this article would be about bad practices, rather than best practices. However, there is more.

The court went on to say: “While the Court finds the level of involvement and seriousness with which several Committee members treated their fiduciary duty troubling, it does not find that this rose to a level of failure to fulfill fiduciary obligations.”

How is that possible?

Sadly, I will leave you hanging for a week, until I post Part 2 of this article. However, I don’t want you to be disappointed. So, let me give you a preview. There were other committee members, some of whom were fairly sophisticated and very engaged. However, there is even more than that. The court noted two or three other steps taken by the committee that saved NYU and the committee members from a litigation disaster. My next article will cover that.

POSTSCRIPT: One lesson from this case, independent of the committee actions that saved the day for NYU, is that committees should have formal programs for fiduciary education. The fiduciary education should cover, at the least: Who is a fiduciary and what are the fiduciary responsibilities? How do fiduciaries fulfill those duties in the real world? How do fiduciaries review and examine the advice that they receive? And, how do fiduciaries monitor the costs and compensation related to their service providers and plan investments? That education should be reinforced at least annually, together with updates on current developments. Finally, new committee members should be educated about their roles and responsibilities when they start serving.

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 #1

Best Practices for Plan Sponsors: Projection of Retirement Income

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 Best Practices for Plan Sponsors.

“Best Practice” is above and beyond the legal requirements. Best Practices are not mandated; they are elected.

While the most obvious Best Practices are automatic enrollment and automatic deferral increases, I want to start with the projection of retirement income for participants. That’s partially because it is in a current legislative proposal—in the Retirement Enhancement and Savings Act (RESA), and also because, in my opinion, it doesn’t receive the attention that it deserves.

Under current rules, participants in 401(k) plans receive quarterly reports of the balances and the investments in their accounts. While that is important information, it is only part of the story. Let me explain what I mean.

An account balance is a statement of wealth. It is a snapshot of how much money is in the participant’s account at a given point in time. However, it does not provide the most important information, which is whether the participant is on course to have a financially secure retirement. To provide that information, participants need projections of retirement income and “gap analysis.” A projection of retirement income would tell a participant how much their current behavior—including account balance and deferral rate—will provide as retirement income. Then, gap analysis could be automatically provided to participants. Gap analysis provides a benchmark for retirement adequacy (for example, a 70% income replacement ratio); whether the projected income is at that level or not; and, if the projection is lower than the benchmark, the analysis suggests a deferral increase to close the “gap.”

Some people object to retirement income projections because they might be inaccurate. We need to get beyond that. Let’s just accept that the projections will be inaccurate, since they are based on actuarial assumptions, which are educated guesses about the future. But, let’s also agree that the projections will be directionally correct. In other words, the projections will provide valuable information to participants about whether they are saving enough to reach their goals. And, since the projections will be updated every year, participants can make adjustments along the way based on updated information.

On the subject of actuarial assumptions, let’s also agree that the typical participant doesn’t know how to do actuarial calculations and may not even know what assumptions to use. For example, retirement income projections involve assumptions about retirement age, investment earning rates, inflation, and so on. Providers and plan sponsors are, generally speaking, in a much better position to be able to determine which assumptions are reasonable for those purposes. (Incidentally, RESA proposes to create a fiduciary safe harbor for retirement income projections—and the Department of Labor is directed to provide the assumptions to be used.)

Others may argue that calculators are available on websites to enable participants to generate retirement income projections. While that is true, the reality is that participants haven’t, by and large, used those calculators. While some might argue that participants have that responsibility, I am not of that school of thought. I agree that people should be responsible for themselves. But, I don’t agree that we should continue to rely on services that aren’t working. Let’s do things that work, rather than taking dogmatic approaches.

So, my view of the future is that, if retirement income projections and gap analysis are offered to participants, with annual updates, we will have better outcomes . . . because participants will be empowered to make smarter decisions about deferral rates, investing, retirement ages, and so on.

While retirement income projections are not mandated at this time, most providers offer that service. In fact, some have offered them for years and have done so successfully . . . particularly in the 403(b) area. As a result, sponsors have the opportunity to voluntarily provide that service to participants, and advisors have the opportunity to educate plan sponsors about the availability and importance of that service. Those are Best Practices.

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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