journal in the round august 31, 2016 why the fiduciary ... · 8/29/2016 · 8/29/2016 7 the...

8/29/2016

1

© 2016 fi360 Inc. All Rights Reserved. 1

Journal In the Round – August 31, 2016Why the Fiduciary Standard Exists

Blaine Aikin, AIFA®, CFA, CFP®

Executive Chairman, fi360, Inc.

www.fi360.com

[email protected]


Society Expects Fiduciary Conduct by Professional Advisors

…[W]e cannot do everything

ourselves; different people are more

capable in different matters.

…[I]n cases where we ourselves

cannot be present, the vicarious faith

of friends is substituted; and he who

impairs that confidence, attacks the

common bulwark of all men, and as far

as depends on him, disturbs the bonds

of society…

- Cicero, 106-43 BC, Oration for

Sextus Roscius of Ameria

http://www.fi360.com/

mailto:[email protected]

8/29/2016

2


Protecting Professional Standards

“A trustee is held to something stricter

than the morals of the market place. Not

honesty alone, but the punctilio of an

honor the most sensitive, is then the

standard of behavior.

… Uncompromising rigidity has been the

attitude of courts of equity when petitioned

to undermine the rule of undivided loyalty

by the “disintegrating erosion” of particular

exceptions. Only thus has the level of

conduct for fiduciaries been kept at a level

higher than that trodden by the crowd.”

‒ Supreme Court Justice Benjamin Cardozo,

Meinhard v. Salmon, 1929


The Problem of Economic Self-Interest

“The moral principle upon which the statute is based has its foundation in the Biblical admonition that no man may serve two masters…a maxim which is especially pertinent if one of the masters happens to be economic self-interest.”- Opinion of the U.S. Supreme Court delivered by Justice Warren in United States

versus Mississippi Valley Generating Company (1961) concerning fiduciary responsibility and conflicts of interest

* No one can serve two masters. Either you will hate the one and love the other, or you will be devoted to the one and despise the other. Matthew 6:24

8/29/2016

3


Pharmacist versus Physician

Pharmacist (non-fiduciary)

• Educates

• Fills Doctors’ prescriptions

• Provides generalized

answers: “You can take this

for that.”

Physician (fiduciary)

• Conducts examinations

• Diagnoses problems

• Prescribes products or

course of treatment specific

to the patient


Advice + Product Sales = Conflict

Questions to consider

1. What conflicts of interest

would exist?

2. Who would benefit from this

business model?

3. How might the quality of

medical advice be impacted?

4. How might society be

impacted?

5. What would be the likely

impact of this new occupation

on the reputations of medical

professionals generally?

6. Should professionals be able

to dispense advice and sell

products without fiduciary

accountability?

Pharmasician? What if pharmacists

could make medical diagnoses,

write prescriptions, and sell drugs

without fiduciary accountability?

8/29/2016

4


Most Conflicts are Financial

“Doctor who plunged hundreds of patients into

bankruptcy by falsely diagnosing cancer and giving

them unnecessary chemo is jailed for 45 years”

“Doctor at center of pill mill investigation arrested”


The Curious Erosion of Fiduciary Accountability in Financial Services

“Instead of ensuring that trusted advisers give prudent and unbiased advice in accordance with fiduciary norms, the current regulation erects a multi-part series of technical impediments to fiduciary responsibility.”— DOL Notice of Rulemaking, April 2015 referencing the 5-part test of ERISA fiduciary status

Section 202(a)(11)(C) of the Advisers Act excepts, from the definition, a broker or dealer ‘‘whose performance of [advisory] services is solely incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor.’’ — SEC 17 CFR Part 275 [Release Nos. 34–51523; IA–2376; File No. S7–25–99] RIN 3235–AH78

Certain Broker-Dealers Deemed Not To Be Investment Advisers

8/29/2016

5


Product Distributors Versus Advisers

• Product Distribution and Advice are different occupations, not simply different business models

• Product distributors are counterparties to a transaction.– Their reason for being is to maximize profitability while seeking to

satisfying customers’ buying interests

– Conflicted compensation is the norm

– Subject to rules of fair dealing

• Professional advisers are “trustees” of client assets– Their reason for being is to optimize client outcomes while they seek to

run a profitable and sustainable practice

– Conflicts, including conflicted compensation arrangements, are prohibited or must be mitigated in the best interest of the client

– Subject to the principles-based fiduciary standard


Unraveling Sales From Advice

• Firms that have been able to give advice without fiduciary accountability will have three choices:

1. Stop giving advice to focus exclusively on product manufacturing and distribution

2. Exit product manufacturing to operate as an advisory firm, or

3. Reconfigure internally to formally segregate the businesses, albeit under one roof in a house divided.

• Success depends upon how deeply they understand why the fiduciary standard exists and embed fiduciary principles, processes, and practices in the fabric of their business

8/29/2016

6


Fix the Foundation and Focus Higher

Individual

Professional Organizations

Employer

State Regulators

Federal Regulators (SEC, DOL., etc.) and Self-Regulatory Organizations (FINRA)

a think2perform program

Preparing for the Certainty of

Uncertainty under the New DOL

Rule

Doug Lennick

Chief Executive Officer, Founder

8/29/2016

7

The information in this presentation was compiled

from sources believed to be reliable for

informational purposes only. Any and all

information contained herein is not intended to

constitute legal advice, and thus you should

consult your own attorney regarding the

information contained herein and its applicability, if

at all, to your situation.

Department of Labor fiduciary standard ruling

© 2016 think2perform. All rights reserved.

Q: What was the annual performance of the

S&P 500 in the 20 years from 1996-2015?

a) 5.02%

b) 6.71%

c) 8.19%

d) 10.13%


Answer is c) 8.19%

Source: 2016 DALBAR Study: “Quantitative Analysis of Investor

Behavior”

Prepare yourself and your clients for the ‘certainty of uncertainty’

8/29/2016

8

Q:

A:

In the 20 years ending in 2015,

the average performance of an

equity fund investor was 5.6%.

FALSE – 4.67% - Investments work,

Investors don’t.

© 2016 think2perform. All rights

reserved.Source: 2016 DALBAR Study: “Quantitative Analysis of Investor Behavior”


Q:

A:


the annual performance of the

Barclays Aggregate Bond Index

was 5.34%.

TRUE




8/29/2016

9

Q:

A:


the average performance of

fixed income investors was

0.51%.

TRUE – Investments work, Investors

don’t




Q:

A:

Why does this happen?

Emotions



8/29/2016

10

What’s the value of your value?



in net returns

for your

clients3%“Putting a value on your value: Quantifying Vanguard Advisor’s Alpha, March 2014. Vanguard Research.

Business Results


Business

Results

Leadership

Effectiveness =

Macro-

economics

Business

Model ++


8/29/2016

11

DOL Survival Kit



Advice-based fees vs. transaction based fees or

fee-based advice1

Behavioral Financial Advice> Know your clients values and discuss them in

your client review

> Demonstrate empathy

> Utilize the 4Rs (Recognize, Reflect, Reframe,

Respond)

2

3

4 Smart Money Philosophy3

Actions now and going forward



Aggressively discount product related fees1

Shift product related fees to advice based

fees2

Implement the Smart Money Philosophy3

4

8/29/2016

12

Western Kentucky University

Gordon Ford College of Business

Dept. of Finance

KEY IMPACTS OF DOL FIDUCIARY RULES ON INDIVIDUAL FINANCIAL PLANNERS

Ron A. Rhoades, JD, CFP®Director, Financial Planning

ProgramAsst. Prof. – Finance

The views and opinions expressed herein are those of Ron A. Rhoades, only, and are not necessarily those of the Journal of Financial Planning, its editors, or any other institution, organization or firm with whom Ron A. Rhoades may be associated.

Duty of Loyalty

• Found in the “Impartial Conduct Standards” applicable to:– ERISA-covered QRPs– IRAs (including SIMPLEs, SEPs, Roths)

• Remain applicable if using:– Best Interests Contract Exemption– 84-24 Exemption (Fixed Rate Annuities)– Proprietary Products– Principal Trades

8/29/2016

13

• Contrasts: ERISA’s “sole interests” standard: no conflicts of interest are permitted.

• “Best Interests” standard adopted by DOL in the “exemptions”: Prove the client is not harmed.– The DOL noted that BICE’s “goal is not to wring out

every potential conflict, no matter how slight, but rather to ensure that Financial Institutions and Advisers put Retirement Investors’ interests first, take care to minimize incentives to act contrary to investors’ interests, and carefully police those conflicts that remain."

Impartial Conduct Standards: Loyalty

• Clients’ Best Interests Must Be Kept Paramount. – The advice must be provided “without regard to

financial or other interests of the Adviser, Financial Institution, or any Affiliate, Related Entity or any other party.

– Stated differently, “[t]he Adviser may not base his or her recommendations on the Adviser’s own financial interest in the transaction.”

• Incentives to Individual Advisers Prohibited. Financial Institutions must refrain from giving or using incentives for Advisers to act contrary to the customer’s best interest.


8/29/2016

14

• Product Manufacturer’s Interests NOT a Consideration. As to the use of the phrase “other party,” the DOL stated that it “intends the reference to make clear that an Adviser and Financial Institution operating within the Impartial Conduct Standards should not take into account the interests of any party other than the Retirement Investor – whether the other party is related to the Adviser or Financial Institution or not – in making a recommendation. For example, an entity that may be unrelated to the Adviser or Financial Institution but could still constitute an ‘other party,’ for these purposes, is the manufacturer of the investment product being recommended.”


Disclosure is Not a Defense! The DOL noted that

“full disclosure is not a defense to making an

imprudent recommendation or favoring one’s

own interests at the Retirement Investor’s

expense.”


8/29/2016

15

Impartial Conduct Standards: Loyalty• Cannot Favor Your Own Firm’s Profits. The DOL

provided a specific example of the application of these requirements: “[F]or example, an Adviser, in choosing between two investments, could not select an investment because it is better for the Adviser’s or Financial Institution’s bottom line, even though it is a worse choice for the Retirement Investor.”

• Close to the Sole Interests Standard! The DOL also cited several decisions addressing the requirements when a conflict of interest is present: “Donovan v. Bierwirth … the decisions of the fiduciary must be made with an eye single to the interests of the participants and beneficiaries.”

Impartial Conduct Standards: Due Care

DOL: “When providing investment advice

to the Retirement Investor, the Financial

Institution and the Adviser(s) provide

investment advice that is, at the time of

the recommendation, in the Best Interest

of the Retirement Investor … such advice

reflects 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….”

PRUDENT INVESTOR RULE: A trustee is under a duty “to invest and manage the funds of the trust as a prudent investor would, in light of the purposes, terms, distribution requirements, and other circumstances of the trust." Subsection (a) explains that “this standard requires the exercise of reasonable care, skill, and caution …”- RESTATEMENT (3RD)

OF TRUSTS

8/29/2016

16

• The prefatory note to ERISA states, in part: “the prudent investor rule [of ERISA] also bears on ... pension trusts [governed by ERISA] . . . [and] . . . absorbs trust-investment law [developed by the states] through the prudence standard of ERISA § 404(a)(1)(B).”

• John Langbein, the reporter for the Uniform Prudent Investor Act observed: "ERISA has always been interpreted with a strong eye on the common law, and it is therefore quite clear that the Uniform Prudent Investor Act will powerfully affect the federal courts in their interpretation of ERISA.”

Impartial Conduct Standards: Due Care

Impact of Academic Research

• Under the Prudent Investor Rule, the fiduciary may “incur only costs that are reasonable in amount and appropriate….”

• An overwhelming body of academic research reveals that higher fees and costs for mutual funds (and, by extension, to other products) results in lower returns to the investor

8/29/2016

17

Conclusions …

1. DOL’s Impartial Conduct Standards are very, very tough.

2. Investment firms who seek additional compensation under BICE should only do so if they offset the fees against other agreed-in-advance compensation.

HIGH RISKS exist. Difficult to prove additional

compensation is in client’s best interests.

DOL

3. Only “prudent” investment strategies should be employed in ERISA-covered DC plan accounts and IRAs (after 4/10/2017)

– Diversify, diversify, diversify

– Use only those investment strategies backed up by either: (1) extensive back-testing; (2) generally accepted academic research; or (3) very high review undertaken with intellectual rigor

– DOCUMENT investment strategy research – including strategies / asset classes you choose NOT to utilize

Conclusions …

8/29/2016

18

4. Investment product due diligence: pay close attention to “total fees and costs”:

- avoid 12b-1 fees- avoid commissions, surrender fees- no soft dollar compensation- no payment for shelf space- low annual expense ratios- low portfolio turnover

No-load, no 12b-1 fee, low-cost passively managed funds and ETFs in AUM/flat fee accounts become favored.Very low total cost actively managed strategies … the research remains unclear.

Conclusions …

5. Broker-dealer / insurance company / insurance marketing organization interests diverge from those of individual financial advisors

• Firms: may receive additional compensation under DOL BICE. If firm sued may view any liability as just a “cost of doing business”

• Individuals: cannot receive additional compensation (except to explain more complicated products). AND reputation –“my most valuable asset” – is at stake!”

Conclusions …

8/29/2016

19

6. If your BD firm / IMO is not demonstrating to you full adherence to DOL’s fiduciary duties ….

Conclusions …

journal in the round august 31, 2016 why the fiduciary ... · 8/29/2016 · 8/29/2016 7 the...

Documents